INTRODUCTION TO 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"

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.
 NEED OF ETHICS IN FINANCE.
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
prohibition 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.
 The Value of Financial Ethics

The term, ‘ethics’, can mean three things. Firstly, it denotes the ethical outlook of an entity,
whether implied by its behaviour or explicitly stated. Secondly, it may refer to the set of
normative principles and reasons which govern conduct, whether at the individual or collective
level. Thirdly and most commonly, it is defined as an area of philosophical enquiry devoted to
grasping the principles constituting ‘ethics’ in its second sense explained above. It then follows
that the term, ‘financial ethics’, refers to the philosophical endeavours which seek to postulate
the set of principles which govern individual and collective conduct in the field of finance, as
well as more general enquiries into the justifications, both moral and amoral, which purport to
guide conduct in a financial environment. However, despite the fact the examination of such
issues and norms is long standing because they underline much of the popular concern with
regulating financial activity, financial ethics as an academic discipline is relatively new. This is
due to a lack of recognition of ethics in finance, which reflects not only the perception of many
people in and out of the business world, but also the way many would like to continue to
perceive business and finance. Until the mid-1990s, the norm in business schools has been to
concentrate on the ‘hard’ disciplines such as economics, finance and accounting, which can
purportedly boast ‘objective’ quantitative methodologies. On the other hand, ethics was, and still
is, to a certain extent, dismissed as subjective, relativistic and undeserving of a place in finance.
Therefore, this article aims to defend the importance of financial ethics by examining the
normativity of finance theory, the necessity of moral thinking in real life decision-making and
the ethical foundation upon which financial markets operate.

 Normativity of Finance Theory

A. An Objective Science?

Finance theory is regarded by its advocates to be ethically neutral. However, the finance
discipline has borrowed, almost in toto,from economics various value assumptions which depend
for their certainty on an account of the world where ‘ceteris’ are always ‘paribus’. It then follows
that finance theory only offers a limited paradigm which stands in stark contrast against a world
of imperfect information and unpredictable human behaviour. Furthermore, the main
assumptions of finance theory, such as rational or self-interested behaviour, and the models that
have been developed pursuant to the acceptance of those assumptions, such as the capital asset
pricing model or the efficient market hypothesis, potentially lead to conclusions about how
people ought to behave and how corporations ought to be organised and operated. It only takes a
short intellectual leap from ‘assuming that individuals are self-interested’ to ‘a rational actor is
self-interested’ to ‘one ought to act as to maximise self-interest’. These assumptions may well
lack normative import when first introduced to the world of finance, but a critical transition takes
place when those ideas are advocated as guides for conduct. In the words of Robert W Kolb,
there is a tendency for characterizations of human psychology that are consciously adopted as
methodological fictions to harden into descriptions of the ways that people actually think and
behave, and eventually to become even a prescription for how people ought to think and behave.

Therefore, it is not surprising that many, like Kolb, argue that even though the finance discipline
often attempts to present itself as an objective, ethically neutral science, not dissimilar to other
natural sciences, it is in fact ‘essentially prescriptive and normative’.

B. Challenges to Assumptions

The traditional assumptions adopted by finance theory have been challenged on two broad fronts.
Firstly, a growing body of empirical and experimental evidence has challenged the simplified
view of society and human psychology discussed briefly above. Secondly, and somewhat linked
to the first ground for objection, it is argued that the descriptive accuracy of economic rationality
is inseparable from its prescriptive desirability. Relying on the fact that human behavior is
fundamentally malleable and suggestible, scholars have found that actors in the marketplace
actually change their behavior when confronted with role models, or assumptions about how
other actors conduct themselves. Furthermore, even in strictly financial environments, human
psychology has proven to be far more ‘complex, multifaceted and unpredictable’ than that
characterised by the traditional assumptions. Therefore, these assumptions and models retain
their place in the finance discipline not because of their purported descriptive accuracy which
befits an ‘objective science’, but rather their latent normative power which transforms ‘is’ into
‘ought’. It is unsurprising one scholar has made the following criticism:

[such] methodologies perhaps give their practitioners delusions of grandeur, the belief that their
application can solve real problems, when they are often more akin to the technique of the drunk
looking for a dropped coin underneath a lamp-post, not because that is where it fell but because
that is the only place there is any light.

In the face of such criticism, virtually all finance theorists readily concede that the traditional
assumptions about human behaviour are not realistic. However, the finance discipline as a whole
seeks to justify those assumptions upon two grounds. Firstly, its narrow view of rationality and
reduction of human values to monetary terms are perceived to be methodological simplifications
of reality that make it possible to proceed with financial investigations. The making of such
assumptions have been likened to the unrealistic assumptions that have proven to be useful in
physics, such as the assumption that a feather falls in a vacuum. Finance theorists hope that
similarly, the simplification of the paradigm of human psychology will prove to be elucidating
and facilitative for the field of finance. Secondly, defenders of finance theory argue that finance
does not stand itself on the pedestal of scientific realism, but rather an instrumental approach is
taken in which the value of the discipline should not be judged by how well its theories
correspond to the full complexity of reality, but how they are able to develop a useful heuristic
which facilitates the prediction of economic behaviour and explains observed market prices.This
Keynesian line of argument suggests the correspondence of the predictions made by finance with
subsequent realities justifies the reasonableness of its simplifying assumptions. However, whilst
the utility and reasonableness of such assumptions might be accepted, it does not follow that the
finance discipline can present itself as an ‘objective science’ devoid of any normative import.

