Trust and Ethics in Finance
A new book compiles innovative ideas from the Robin Cosgrove Prize.
PREFACE, by John Plender
Has the business community lost the ethical plot? Over the past two decades successive boom and bust cycles have thrown up extraordinary examples of ethical failure. First, the dot.com era in the United States produced scandals at Enron, WorldCom, Tyco International, Qwest, HealthSouth and sundry others. Andersen, one of the big five global audit firms, disintegrated when the U.S. Department of Justice investigated its audit failures at Enron.
In the first decade of the new millennium Europe saw fraud at Parmalat, where the U.S. and European investment banks turned out to have connived in concealing the Italian dairy company's dire financial plight. Royal Dutch Shell, once regarded as a beacon of ethical solidity, was found to have cooked the books by inflating its production reserves. Volkswagen was beset by charges of bribery and corruption, while Siemens ran into trouble with the U.S. Foreign Corrupt Practices Act.
Then in the protracted financial crisis that began in 2007 the behavior of U.S. banks in the subprime mortgage market was shown to have been outrageously rapacious towards borrowers, while retail banking in Europe was marred by a succession of mis-selling scandals—the financial world's pet euphemism for ripoffs. Fraud charges have been brought against senior executives of Fannie Mae and Freddie Mac, the big U.S. semi-official mortgage institutions. Goldman Sachs, the world's preeminent investment bank, has been exposed by a departing senior executive in an article in the New York Times as being hell-bent on fleecing its clients, which Goldman bankers referred to as muppets. It had earlier paid $550 million to settle a case brought by the Securities and Exchange Commission for misleading investors without admitting or denying wrongdoing.
In China the falsification of company accounts has turned into an epidemic, leaving auditors unable to form an opinion. The Japanese company Olympus provided one more example of concealment of losses. All of this took place against the background of top executives' pay spiraling to unprecedented levels regardless of corporate performance. In banking the bonuses continued even after the banks were the recipients of the greatest bailout in financial history. Finance was at the epicenter of ethical failure.Incentive structures are at odds with the requirements of decent ethics.
It has to be acknowledged, then, that the environment into which the Robin Cosgrove prize for innovative ideas in finance was launched was more than a little challenging. How can this be rationalized? Some argue that these ethical aberrations were simply a reflection of the business cycle. When times are good and share prices soar, ethical standards tend to drop as people become greedy and succumb to temptation. When companies fail in the bad times and fraud is exposed, moral standards are reemphasized. Yet there is surely more to it than that.
I would argue that there has been a secular decline in ethical standards. In part this stems from the change from a world of heavily regulated and cartelized markets, in which managers enjoyed paternalistic power with relatively little accountability, to one of liberalized markets in which greater emphasis is placed on shareholder value. Chief executives are now in a capital-market pressure cooker, with fund managers and analysts becoming ever more vocal in their demands for value. Their definition of value is narrowly financial. Together with the requirement for quarterly reporting, this has bred a hitting-the-numbers culture, with attendant temptations for executives to cook the books to meet capital market demands.
This spur to short-termism has been compounded by the growth of performance-related or equity-type incentives, whether in the form of conventional bonuses or stock option rewards. The metrics used to calculate these performance-related rewards are mainly such crude yardsticks as total shareholder return and earnings per share, usually measured over absurdly short time periods. The accounting numbers in the calculation are, to a degree, manipulable. The result is that incentive structures are at odds with the requirements of decent ethics. When that is the case, it is inevitable that ethics will sometimes become the casualty.
The problem of short-termism has been compounded in finance by the growing opacity and complexity of markets, notably the over-the-counter markets in derivatives and structured products. Also by the ascendancy of traders over corporate financiers and commercial bankers in the banking hierarchy. A transactional culture now prevails. On the trading floors, many regard themselves as hired guns, borrowing the capital of the bank to support their individualistic pursuit of personal profit. Loyalty to the organization is minimal. The culture of the trading floor owes more to the animal kingdom than to the fiduciary ethos that used to be seen as central to the workings of finance.
Equally problematic are the assumptions of economics and of modern finance theory, which put heavy emphasis on the behavior of "rational" agents who seek to maximize their own welfare through opportunistic behavior. The pursuit of material wealth is assumed to be the justification for individual and group behavior. For anyone lacking much of a moral conscience this amounts to an implicit ethical—or rather, unethical—agenda, given that acting other than opportunistically is perceived as irrational.
Much of the response to the scandals referred to earlier has been in the form of increased regulation. An ethics industry has grown up, with myriad ethics courses appearing in business schools and countless consultants devising ethics codes for large corporations. People at the top of the corporation have thus outsourced ethics. An internal market has thus developed to shift moral responsibility around the organization. All of this has spawned a culture of compliance and done nothing to prevent a plethora of corporate scandals and ethical lapses. Few are convinced by the statements of ethical principles produced by large corporations, still less by investment banks. So what can be done to address the ethical deficit in business and finance?Bad behavior erodes trust and forces people to place heavier reliance on law and regulation.
