Ethics in Banking

The Role of Moral Values and Judgements in Finance

Jes Villa

• Publisher: Palgrave Macmillan
• Year: 2015
• Print ISBN: 9781137343406
• eBook ISBN: 9781137340283
• Topic: Business
• Subtopic: Business General
• Index: Business

The solution to the uninhibited lending that was commonplace before the financial crisis has been to introduce tighter regulation to ensure robustness within banks. However, this solution has overlooked the underlying problem of ethical failure in the industry. In the wake of numerous bank collapses, many survivors continue in unprincipled conduct because ethical virtues have not been instilled. This book investigates the ethical basis of banking practice. It explores the conflict between the interests of banks and their customers, and how this conflict plays out in relation to the lending policies and fee structures of banks. Where such lending policies have a significant effect on banks, their customers and a range of stakeholders, the author investigates the views of leading bankers on their lending practices. The author then goes on to debate the events of the global financial crisis from a moral perspective, and argues that ethical failure triggered the American sub-prime calamities which have devastated homeowners and the global economy. The book argues that American banks and regulators both operated on the erroneous supposition that the quest after extreme profits would be restrained by free market forces. Where banks have a central role and importance in all commerce and hence in all societies, the author concludes by revealing a set of virtues that are necessary for banks to espouse moral conduct. He suggests that these virtues can be embedded through leadershipand cultural change, with the aim of developing an account of the virtues appropriate to bankers and banking.

Part I

Approaching Banking from a Philosophical Perspective

1

Global Credit Crisis

Apocalypse

The credit crunch that had first manifested itself in August 2007 was accelerating briskly during the summer months in the northern hemisphere, though much of the population outside mainstream finance in America and England was oblivious to this ominous tidal event. By September 2007 the US Federal Reserve Bank had started to slash interest rates so dramatically that economists expressed concern that such action might spark a downturn. The American central bank had taken this action to avert some of the harmful consequences on the economy,¹ but even then it could not stop the tidal wave. The economic indicators were worsening. The housing downturn continued to deteriorate with housing starts plummeting to a 12-year low and foreclosures doubling from the previous year. The construction industry was at its bleakest since the 1991 recession.²

Despite the rapidly spreading distress, bankers still had a sanguine outlook in November 2007, proclaiming circumstances would be different this time.³ Bankers had been responsible for the circumstances that instigated the collapse of credit, but they failed to appreciate the full ramifications. Several top bankers would soon be fired, and leading financial institutions would collapse, eventually requiring government rescue. As the analyses in Chapters 6 and 7 will highlight, the roots of the troubles lay in the flawed ethos of sub-prime loans, which were characterized by irresponsible lending. Most of these loans subsequently became delinquent, and by July of 2007 the affected banks were required by regulations and accounting convention to set aside commensurate loan loss provisions. These substantially impaired their equity position and compelled them to raise funds in the capital and money markets. As in any panic-driven rush, many would be crushed along the way, while only a few banks would survive the credit squeeze.

Central banks around the world responded to this credit crisis with unprecedented interest rate cuts in order to restore liquidity in the financial markets, but the problems were the collapse of trust among banks in each other (as will be probed in Chapter 7) and the defensive reaction of banks to discontinue lending to most of their customers. Even after central banks continued to drop interest rates, banks would either not resume lending or would do so at higher interest margins to preserve profits. The cycle of trust that is so essential to banking had been ruptured.

What were the immediate and continuing repercussions? Firstly, as later chapters will show, millions of homeowners lost their homes and incurred substantial financial costs. Secondly, countless companies that could not get hold of economically viable financing were forced to cut production and employment. Many major industries would suffer economic hardship, for example, automobiles, airlines, heavy equipment, consumer goods, department stores and restaurants among others.

