Ethics in Finance
ETHICS IN FINANCE
Ethics in general is concerned with human behavior that is acceptable or "right" and that is not acceptable or "wrong" based on conventional morality. General ethical norms encompass truthfulness, honesty, integrity, respect for others, fairness, and justice. They relate to all aspects of life, including business and finance. Financial ethics is, therefore, a subset of general ethics.
Ethical norms are essential for maintaining stability and harmony in social life, where people interact with one another. Recognition of others' needs and aspirations, fairness, and cooperative efforts to deal with common issues are, for example, aspects of social behavior that contribute to social stability. In the process of social evolution, we have developed not only an instinct to care for ourselves but also a conscience to care for others. There may arise situations in which the need to care for ourselves runs into conflict with the need to care for others. In such situations, ethical norms are needed to guide our behavior. As Demsey (1999) puts it: "Ethics represents the attempt to resolve the conflict between selfishness and selflessness; between our material needs and our conscience."
Ethical dilemmas and ethical violations in finance can be attributed to an inconsistency in the conceptual framework of modern financial-economic theory and the widespread use of a principal-agent model of relationship in financial transactions. The financial-economic theory that underlies the modern capitalist system is based on the rational-maximizer paradigm, which holds that individuals are self-seeking (egoistic) and that they behave rationally when they seek to maximize their own interests. The principal-agent model of relationships refers to an arrangement whereby one party, acting as an agent for another, carries out certain functions on behalf of that other. Such arrangements are an integral part of the modern economic and financial system, and it is difficult to imagine it functioning without them.
The behavioral assumption of the modern financial-economic theory runs counter to the ideas of trustworthiness, loyalty, fidelity, stewardship, and concern for others that underlie the traditional principal-agent relationship. The traditional concept of agency is based on moral values. However, if human beings are rational maximizers, then agency on behalf of others in the traditional sense is impossible. As Duska (1992) explains it: "To do something for another in a system geared to maximize self-interest is foolish. Such an answer, though, points out an inconsistency at the heart of the system, for a system that has rules requiring agents to look out for others while encouraging individuals to look out only for themselves, destroys the practice of looking out for others" (p. 61).
The ethical dilemma presented by the problem of conflicting interests has been addressed in some areas of finance, such as corporate governance, by converting the agency relationship into a purely contractual relationship that uses a carrot-and-stick approach to ensure ethical behavior by agents. In corporate governance, the problem of conflict between management (agent) and stockholders (principal) is described as an agency problem. Economists have developed an agency theory to deal with this problem. The agency theory assumes that both the agent and the principal are self-interested and aim to maximize their gain in their relationship. A simple example would be the case of a store manager acting as an agent for the owner of the store. The store manager wants as much pay as possible for as little work as possible, and the store owner wants as much work from the manager for as little pay as possible. This theory is value-free because it does not pass judgment on whether the maximization behavior is good or bad and is not concerned with what a just pay for the manager might be. It drops the ideas of honesty and loyalty from the agency relationship because of their incompatibility with the fundamental assumption of rational maximization. "The job of agency theory is to help devise techniques for describing the conflict inherent in the principal-agent relationship and controlling the situations so that the agent, acting from self-interest, does as little harm as possible to the principal's interest" (DeGeorge, 1992). The agency theory turns the traditional concept of agency relationship into a structured (contractual) relationship in which the principal can influence the actions of agents through incentives, motivations, and punishment schemes. The principal essentially uses monetary rewards, punishments, and the agency laws to command loyalty from the agent.
Most of our needs for financial services—management of retirement savings, stock and bond investing, and protection against unforeseen events, to name a few—are such that they are better entrusted to others because we have neither the ability nor the time to carry them out effectively. The corporate device of contractualization of the agency relationship is, however, too difficult to apply to the multitude of financial dealings between individuals and institutions that take place in the financial market every day. Individuals are not as well organized as stockholders, and they are often unaware of the agency problem. Lack of information also limits their ability to monitor an agent's behavior. Therefore, what we have in our complex modern economic system is a paradoxical situation: the ever-increasing need for getting things done by others on the one hand, and the description of human nature that emphasizes selfish behavior on the other. This paradoxical situation, or the inconsistency in the foundation of the modern capitalist system, can explain most of the ethical problems and declining morality in the modern business and finance arena.
The most frequently occurring ethical violations in finance relate to insider trading, stakeholder interest versus stockholder interest, investment management, and campaign financing. Businesses in general and financial markets in particular are replete with examples of violations of trust and loyalty in both public and private dealings. Fraudulent financial dealings, influence peddling and corruption in governments, brokers not maintaining proper records of customer trading, cheating customers of their trading profits, unauthorized transactions, insider trading, misuse of customer funds for personal gain, mis-pricing customer trades, and corruption and larceny in banking have become common occurrences.
Insider trading is perhaps one of the most publicized unethical behaviors by traders. Insider trading refers to trading in the securities of a company to take advantage of material "inside" information about the company that is not available to the public. Such a trade is motivated by the possibility of generating extraordinary gain with the help of nonpublic information (information not yet made public). It gives the trader an unfair advantage over other traders in the same security. Insider trading was legal in some European countries until recently. In the United States, the 1984 Trading Sanctions Act made it illegal to trade in a security while in the possession of material non-public information. The law applies to both the insiders, who have access to nonpublic information, and the people with whom they share such information.
