All You Need to Know about Ethics and Finance

Citation

Cornford, A. (2008), "All You Need to Know about Ethics and Finance", Journal of Financial Regulation and Compliance, Vol. 16 No. 1, pp. 120-124. https://doi.org/10.1108/13581980810853280

The principal objective of this highly topical guide to ethical behavior for economic actors in finance is to get people to think for themselves about what constitutes ethical behavior in situations often confronted in business and finance. The text is readable and well organized: each chapter is prefaced by a summary, and most conclude with a checklist of relevant ethical questions which economic actors should ask themselves. These features should make the book especially useful for teaching, and the prominence accorded on the title page to “2007/8 edition” suggests that the authors intend regular updates.

The discussion of moral foundations and the culture of the financial sector is largely limited to that needed for the guidance which Persaud and Plender provide. While this limitation is understandable in the light of the book's main objective, it leads to some questionable omissions and sits uneasily with the “All you need to know” of the title.

The subjects covered include many of particular interest to specialists in financial regulation. Chapters concerning behavior within firms cover the failure of stockbrokers, money managers and financial advisers to fulfil their fiduciary responsibilities; mis‐selling of investment products to retail clients; trading which threatens the integrity of markets in particular financial instruments; creative accounting; and tax avoidance. Other chapters take up external scrutiny of financial systems' functioning by the parties sometimes described as the systems' gatekeepers or watchdogs. Here, the coverage comprises bankers, consultants, financial analysts, and regulators.

Under fiduciary responsibilities the authors take up misconduct on the part of mutual funds and the potential for conflicts of interest created by the rolling‐back of the regulatory framework in the USA established after the crash of the stock market in 1929. On the mis‐selling of investment products to retail clients they note that the consequences have included not only large fines for banks and insurance companies but also widespread erosion of public confidence in suppliers of financial services.

The example used to illustrate trading threatening the integrity of particular markets is Citibank's “Dr Evil” trade of August 2004 which was designed to exploit weaknesses in the Italian‐based MTS electronic bond market by overwhelming it with sell orders during a short period of less than a minute. Citibank was eventually fined by the Financial Services Authority but, in spite of the transactions' apparent inconsistency with the adherence to the highest business standards proclaimed in 2003 by the incoming CEO, Chuck Prince, no traders were fired.

The subject of creative accounting is taken up in the context of the pressures exerted by the dependence of the Anglo‐American model of capitalism on the evaluation of performance by financial markets and the reliance of bonus and incentive schemes for senior management on share prices. Issues related to tax avoidance are exemplified by the mass marketing by the auditing firm, KPMG, of tax shelters involving artificial share and loan transactions. This was to lead to payment of USD 456 million in fines, restitution and penalties as part of a deal with the authorities as well as to criminal prosecution for tax fraud of KPMG's former deputy chairman and six other former partners.

Much of the discussion of the failures of financial sector's private‐sector gatekeepers or watchdogs concerns the role they played in recent corporate scandals with the emphasis on performance shortcomings linked to pressures associated with the stock‐market boom of the 1990s. In the case of auditors the authors draw attention to the much discussed changes in the business model of the big auditing firms since the 1980s toward that of global financial advisory conglomerates. This model increased exposure to conflicts of interest due to the pressures on the firms to sell their clients a wide range of management‐consulting, actuarial, human‐resource, legal and other services in addition to auditing. The authors also draw attention to evidence from psychological research which points to an “illusion of objectivity” amongst auditors leading to reluctance to acknowledge that their willingness to accept dubious accounting practices varies according to whether or not they are employed by the company involved.

In view of their position at the centre of recent debate about fiduciary responsibilities, transparency and tax avoidance in financial markets, derivatives and financial innovation more generally might have been treated at greater length. Over‐the‐counter (OTC) derivatives can be designed to change the timing or other characteristics of payments to reduce tax liability. Their potential for enabling avoidance of satisfactory standards of transparency for regulators and investors is a recurring theme of the literature and was an important part of the Enron scandal. Moreover, OTC derivatives have been the subject of high‐profile legal cases where a major issue was fiduciary obligations. OTC derivatives also pose questions concerning fair dealing between market professionals, a subject to which Persaud and Plender devote little explicit attention[1].

Under regulation the authors discuss capture of the regulators by the institutions which they are supposed to regulate. Here, they take the Basel 2 process as an example, alleging that the Basel Committee on Banking Supervision (BCBS) was captured by big banks – i.e. the large international banks of industrial countries – in developing the new rules. This is a charge of special interest to readers of this journal. The authors' argument draws attention to such features of the outcome of the process as the complexity of Basel 2's rules, their dependence on large computer models for monitoring credit risk and for opportunities to reduce capital charges, and the failure to allow for the fact that systemic risk – in the authors' view the most important concern of financial regulators – is largest for big banks.

However, while it was inevitable that efforts by big banks to influence the Basel 2 negotiations would leave their mark, the authors' characterization is s a partial account of the many inputs to the process. Basel 2 may not resemble the set of rules consistent with one view (shared by the authors) of the best way to achieve its objectives. But focusing on this is to abstract from the multiple pressures from different sources – many of them admittedly with a potential for having distorting effects on the outcome – which inevitably accompany multilateral economic negotiations. The shape and limitations of the IMF and the GATT/WTO, for example, reflect no less the imprint of the corporate sector and other lobbies.

