Ethics in Finance

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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.” Of course, the pages are all blank ! However, a moment’s reflection reveals that finance would be impossible without ethics.

Ethics is needed in financial markets. Financial transactions typically take place in markets and presuppose certain moral rules and expectations of moral behavior. The most basic of these is a prohition against fraud and manipulation, but, more generally, the rules and expectations for markets are concerned with fairness, which is often expressed as a level playing field. The playing field in financial markets can become ”tilted” resources.

Ethics is needed in the financial services industry. The financial services industry is the most visible face of finance and the aspect that affects ordinary citizens most directly. As an industry, it has an obligation to develop products that fit people’s needs and to market them in a responsible manner, avoiding, for example, deceptive or coercive sales tactics. In addition, organizations that provide financial services typically deal with individuals as clients. A reputation for ethical behavior is crucial in gaining the confidence of clients. For example, a stock broker or an insurance agent is (or should be) more than an order-taker or peddler in a buyer-seller environment. Such a person is offering to put special skills and knowledge to work for the benefit of others. The people who make such offers become fiduciaries and agents who have an obligiation to subordinate their own interests to those of clients. Some financial service professionals duties like those of physicians and lawyers. The main duties of professionals are to perform services with competence and due care, to avoid conflicts of interest, to preserve confidentality, and to upload the ideals of the professions.

Ethics is needed in financial management. Financial managers, espeically chief financial officers or CFOs, have the task of raising capital and determining how that capital is to be deployed.  Financial managers are also agents and fiduciaries who have a duty to manage the assets of a corporation prudently, avoiding the use of these assets for personal benefit and acting in all matters in the interest of the corporation and its shareholders. Specifically, this duty prohibits unauthorized self-dealing and conflict of interest, as well as fraud and manupulation in connection with a company’s financial reporting and securities transactions.

Ethics is needed by finance people in organizations. The vast majority of people in finance are employees of an organization, and they and their organizations encounter the full range of ethical problems that occur in business. These include personal ethical dilemmas, such as the situation of the financial manager of a corporation who is instructed to overstate the return on a project in order to gain its approval, or the analyst in a brokerage firm who is pressured to withdraw a planned ”sell” recommendation for the stock of a company that is also a client of the firm. Individuals who are aware of or involved in unethical and/or illegal conduct face the difficult dilemma of whether to become a whistleblower.
Most finance theorists would insist, moreover, that finance is an objective science that depends solely on observable facts and assumes nothing about moral values. Finance theory, in other words, is completely value-free. The point is often expressed by saying that finance theory is a positive science which contains only statements that are verifiable by empirical evidence. Positivists hold that all sciences should exclude normative statements, which is to say statements that express a value judgment.

In view of this extensive regulation, people in finance might well assume that law is the only guide. Their motto might be: ”If it’s legal, then it’s morally okay. ” This motto is inadequate for many reason. As a former SEC chairman observed, ”It is not an adequate ethical standard to aspire to get through the day without being indicted.” A certain amount of self-regulation is necessary, not as a replacement for legal regulation, but as a supplement for areas which the law cannot easily reach and as an ideal for rising above the law.

It would be perverse to encourage people in finance to to anything that they want until the law tells them otherwise. Besides, the law is not always settled, and many people who thought that their actions were legal, though perhaps immoral, have ruefully discovered otherwise. Third, merely obeying the law is insufficient for managing an organization or for conducting business because employees, customers, and other groups expect, indeed demand, ethical treatment.
The ethical treatment of clients requires salespeople to explain all of the relevant information truthfully, and in an understandable and nonmisleading manner. One observer complains that brokers, insurance agents, and other salespeople have developed a new vocabulary that obfuscates rather than reveals: Walk into a broker’s office these days. You won’t be sold a product. You won’t even find a broker. Instead, a ”financial adviser” will ”help you select” an ” appropriate planning vehicle,” or ”offer” a menu of ”investment choices” or ” options” among which to ”allocate your money. ”. . . [Insurance agents] peddle such euphemisms as ”private retirement accounts, ” ”college savings plans, ” and ” charitable remainder trusts.” . . . Among other linguistic sleights of hand in common usage these days: saying tax-free when, in fact, it’s only tax-deferred; high yield when it’s downright risky; and projected returns when it’s more likely in your dreams.

Salespeople avoid speaking of commision, even though this is the source of their remunerations. Commission on mutual funds is ”front-end” or ”back-end loads”; and insurance agents, whose commision can approach 100 percent of the first year’s premium, are not legally required to disclose this fact—and they rarely do. The agents of one insurance company represented life insurance policies as ” retirement plans” and referred to the premium as ” deposits.”