Campaign financing in the United States has been a major source of concern to the public because it raises the issue of conflict of interest for elected officials in relation to the people or lobbying groups that have financed their campaigns. The United States has a long history of campaign finance reform. The Federal Election Commission (FEC) administers and enforces the federal campaign finance statutes enacted by the Congress from time to time. Many states have also passed lobbying and campaign finance laws and established ethics commissions to enforce these statutes.
Approaches to dealing with ethical problems in finance range from establishing ethical codes for financial professionals to efforts to replace the rational-maximizer (egoistic) paradigm that underlies the modern capitalist system by one in which individuals are assumed to be altruistic, honest, and basically virtuous.
It is not uncommon to find established ethical codes and ethical offices in American corporations and in financial markets. Ethical codes for financial markets are established by the official regulatory agencies and self-regulating organizations to ensure ethically responsible behavior on the part of the operatives in the financial markets.
One of the most important and powerful official regulatory agencies for the securities industry in the United States is the Securities and Exchange Commission (SEC). It is in charge of implementing federal securities laws, and, as such, it sets up rules and regulations for the proper conduct of professionals operating within its regulatory jurisdiction. Many professionals play a role within the securities industry, among the most important of which are accountants, broker-dealers, investment advisers, and investment companies. Any improper or unethical conduct on the part of these professionals is of great concern to the SEC, whose primary responsibility is to protect investor interests and maintain the integrity of the securities market. The SEC can censure, suspend, or bar professionals who practice within its regulatory domain for lack of requisite qualifications or unethical and improper conduct. The SEC also oversees self-regulatory organizations (SROs), which include stock exchanges, the National Association of Security Dealers (NASD), the Municipal Securities Rulemaking Board (MSRB), clearing agencies, transfer agents, and securities information processors. An SRO is a membership organization that makes and enforces rules for its members based on the federal securities laws. The SEC has the responsibility of reviewing and approving the rules made by SROs.
Other rule-making agencies include the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and state finance authorities. Congress has entrusted to the Federal Reserve Board the responsibility of implementing laws pertaining to a wide range of banking and financial activities, a task that it carries out through its regulations. One such regulation has to do with unfair or deceptive acts or practices. The FDIC has its own rules and regulations for the banking industry, and it also draws its power to regulate from various banking laws passed by Congress.
In addition to federal and state regulatory agencies, various professional associations set their own rules of good conduct for their members. The American Institute of Certified Public Accountants (AICPA), the American Institute of Certified Planners (AICP), the Investment Company Institute (ICI), the American Society of Chartered Life Underwriters (ASCLU), the Institute of Chartered Financial Analysts (ICFA), the National Association of Bank Loan and Credit Officers (also known as Robert Morris Associates), and the Association for Investment Management and Research (AIMR) are some of the professional associations that have well-publicized codes of ethics.
TOWARD A PARADIGM SHIFT
There has been an effort to address the ethical problems in business and finance by reexamining the conceptual foundation of the modern capitalist system and changing it to one that is consistent with the traditional model of agency relationship. The proponents of a paradigm shift question the rational-maximizer assumption that underlies the modern financial-economic theory and reject the idea that all human actions are motivated by self-interest. They embrace an alternative assumption that human beings are to some degree ethical and altruistic and emphasize the role of the traditional principal-agent relationship based on honesty, loyalty, and trust. Duska (1992) argues: "Clearly, there is an extent to which [Adam] Smith and the economists are right. Human beings are self-interested and will not always look out for the interest of others. But there are times they will set aside their interests to act on behalf of others. Agency situations were presumably set up to guarantee those times."
The idea that human beings can be honest and altruistic is an empirically valid assumption; it is not hard to find examples of honesty and altruism in both private and public dealings. There is no reason this idea should not be embraced and nurtured. As Bowie (1991) points out: "Looking out for oneself is a natural, powerful motive that needs little, if any, social reinforcement … Altruistic motives, even if they too are natural, are not as powerful: they need to be socially reinforced and nurtured" (p. 19). If the financial-economic theory accepts the fact that behavioral motivations other than that of wealth maximization are both realistic and desirable, then the agency problem that economists try to deal with will be a nonproblem. For Dobson (1993), the true role of ethics in finance is to be found in the acceptance of "internal good" ("good" in the sense of "right" rather than in the sense of "physical product"), which, he adds, is what classical philosophers describe as "virtue"—that is, the internal good toward which all human endeavor should strive. He contends: "If the attainment of internal goods were to become generally accepted as the ultimate objective of all human endeavor, both personal and professional, then financial markets would become truly ethical" (p. 60).
see also Finance
Bowie, Norman E. (1991). "Challenging the Egoistic Paradigm." Business Ethics Quarterly. 1:1, 1-21.
Dobson, John (1993). "The Role of Ethics in Finance." Financial Analysis Journal. 49:6, 57-61.
Duska, Ronald R. (1992). "Why Be a Loyal Agent? A Systematic Ethical Analysis." In Ethics and Agency Theory: An Introduction. Norman E. Bowie and Edward R. Freeman, eds., New York: Oxford University Press.
Frowen, S.F., and McHugh, F.P., eds. (1995). Financial Decision-Making and Moral Responsibility. New York: St. Martin's Press.
Goodpaster, Kenneth E. (1991). "Business Ethics and Stake-holder Analysis." Business Ethics Quarterly. 1:1, 52-71.
Anand G. Shetty