Still the influence of big banks on Basel 2 is an interesting question, which may eventually benefit from greater disclosure by those who actually participated in the process of drafting it. Arguably banks' greatest success in their efforts to influence international initiatives on capital adequacy involved Basel 1 when, in reaction to the rigid rules for setting minimum regulatory capital for market risk proposed by the BCBS in 1993, industry pressure led to the incorporation of the endorsement of banks' in‐house models in the 1996 Market Risk Amendment as well as to the eventual inclusion of a similar approach in the capital adequacy regulation of the EU.

The usual explanations for the initiation of the Basel 2 process seem consistent with currently available information: perverse incentives to regulatory arbitrage created by a calibration of credit risk in Basel 1 in which riskier but more profitable loans were not associated with higher minimum regulatory capital charges; the need for new rules to take account of techniques resulting from financial innovation since the adoption of Basel 1; and the lack of internationally agreed rules for securitization exposures which were rapidly increasing in importance.

Pressure from big banks for permission to rely on their internal systems for monitoring credit risk in the setting of capital charges no doubt influenced the decision to start the Basel 2 process and contributed to the incorporation of internal ratings‐based approaches in the rules adopted. But the BCBS went only part of the way towards allowing banks to use their internal systems owing to its belief that data on credit risk and models for measuring it were not yet sufficiently reliable for greater reliance.

Moreover, the consultations and revisions which followed the publication in 2001 of the massive first draft of Basel 2 led to changes likely to favour smaller banks. Of special importance were the replacement of the all‐or‐nothing rules of the 2001 draft for the adoption of the more advanced approaches to measuring capital adequacy (which would lead to the greatest reductions in capital charges in comparison with Basel 1) by rules accommodating partial adoption, and the inclusion of special provisions designed to lower capital charges for lending to SMEs.

Statistical exercises conducted by the BCBS itself as well by national authorities and the EU suggest (though for various reasons not conclusively) that the greater flexibility afforded by revisions since 2001 will go some way towards reducing advantages to big banks of the different options of Basel 2. Much will eventually depend on how regulators in different countries apply the Basel 2 rules, in particular which of its options for the measurement of risk they authorize in their jurisdictions.

Available information on plans for the introduction of Basel 2 in a large number of countries indicates considerable variation in regulatory approaches as well as in timetables for introduction[2]. An important part of the work of the BCBS (through its Accord Implementation Group) is now concerned with trying to avoid divergences in national implementation of Basel 2 which would nullify the basic objective of minimizing distortions to competition among banks stemming from capital regulation. The resources of big banks tend to give them an advantage in the cross‐border implementation of new regulations but in the introduction of Basel 2 this will not necessarily translate into substantial competitive advantages vis‐à‐vis other banks in different national markets.

In their general discussion, Persaud and Plender emphasize the pervasive influence of ethics in finance and business. By building trust ethical behavior facilitates trust, of which a by‐product is lower transaction costs. By contrast unethical behavior leads to greater reliance on law and regulation. Indeed, as the authors note, extensive ethical abuses tend to lead to additional regulation that is often heavy‐handed and difficult subsequently to roll back or amend.

Several factors are singled out as having contributed to the deterioration in recent years of the ethical climate in finance: the greater complexity of the business; technology which increases the distance between banks and their customers; the lack of ethical content in advanced training in finance; the increasingly overriding importance attributed to the maximization of shareholder value (in practice all too often equivalent to short‐term maximization of profits); the adoption of incentive structures linking remuneration closely to movements of share prices; and introduction of free‐market competition into the practice of accountancy and law.

Inevitably this list omits influences which many other people would like to see included. Perhaps, more importantly the authors do not address links between the factors cited and systemic features of business and economic regimes relevant to the subject. Arguably this reflects the authors' self‐imposed limitations regarding discussion of underlying ethical principles.

Persaud and Plender acknowledge the ultimate dependence on major philosophical traditions of the guidance provided in their checklists for economic actors. However, they shy away from extensive exploration of differences in these traditions likely to be relevant to financial ethics. Instead they choose to point to globally shared features of different ethical systems such as truth, compassion, responsibility, freedom, reverence for life, and fairness as necessary foundations. But the very generality of such features precludes discussion of the relationship between historically observed differences in financial systems, on the one hand, and in the ethical and cultural principles which underpin them, on the other.

These differences have involved such subjects as the respective roles of institutionally determined as opposed to individual ethics, primary reliance on competition in the markets for goods and services as an agent for enforcing economic discipline, and the weights attributed to the different corporate objectives of firms' activities as well as to the interests of not only their shareholders but also other stakeholders (a term which, roughly speaking, denotes those other than shareholders who are significantly affected by a firm's decisions). Many of these subjects belong under the heading of models of corporate governance and of business models more generally.

Their inclusion in the discussion would no doubt have taken the authors further afield than they would have wanted. They might well justify their unwillingness to extend their discussion by their expressed belief that the world is converging on the US model of capitalism, so that consideration of alternatives would be redundant. However, this would be to ignore important ongoing political and economic controversy concerning the benefits and conceptual rationale of such alternatives. It seems quite likely that, contrary to the authors' assumption, the US model is at risk of losing ground even in quarters where it is currently ascendant owing to questions raised by the dysfunctionality of major features revealed in recent events. If there are major changes in the political and intellectual climate in response to these questions, in future editions of the book extension of the discussion to the systemic implications for ethics of alternative business models may become unavoidable.

Notes

These dimensions of derivatives and financial innovation are omnipresent in the comprehensive legal treatise, Henderson (2003), Chapter 14.

See, For example, the recent global survey of plans for introducing Basel 2 in Financial Stability Institute (2006). Other information at country level is summarised in Cornford (2006a, b).