Suitability and risk disclosure are closely related. The obligation to recommend only suitable investments for a client includes judgements of the appropriate level of risk among many other factors. In addition, brokers, agents, and other salespeople have and obligations are problematic for at least three reasons. First, is the relation merely a buyer- seller relation or an agent – principal relation? If a customer places an order with a broker to buy 100 shares of IBM stock, then under most circumstances, the broker is being paid to execute the order and has no obligation to judge the suitability of the investment or to disclose any risk. On the other hand, if a client asks for investment advice, then the broker are unclear. The nature of the relation may also be a source of misunderstanding, as when a client believes that he or she is obtaining investment advice while the broker views his or her role as that of a salesperson.

Consumers are increasingly losing the right to sure banks, credit card companies, mortgage lenders, insurers, and other providers of financial services. Many consumers are unaware that they have lost the right to sue, and those pulsory arbitration can also be a headache for financial services firms. In particular, the securities industry has been concerned about large punitive damages. In response to both industry concerns and the objections of  investors, an arbitration policy task force, which was formed by the National Assocation of Securities Dealers ( NASD), issued a report in 1996 that made 70 recommendations for overhauling the system of compulsory arbitration.

Some mutual funds, pension plans, and endowments go beyond and engage in socially responsible investing. The aim of socially responsible investors is to hold stocks only in corporations that treat employees well, protect the environment, contribute to communities, produce safe, useful products, and, in general, exercise social responsibility. In particular, all socially responsible investprs avoid the stocks of companies involved with tobacco, alcohol, and gambling (so-called ” sin stocks”), and some screen out companies that are engaged in defense contracting, nuclear energy, and business with oppressive foreign regimes. Socially responsible funds enable people who are concerned with where their money is going and how it is used to invest with a clear conscience. Churches, universities, and foundations want their investment decisions to be consistent with the values that they espouse.
In order to analyze and resolve ethical issues in any field, we must first understand the theoritical  perspectives that prevail in that field. In medical ethics, this means understanding the physician’s role; in legal ethics, the adversary system. Because of the diversity of financial activity, no one perspective is all-encompassing, but two features are characteristic of the financial world, namely market transactions and financial contracting. The ethical issues in fairness or equity can sometimes conflict with efficiency, a major problem in finance ethics is managing the so-called equity/efficiency trade-off. Financial contracting, by contrast, does not consist merely of one-time economic exchanges but involves the creation of ongoing relationships, in which two parties mutually agree to certain roles. In financial contracts, people often become fiduciaries and agents with certain roles. In financial contracts, people often become fiduciaries and agents with certain attendant duties. For this reason, the duties of fiduciaries and agents are prominent in finance ethics. The most significant breach of the these duties occurs in conflicts of intersts, in which some interest, usually a personal interest, interferes with the ability of a fiduciary or agent to fulfill the obligation to serve the interests of others.

Fairness in financial markets is often expressed by the concept of a ”level playing field,” which requires not only that everyone play by the same rules but that they be equally equipped to compete. Competition between parties with very unequal information is widely regarded as unfair because the playing field is tilted in favor of the player with superior information. When people talk about equal information, however, they may mean that the parties to a trade actually possess the same information or have equal access to information.
The trouble with defining equal information as having equal access to information is that the notion of equal access is not absolute but relative. Any information that one person possesses could be acquired by another with enough time, effort, and money. An ordinary investor has access to virtually all of the information because of an investment in resources and skills. Anyone else could make the same investment and thereby gain the same access- or a person could simply ” buy” the analyst’s skilled services. Therefore, accesibility is not a feature of information itself but a function of the investment that is required in order to obrain the information.
Yet another argument against insider trading is that insiders ise information that is not merely costly to obtain but that cannot be obtained by an outsider at any price. In other words, the information is inherently inaccesible.  Some people asking the questions, ” If one who is an ’outsider’ today could have becomea manager by devouting the same time and skill as today’s ’insider’ did, is access to information equal or unequal?” And they conclude that there is ” no principled answer to such questions.” The information of an insider can also be acquired by sleuthing or bribery, or merely by becoming a ”tipee”.

Investors are only human, and human beings have many weaknesses that can be exploited. Some regulation is designed to protect people from the exploitation of their vulnerabilities. Thus, consumer protection legislation often  provides for a ”cooling-off” period during which shoppers can cancel an impulsive purchase. The requirements that a prospectus carefully serve to curb impulsiveness. Margin requirements and other measures that discourage speculative investment serve to protect incautious investors from overextending themselves, as well as to protect the market from excess volatility. The legal duty of brokers and investment advisers to recommend only suitable investments and to warn adequately of the risks of any investment instrument provides a further check on people’s greedy impulses.
The contractual relations that occur in financial activity are diverse, and so the duties involved in these relations are not easily summarized. However, two distinct roles are those of fiduciaries and agents. Although finance cannot be generally characterized as a profession like medicine, law, or engineering, some roles might be accorded professional status. And so the basis for the duties of professionals has some relevance to ethichs in finance. The section is concerned, then, with the duties of fiduciaries and agents, as well as those professionals, and in particular with the duties to avoid conflicts of interest and to preserve the confidentiality of information.

