Ethics in Finance

• Publisher: Wiley-Blackwell
• Year: 2013
• ISBN:
  9781118789261
• Edition: 3
• Topic: Betriebswirtschaft
• Subtopic: Wirtschaftssethik

The third edition of Ethics in Finance presents an authoritative and wide-ranging examination of the major ethical issues in finance.

This new edition has been expanded and thoroughly updated with extensive coverage of the recent financial crisis and the very latest developments within the financial world.

• Substantially updated new edition with nearly 40% new material, including sections on credit cards, mortgage lending, microfinance, risk management, derivatives, and securitization
• Includes coverage and references to the recent financial crisis and the very latest developments within the financial world
• Focuses on the practical issues that confront finance professionals, policy makers, and consumers of financial services
• Cites examples of the scandals that have shaken public confidence in Wall Street and world financial markets
• Includes numerous examples throughout to illustrate the concepts and issues described within the text

Chapter One

Finance Ethics: An Overview

Some cynics jokingly deny that there is any ethics in finance, especially on Wall Street. This view is expressed in a thin volume, The Complete Book of Wall Street Ethics, which claims to fill “an empty space on financial bookshelves where a consideration of ethics should be.”¹ Of course, the pages are all blank! However, a moment's reflection reveals that finance would be impossible without ethics. The very act of placing our assets in the hands of other people requires immense trust. An untrustworthy stockbroker or insurance agent, like an untrustworthy physician or attorney, finds few takers for the services offered. Financial scandals shock us precisely because they involve individuals and institutions that we should be able to trust.

Trust is essential in finance, but finance ethics is about far more than trust. Finance consists of an array of activities that involve the handling of financial assets—usually those of other people. Not only does the welfare of everyone depend on the safeguarding and deployment of these assets, but billions of financial transactions take place each day with a high level of integrity. With this large volume of financial activities, there are ample opportunities for some people to gain at other’s expense. Simply put, finance concerns other people's money (OPM), and OPM invites misconduct. Individuals in the financial services industry, such as stockbrokers, bankers, financial advisers, mutual fund and pension managers, and insurance agents, have a responsibility to the customers and clients they serve. Financial managers in corporations, government, and other organizations have an obligation to manage the financial assets of these institutions well. It is important that everyone else involved in finance, in whatever role, conduct themselves with the utmost attention to ethics.

The ethics of an occupation or a profession is best understood not by examining the worst conduct of its members but by attending to the conduct that is commonly expected and generally found. In finance, as in other areas of life, three questions of ethics are critical: What are our ethical obligations or duties? What rights are at stake? And what is fair or just? Beyond these more specific questions lies the ultimate ethical question: How should we live? In the case of finance, this question goes to the heart of the purpose of financial activity: What role should finance play in our individual lives and in the development of a good society?² These four fundamental questions are not easily answered, but an attempt to answer them—or at least the first three—is the main task of this book.

This chapter lays the groundwork for the ones that follow by providing an overview of the need for ethics in finance and the main areas of finance ethics. A comprehensive treatment of ethics in finance is, of necessity, long and involved because of the diversity of financial activities and the range of ethical issues they raise. However, there is little that is unique to finance ethics. The ethics of finance has counterparts in other areas of business and in the professions, such as medicine and law. Thus, our discussion of ethics in finance can be facilitated by drawing on the well-developed fields of business and professional ethics.

The Need for Ethics in Finance

Although the need for ethics in finance should be obvious, it is useful to understand both the misconduct that occurs all too frequently and its causes. Most people in finance are decent, dedicated individuals, but, unlike the professions, which involve a strong commitment to service, finance relies mainly on the search for gain, which can easily become greed. Moreover, individuals operate within and through organizations, institutions, and systems, including markets, which may be faulty. Consequently, scandals may occur that were part of no one person's intentions and for which no one bears responsibility. Many scandals result not from deliberate misconduct—doing what one knows to be wrong—but from rational actors following incentives in situations with complex interactions. Ethical misconduct is not always a matter of bad people doing bad things, but often of good people who stumble unwittingly into wrongdoing. This section describes some of the scandals of recent years, which have created an image of finance as an activity devoid of ethics, and it also explores some of the causes for these scandals.

Financial scandals

Wall Street was shaken in the late 1980s by the insider trading and market manipulation of Dennis Levine, Martin Siegel, Ivan Boesky, Michael Milken, and others. In 1990, Mr Milken pleaded guilty to six felonies and was sentenced to 10 years in prison. Previously, his firm, Drexel Burnham Lambert, collapsed after admitting to six felonies and agreeing to pay $650 million. James B. Stewart, the author of Den of Thieves, calls their activities “the greatest criminal conspiracy the financial world has ever known.”³ Insider trading continues to be not only a frequent occurrence but also a source of controversy. Although the domestic maven Martha Stewart was convicted in 2004 for lying to investigators about a suspicious transaction, questions remain about whether she had actually committed insider trading. However, the investigation of Raj Rajaratnam, head of the Galleon Group—who was convicted of insider trading in 2011 and sentenced to 11 years in prison—also ensnared many members of the circle of informants that he had built over many years, including a respected director of Goldman Sachs and Procter & Gamble. This conviction exposed the extent to which insider trading had become organized in the hedge fund world through so-called expert networks.