Paradise Lost

Despite attempts to find other scapegoats, most economists agree that the blame for the global financial crisis lies with the banks. Instead of prudent and efficient allocation of capital to corporate and retail clients, banks ignored credit standards and disbursed loans to anyone who was interested. Rather than acting as professional risk managers, banks assumed extraordinary risks and compelled unwitting customers to do the same; in the process everyone suffered financial ruin. The banking industry is tasked with facilitating the flow of funds in the global markets, but now it precipitated a dangerous obstruction.⁴ Having broken down as an industry, America’s financial-services companies were the earliest ones to suffer, slashing nearly half a million positions since the heights of December 2006 – more than half of them in the seven months prior to mid-May 2009. Many jobs were permanently eliminated.⁵

The financial disaster started with the asset bubbles created through excessive and irresponsible lending that inevitably had to burst. But this was a crisis not just of money but also of confidence because the problems had been greatly magnified through certain unique aspects of modern finance, which we will further examine in Chapter 7. These included the innovation of synthetic derivatives to create exposure to risk without actually having to own the underlying assets; the application of fair-value accounting, which compelled financial institutions to constantly evaluate assets on the basis of current market prices that could activate signals to dispose of investments, further pushing down prices, until the process became a vicious circle. The principal accelerant was excessive leverage.⁶

The amplifiers noted above could have been kept under control if banks had exercised better governance under sound ethical principles or if regulators had acted judiciously to prevent negligent bank practices. Alan Blinder, a professor of economics at Princeton and former vice chairman of the Federal Reserve, raised the same criticism and especially found fault with government regulators for allowing sub-prime loans to flourish and for their failure to contain home foreclosures.⁷ This crisis is acutely severe because of the unique characteristics of banks. A special report on international banking in The Economist explained why banks are special. Firstly, their fundamental structure is grounded in trust. Banks are reliant on deposits and the inter-bank money market in order to extend credit to customers, and, when trust is forfeited, those funds can be demanded back more rapidly than loans they have extended. Secondly, banks are unique in that they undertake numerous transactions with each other. Thirdly and most importantly, the banking industry serves to promote the smooth operation of the economy by efficiently directing credit in order to effect productive uses of capital. The financial crisis upturned the system.⁸

After the crisis erupted in the banking sphere, it gradually spread to non-financial businesses with the onslaught of recession at the end of 2007. From that time till May 2009, America had shed 5 million jobs. It was estimated that more than 15 per cent of workers were either jobless or underemployed. The market value of listed shares in American companies tumbled 57 per cent from its high point in October 2007 to a low in March 2009, with some recovery thereafter.⁹

Since the credit squeeze had progressed to a global recession, the industry slowdown was felt in all countries. On 26 January 2009 major multinational companies that included, among others, Caterpillar, ING, Pfizer and Sprint Nextel announced several thousands of job cuts each; the International Labour Organisation issued a gloomy forecast of an upsurge in the global jobless rate to 7.1 per cent this year or 230 million people, which is a significant growth from 179 million in 2007.¹⁰ Such large-scale unemployment is a cruel penalty on innocent victims.

In the spring of 2009 both General Motors (GM) and Chrysler, which had once been respectively the largest and the third-largest carmakers in America, were forced into bankruptcy proceedings because they were slowly haemorrhaging due to the drastic collapse of their sales. Though the fundamental reason behind the failure of both firms was inefficiency and overproduction, the immediate factors behind their demise were the higher cost of finance,¹¹ which was extremely difficult to obtain, and the sudden reduction of the take-home pay of American consumers. Many individuals had lost their jobs while others were constrained to embrace a more frugal lifestyle that meant either not regularly changing cars or buying cheaper fuel-efficient imports. The American car manufacturers had reacted defensively to the influx of better and more efficient Japanese cars in the 1970s by lobbying for government protection instead of responding in kind; in addition, their ill-conceived agreement on benefits with the unions saddled them with a heavy cost structure. GM’s bankruptcy resulted in the loss of 14 factories, 29,000 jobs and 2400 dealerships in America;¹² it also involved the sale of the European operations.