A duty of loyalty has two aspects: it requires a fiduciary to act in the interest of the beneficiary and to avoid taking any personal advantage of the relationship. In a market transaction, there is generally no obligation to serve the interests of another except to make good faith efforts to abide by the contracts made; and gaining some personal advantage is the whole point of entering into a market transaction. In general, acting in the interest of a beneficiary is acting as the beneficiary would if that person had the knowledge and skills of the fiduciary. Taking personal advantage, by contrast, is deriving any benefit from the relationship without the knowledge and consent of the beneficiary.  An example of personal advantage-taking in a fiduciary relationship is self-dealing, as when a director or executive buys some asset from the company or sells something to it, unless it can be shown that the transaction is fair and would have occurred at arm’s length. Insider trading or other personal use of confidential information gained in a fiduciary relationship is also a violation of a duty. It is wrong for a fiduciary to gain some personal benefit, even if the beneficiary is not harmed, because the fiduciary would no longer have an undivided loyalty. To have such a divided loyalty is also a conflict of interest, and so the principle of loyalty entails that a fiduciary should avoid any conflict of interest.
By agreeing to serve the interest of another, an agent, as well as a fiduciary, has a duty to avoid conflict of interest. Another important duty that gives rise to some difficult ethical dilemmas is the duty of an agent or a fiduciary to maintain confidentality. The need for confidentiality arises from the fact that people in finance, in order to do their work, must have access to sensitive, privileged information, and this kind of information will be held in confidence and used only for the purpose for which it was provided.

Agency theory accepts the standard economic assumption of egoism, which holds that individuals seek to maximize their own perceived self-interest. In other words, we all act selfishly to get the most of whatever it is that we want. Economics does not make any value judgement about the goods that people prefer or about the selfishness that is assumed.

The term moral hazard developed from the problem in insurance that is created when an insured person (a driver, for example) has little incentive to be careful because the risk of an activity is borne largely by others (by the insurer, in this case, and also by hapless people in the driver’s path). Moral hazard insurance can be reduced by contractual means, such as deductibles and copayments, which share some of the risk with the insured, but insurance compaies also benefit by seeking out careful, trustworthy people to insure. Similiarly, employers reduce the moral hazard problem when they are able to attract loyal, hardworking employees. Potential insurants and employees have an advantage when they can persuade insurers and employers of their suitability, but attempts to do this raise the second problem.

The problems of moral hazard and adverse selection, which arise from agency theory, can be solved to some extent, then , by discouraging purely self-interested behavior and fostering certain ethical traits, especially those of honesty and reliability. Agency theory reminds us that self-interested behavior and the problems it creates must be taken into account, but to think only in terms of egoism may blind us to other possible solutions to these problems.

Financial services could scarcely be provided without raising conflicts of interest. In acting as intermediariers for people’s financial transactions and as custodians of their financial assets, financial service providers are often forced to choose among the competing interests of others- and weigh those interests against their own. Although personal interest plays some role, the conflicts of interest in financial services arise primarily from attempts to provide many different kinds of services to a number of different parties, often at the same time. Conflicts of interest are built into the structure of our financial instutions and could be avoided only with great difficulty. As one person has noted, ” The biblical observation that no man can serve two masters, if strictly followed, would make many of Wall Street’s present activities impossible. ” In interest and can be induced to serve any master only within limits. The challenge, therefore, is not to prevent conflicts of interest in financial services but to manage them in a workable financial system.

Finally, financial services providers avoid conflicts of interest by seeking parties with independent judgement in situations in which their own judgement is compromised. Examples of such independent parties include independet trustees on the boards of mutual funds, independent appraisers in the determining the value of assets in cases of self dealing, independent actuaries in the operation of corporate pension funds, and independent proxy advisory services in deciding how to vote shares held by trusts and funds.

Fairness in market transactions, the obligations or duties of people in financial contracting, and conflict of interest- which provide a foundation for examining specific ethical issues in financial markets, financial institutions, and financial management. Although finance ethics involves many complex and difficult issues, virtually the whole of ethics in finance can be reduced to two simple rules: ” Be fair ( in market transactions!)” and ” Keep your promises ( made in contracts)!” Since one promise that is often made in finance is to serve the interests of others, the rule ” Keep your promises!” includes a third rule, ” Avoid conflicts of interest!” However, as the subsequent chapters illustrate, determining what is fair in market transactions, what are the obligations of people in financial relationships, and how to avoid or manage conflicts of interest are very challenging tasks.


Mert E. M.