The investment bank Salomon Brothers was nearly destroyed in 1991 by charges that traders in the government securities division had attempted to execute a “squeeze” by rigging several auctions of US Treasury notes. The total cost of this scandal—including legal expenses and lost business, on top of a $290 million fine—has been estimated at $1 billion. The firm dismissed the people responsible for the bid-rigging, as well as CEO John Gutfreund, who was unaware of the activity at the time. (Gutfreund's offense was that he sat on the news for more than three months before reporting it to the Treasury Department.) Also ensnared in this scandal was vice-chairman John Meriwether, who went on to head Long-Term Capital Management, a hedge fund that collapsed at great loss in 1998. The name of this venerable firm, founded in 1910, was eventually abandoned in 2003, after a new owner, Citigroup, was itself involved in a series of scandals. At that time, the reputational value of the Salomon Brothers franchise was apparently deemed to be worth little.

After losing $1.6 billion on derivative transactions in 1994, Orange County in California sued its financial adviser Merrill Lynch for concealing the amount of risk that was involved in its investments. In 1998, Merrill Lynch settled the suit for more than $400 million. In 1996, Procter & Gamble (P&G) settled with Bankers Trust after the bank agreed to forgive $200 million that P&G owed on failed derivative transactions. P&G's charge that Bankers Trust had misrepresented the investments was bolstered by damaging audio tapes, including some in which bank employees were recorded using the acronym ROF for “rip-off factor” to describe one method for fleecing customers. Although derivative securities continue to be a source of considerable abuse, efforts to regulate them have been largely unsuccessful. Both Merrill Lynch and Bankers Trust were eventually saved from collapse by absorption into larger banks (Bank of America and Deutsche Bank respectively).

Unauthorized trading by individuals has caused great losses at several banks and trading firms. Nick Leeson, a 28-year-old trader in the Singapore office of Barings Bank, destroyed this venerable British firm in 1995 by losing more than $1 billion on futures contracts that bet the wrong way on the direction of the Japanese stock market. (The final blow to his precarious position came from an unpredictable event, the Kobe earthquake.) In 1996, the acknowledged king of copper trading was fired by Sumitomo Corporation for losing an estimated $2.6 billion, and Sumitomo also sued a number of banks for issuing derivative securities that enabled the trader to hide the losses. Between 2006 and 2008, Jérôme Kerviel, a trader at the French bank Société Générale, managed to lose 4.9 billion euros in unauthorized activity. UBS incurred losses of $2.3 billion in 2011 that had been hidden by a young trader named Kweku Adoboli. In most of these cases, the rogue traders exploited flaws in reporting systems and benefited from lax management supervision, which may have also been weakened by a reluctance to interfere in these traders’ apparent money-making ability. Returns that are “too good to be true” often are, but who wants to point this out?

The usually staid mutual fund industry was roiled in 2003 when New York State attorney general Eliot Spitzer brought charges against a number of mutual fund sponsors, including Bank of America, Putnam Investments, Janus Funds, and Strong Capital Management. These companies had allowed favored traders to operate after the close of the business day and also to make rapid, market-timing trades. Late trading is illegal, and most funds discourage market timing with rules that prevent the practice by ordinary investors. In the case of Strong Capital Management, the founder, Richard S. Strong, not only permitted a favored investor, Canary Capital, to engage in market-timing trades but also engaged in the practice himself. He made 1400 quick trades between 1998 and 2003 in violation of a fiduciary duty that he, as the manager of the Strong family of funds, had to the funds’ investors.

Also in 2003, 10 major investment firms paid $1.4 billion to settle charges that their analysis of securities had been slanted in order to curry favor with client companies. At the height of the Internet and telecommunications boom, the firms’ securities analysts had issued favorable reports of companies such as WorldCom and Global Crossing that subsequently collapsed. These biased reports induced thousands of people to invest millions of dollars, much of which was lost when the market bubble burst. The analysts were, in many cases, compensated for their ability to bring in investment banking business, which created a conflict of interest with their duty to offer objective evaluations of companies. Two analysts, Jack B. Grubman at Salomon Smith Barney, then a part of Citigroup, and Henry Blodget of Merrill Lynch, paid large fines and agreed to lifetime bans from the securities industry for their roles in pushing companies that they knew were troubled. William H. Donaldson, then chairman of the Securities and Exchange Commission, commented, “These cases reflect a sad chapter in the history of American business—a chapter in which those who reaped enormous benefits based on the trust of investors profoundly betrayed that trust.”⁴