Banks and Household Debt

Household savings have traditionally provided a strong impetus to economic growth in many countries, but conditions have changed in recent years. In the American situation, personal indebtedness rose steadily, from less than 80 per cent of disposable income in 1986 to nearly 100 per cent in 2000, and by 2007 it had climbed to 140 per cent.¹³ Looking at actual numbers, the financial historian Niall Ferguson noted that by 2007 American consumer debt had soared to a record US$2.5 trillion.¹⁴ A study entitled ‘For a New Thrift: Confronting the Debt Culture’ commented that the reckless debt culture trapped individuals in a morass of poverty and destroyed lives. Statistics showed that credit-card debt nearly tripled between 1989 and 2001, increasing from US$238 billion to US$692 billion; by 2008, it grew to US$937 billion.¹⁵ The debt was in the main issued by banks, though there were also non-bank financial institutions to blame.

Debt can be a good thing because it enables people to purchase homes, buy goods that contribute to a better quality of life or embark on business ventures. But consumer credit cuts two ways. It brings convenience and expanded options, but, if its promoters are deceptive, it can encourage reckless behaviour and lead to tragedy, as the sub-prime mortgage foreclosures have excruciatingly demonstrated.¹⁶ The mortgage loan problems will be examined in Chapter 6.

The study cited above stated that the percentage of American families with debt-service obligations in excess of 40 per cent of their income increased to 12.2 per cent in 2004. Delinquencies on household debt also rose during this period. Late fees on credit cards totalled US$17.1 billion in 2006.¹⁷

The credit crisis did not just impact on bank customers; it also affected whole societies. Unwitting municipalities suffered investment losses; suburbs declined in value as property foreclosures proceeded; cities and states faced declining tax revenues due to the misfortunes of their constituents; countries suffered drastic financial straits (Iceland would be virtually bankrupted). The shaping force of money on society is manifest in all activities. And banks as the mediator of money have an enormous impact on human lives in all countries.

Judgement on the Banks

Given the great importance of banks and the fears about the consequences of their failure, governments throughout the world have committed to saving the financial system. Many of the institutions that failed were judged too big to fail because there was anxiety that their demise could cause the collapse of the global economy. A massive bank rescue was therefore launched. In May 2009 it was still highly uncertain what form and size of support governments would eventually extend to their banks. Nonetheless governments were already heavily involved in banking systems. They were guarantors of far more retail deposits than prior to the crisis. They guaranteed new debt issues of banks. Governments acquired and owned preferred shares in many banks, common equity in some and were prepared to infuse capital in others if necessary. Banks that had not sought any government funds still benefited from their reassuring presence. Banks continued to exist only due to the generosity of the government.¹⁸

But what caused the banks to fail? The American evidence indicates an ethical failure, which was demonstrated through irresponsible lending, a lack of concern for the plight of borrowers and a lack of transparency.

The empirical research for this book examines the conduct of banks in their day-to-day activities to identify the values and principles underlying their actions. The focus is on those areas of banking directly affecting customers, because that is where banks demonstrate deep-rooted ethical views. The book also presents a case study of the American sub-prime mortgage loan crisis, in which its causes and consequences are analysed in order to draw some lessons for the future. Moral deficiencies are revealed as the grounds that instigated the crisis.

2

Views of Banking Ethics

Development of Modern Banking

Much of the current financial structure can be traced to three innovations in the 17th century. The first of these was the establishment of a system of bank transfers that has survived to this day in the form of cheque issuance and inter-bank transfers. The second was the foundation of fractional reserve banking that enabled banks to lend substantially more than the amount of deposits...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Prologue
• Acknowledgements
• Part I Approaching Banking from a Philosophical Perspective
• Part II The Idea of Ethics in Banking: Self-Conceptions and Critique
• Part III Harsh Realities and Critique of Banking Ethics
• Epilogue
• Appendix A
• Appendix B
• Appendix C
• Notes
• Bibliography
• Index