The progenitors of the Robin Cosgrove prize rightly perceived a need to raise consciousness about the advantages of an ethical culture in finance. And one of the themes that emerge repeatedly throughout the essays in this book is the economic and social value of trust, whether in economies, markets or corporations. Trust is particularly important in financial markets. This becomes obvious if a comparison is made between financial and retail activity. With food, drink and clothes, consumers are quick to detect poor quality and will take their custom elsewhere. In contrast, many retail financial decisions are infrequent. People often make a decision on their pension only when they join the pension scheme and when they are preparing to leave it. By the time you discover you have made a mistake with a pension, a mortgage or car loan, it may be too late to do much about it. This makes it harder for the financial markets to identify rogues than in other industries. It is a sad fact that financial institutions that engage in widespread mis-selling rarely go out of business. They may be fined by the regulatory authorities. But senior management often regards the fines, which anyway fall on shareholders rather than managers, as an operating cost of the business.
This has bred a serious loss of confidence among the public about banking and finance. Against the background of excessive boardroom pay, the legitimacy of wealth creation and of the Western forms of capitalism is increasingly questioned. That underlines the importance of the Robin Cosgrove prize agenda. And the good new is that the environment for that agenda is not uniformly hostile. Many business people now recognize that companies and financial institutions operate in the social system and that their activities have social consequences. They also grasp that in running a business most decisions cannot be taken on the basis of a pure economic calculus and that simply complying with the law is not enough.
I would argue that ethics provide a complement to the internal constitution of the company that sets out the objects and rules for the conduct of the company's business. Likewise that the contract between management and shareholders is necessarily incomplete: Shareholders cannot be expected to sanction each and every decision taken by operational management. In fact, most shareholders—and not just ethical investment funds—would wish management to avoid making the maximum possible profit if, for example, this entailed abuses of human rights. To give just one illustration, how many pension scheme beneficiaries would be happy to profit from financing the building of a pipeline in Myanmar with forced labor? There are occasions when management has to make its best judgment of shareholders' views and allow ethics to trump a narrow profit-maximizing course of action.
A reading of the essays that follow encourages the view that trust in business and finance is vital. It creates social capital that facilitates cooperative behavior both in society and in organizations. Bad behavior erodes trust and forces people to place heavier reliance on the law and regulation. And the more transactions have to be governed by contract, the more cumbersome and expensive business and finance become, as everything has to be negotiated, agreed, litigated, and enforced. Such legalism, as a substitute for trust, gives rise to what economists call transaction costs. At a social level, according to the American thinker Francis Fukuyama, a lack of trust imposes a kind of tax on all forms of economic activity. At the corporate level, I would add, trust is an informal, low-cost substitute for cumbersome internal controls within the company and external regulation without. In an ethical culture everyone knows they can do the right thing decisively and with confidence. The business will tend to attract high caliber people of principle. Relations with customers and the general public will be enhanced.
The recent protests against capitalism and inequality in New York, London, and elsewhere have underlined the public dissatisfaction with the response to the financial crisis. We have learned from experience that it is not possible to regulate people into good behavior. In that sense, the Robin Cosgrove essays are an alternative agenda. If they help persuade their readers that trust matters and that the workplace is not morally neutral territory where it is acceptable to shed personal morality as they walk through the company's doors, they will have achieved something of real value.
TABLE OF CONTENTS
Part I: Beyond Compliance
1 Ethics: A Diet for Highly Leveraged Financial Markets
2 Ethical Cash Management? A Possible Solution
3 Ethics and Order in the Disorderly World of Finance
Elise Pellerin and Marie Casimiro
4 Ethics or Bust: Beyond Compliance and Good Marketing
5 Ethics: The Key to Credibility
6 Emotions, Personal Ethics and Professional Life:
The Lost Link
7 The Financial Sector and the Behaviour of People:
What to Do?
Carlos Eduardo Estapé Viana
8 Decision: The space between the Code of Ethics and
Carmen Lucia Carmona Paredes
9 Ethics: Essential Prerequisite of the Financial System
Part II: Standards and Values
10 Social Impact Ratings: How to Make Responsible
Jonathan M. Wisebrod
11 The Reconciliation of Finance and Ethics: Integrating
the Interior and Exterior Dimensions of Reality
12 Financial Derivatives and Responsibility: How to
Deal Ethically with Financial Risk
13 Internationalism, Institutions and Individuals:
Systemic Changes for a Systemic Ethical Crisis
14 Accountability and the Second Line of Defence
Immaculate Dadiso Motsi-Omoijiada
15 Redefining Capitalism: An Ethical Rating and its
Contribution to Development
16 When Small Companies Dabble in Disinformation
Part III: Solidarity and Sustainability
17 Solidarity Finance and the Democratisation of Money
18 Ethics vs Finance? An analysis of the Origins, Problems
and Future Perspectives of this Relationship
Bruno Federico Fernández
19 In Search of Honesty and Altruism
Raina Abdul Rahim Mousa
20 Microfinance: Getting Money to the Poor or Making
Money out of the Poor?
Joy Mueni Maina Kiiru
21 The South and Carbon Dioxide: Every Cloud has
a Silver Lining
Jem Bendell and Inderpreet Chawla
22 Investing as if People and Planet Mattered
23 Virtuous Enterprises: The Place of Christian Ethics
Jan Thomas Otte
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