The fall of Enron in 2001 and WorldCom in 2002 involved many ethical lapses. An important part of the Enron story involved off-balance-sheet partnerships that generated phantom profits and concealed massive debts. These partnerships were formed by Enron's chief financial officer (CFO) Andrew Fastow. For Fastow to be both the CFO of the company and the general manager of the partnerships, and thus to negotiate for both sides in deals, constituted an enormous conflict of interest—a conflict that he used to reward himself handsomely. Shockingly, the Enron board of directors waived the prohibition on such conflicts in the company's code of ethics to allow Fastow's dual role. Aside from the fact that many of the partnerships violated accounting rules and should have been consolidated on the company's books, Enron guaranteed some of the partnerships against losses with a commitment to infuse them with more stock in the event they lost value. Because the partnerships were capitalized with Enron stock to begin with, a decline in the price of the stock triggered massive new debt obligations. The end for Enron came quickly when investors realized the extent of the company's indebtedness—and the faulty accounting that had hidden it.

By contrast, the accounting fraud at WorldCom was alarmingly simple: the company reported as revenue accruals that were supposed to be set aside for payments, and some large expenses were recorded as capital investments. Both kinds of entries are violations of generally accepted accounting principles (GAAP). WorldCom's end also came quickly when the head of internal auditing unraveled the fraud and courageously reported it to the board of directors. CEO Bernie Ebbers and CFO Scott Sullivan were convicted and sentenced to prison terms of 25 and 5 years respectively. The internal auditor, Cynthia Cooper, was later featured on the cover of Time as one of three women whistle-blowers who were recognized with the magazine's 2002 Persons of the Year award. (Another awardee was Sherron Watkins, who blew the whistle on Enron's perilous financial structure.)

In the financial crisis that began in 2007, the most obvious target of ethical criticism was the mortgage origination process in which unsuitable loans were made without adequate determination and documentation of creditworthiness. Lax mortgage origination practices contributed, in part, to a bubble in housing prices, which precipitated the crisis and left many borrowers “under water,” owing more on their mortgage than the house was worth. Mortgage originators were often heedless about suitability or creditworthiness because they could quickly sell the loans to major banks, which would combine many mortgages into securities that were sold to investors. Woefully inadequate documentation of mortgages (called “robo-signing”) has also proven to be a serious problem as banks, which often lacked clear title to the property, sought to foreclose on borrowers, who, in some cases, did not owe the amounts charged.

Although the securitization of mortgages and other debt obligations has many benefits, the risks of default, which were increased by the housing bubble and uncreditworthy borrowers, tended to be overlooked by both the securitizers and investors. When the bubble burst, the banks that held many of the mortgage-backed securities and financed their holdings by short-term borrowing found themselves unable to obtain funding, and because of their high leverage and assets of questionable value, they faced the threat of insolvency. Since many of these banks were considered “too big to fail,” their collapse threatened the whole economy, which prompted a vigorous government response. A failure on the part of rating agencies to accurately gauge the risk of the mortgage-backed securities and government policies supporting home ownership were also blamed for the crisis. In particular, the federally chartered, for-profit mortgage holders, Fannie Mae and Freddie Mac, were major factors in the financial crisis. Given the many factors in the crisis, controversy remains about which were more important and which of these involved distinctively ethical failings as opposed to poor judgment, failed systems, and plain bad luck.

Since the financial crisis, questions of ethics have been raised in such cases as the collapse of MF Global, in which about $1 billion in clients’ money disappeared in a frantic effort to meet the firm's own obligations after the failure of risky bets on European sovereign debt. MF Global violated a fundamental requirement in their business of derivative trading to segregate client funds from those of the firm. The “flash crash” of May 6, 2010, and the $440 million loss at Knight Capital Group in 2012, both due to malfunctioning software programs, have focused attention on the dangers of high-frequency trading, which some charge is a predatory practice that provides little benefit to investors. Confidence in financial institutions was further imperiled by charges that major banks had intentionally manipulated the widely used London Interbank Offered Rate (LIBOR) by submitting false information to the rate-setting organization. Banks have also been under investigation for aiding in illegal tax evasion and for deliberately circumventing rules to prevent money laundering for clients in countries under international sanctions, such as Iran.

These scandals not only undermine the public's confidence in financial markets, financial institutions, and indeed the whole financial system but also fuel popular perceptions of the financial world as one of personal greed without any concern by finance people for the impact of their activities on others. A 2011 Harris poll revealed that 67 percent of respondents agreed that “Most people on Wall Street would be willing to break the law if they believed they could make a lot of money and get away with it.”⁵ In addition, 70 percent believed that people on Wall Street are not as “honest and moral as other people.” Only 31 percent of people agreed with the statements “In general, what is good for Wall Street is good for the country” and “Most successful people on Wall Street deserve to make the kind of money they earn.” In 2006, 60 percent of respondents polled believed that “Wall Street only cares...