 Moral Reasoning in Financial Decision-Making

Just as how finance theory is essentially normative and prescriptive, few financial decisions can
be made solely on the basis of financial arithmetic, as a degree of ethical judgement is almost
always involved. As finance professionals are involved in processes of allocation across time,
products, markets and people, value judgements are necessarily involved in the identification and
quantification of variables and in the evaluation of consequences. Therefore, financial ethics is
crucial to finance as it presents valuable tools for the systematisation of such moral reasoning in
real life decision-making. However, this proposition is met with the objection the business entity
is not structured to handle questions of values and ethics, and managers are usually not trained in
business schools to do so. Such practical concerns are not unfounded, as it is simpler to deal with
dollars and cents than to deal with value judgements, more comfortable to discuss a problem in
terms of a bottom line in the form of profit or loss, and easier for those outside business to judge
a corporation by its financial status or products.

However, such objections are grounded upon the place of philosophy in our society. According
to some, philosophy has turned itself into a highly specialised and even esoteric discipline which
is solely within the province of the universities; its methods and style have led to its complete
retreat from the public arena. It then follows that philosophy is ignored by business people
because it is too difficult to comprehend in its contemporary form, and philosophers who clearly
possess deep understanding of business and finance only utilise such knowledge as a source of
interesting problems and a context for argumentation within the academia, rather than for the
purpose of communicating with those who are concerned with the ethics of finance. However,
one cannot help but notice the exaggerations of this argument. The objectors clearly disregard
the fact that finance professionals themselves publish in academic journals of ethics, many
business schools now offer courses in ethics, and the fact that business people are almost always
included in conferences and meetings pertaining to the ethics of business and finance.

A somewhat related objection is also mounted by those in the business world against moral
philosophy. Such objectors argue the methodologies of philosophy are ill-suited to answer the
ethical questions which arise from the day-to-day, practical and contextually-rich exigencies in a
business environment. Such objections arise from the perception that there exists an almost
dichotomous relationship between philosophy and reality, but the gap between these two
concepts may not be as great as the objector implies. It seems reasonable to say that when faced
with a moral problem, most people do stop to think, and when they do so, they are seeking to
provide some kind of universal justification for the course of action they eventually choose.
Therefore, people do engage in moral reasoning and philosophy on a daily basis. Furthermore, it
is only a short intellectual leap to recognise our everyday moral thinking has its roots in those
very traditions that lie behind contemporary moral theory, found in the works of Plato, Aristotle
and other worthy philosophers. Whilst one may concede philosophy can be abstract, in that it
consists in the articulation of rather general principles which require much interpretation if they
are to be used as guides for everyday conduct, one must also accept that philosophy can be of
utility in suggesting lines of reasoning, opening up new logical possibilities and extending one’s
imagination, whether the context is business or otherwise. To sum up, in the words of Robert

Crisp: it might be the case that any apparent stand-off that exists between contemporary business
ethics and business itself is at least as much the fault of the majority of businesspeople, who do
not take the trouble to discover even the basics of philosophical business ethics, as it is over-
technical philosophers.

If it is inevitable finance professionals will encounter some ethical issue in some stage of their
career, and if it is accepted the gap between philosophy and real life is not unsurmountable, then
it is reasonable to argue that it is only beneficial if finance professionals make full use of the
tools offered by financial ethics when dealing with such issues.

 Ethical Foundations of Finance

John R Boatright once said, ‘Despite the popular cynical view that there is no ethics in finance, a
moment’s reflection reveals that finance could not exist without it’. If it is true that actors in
finance are not expected to behave in accordance with ethical rules and they are merely expected
to do whatever is necessary to maximise self-interest, then financial scandals would not be met
with indignation, shock or uproar from the rest of society. Whilst it may be accepted that
freedom is necessary to the free-enterprise approach which is characteristic of many
contemporary economies, such freedom always exists within the limits imposed by a political
framework. Without an assumption of fairness, equal opportunity and the observation of basic
rights and duties, nobody would make exchanges in a market or entrust their assets with financial
service providers. Therefore, legitimate businesses, including those in the financial sector, need a
‘societal foundation of ethical values in order to operate efficiently and effectively’.

However, opponents to this view seem to overemphasise the effects of competition, which is a
requisite element for any market economy. By relying upon the notion of the ‘unseen hand’
postulated by Adam Smith, which also produces Pangloss’ ‘best of all possible worlds’,
protagonists of a competitive market regard the system as one where self-interest is maximised
without anyone caring for anyone else. However, such a characterisation is but a myth.
According to Bimal Prodhan, the market ‘is simply the imaginary place where the exigencies of
the material and social conditions of production are imposed’. It then follows the ‘unseen hand’
of the market is not a gift of nature, but a politically chosen set of property rights which depend
upon some minimum of self-constraint. Furthermore, even the concept of efficiency, which is
popularly seen as the virtue of the market system and a product of competitive economic life, is a
value category because it can be perceived as a function of available opportunities, which are
shaped by property rights. As property rights determine which effects of A’s action on B are
costs that must be considered by A, and which are costs to others, social efficiency requires some
general measure of value reflecting group choices in a political system. That general measure of
value, it is argued, takes the form of ethical choices. Therefore, to make rational financial
operations possible, there must be an assumption of general adherence to ethical values.

Ethics in Finance: Why is it such a problem?

Despite the best efforts of all concerned, the financial sector continues to have a bad reputation
for illegal and unethical behaviour and to be more prone to ethical lapses than other business
sectors. John Hendry explores why this should be, and what might be done about it in practice.

Why has the financial sector such a bad reputation for illegal and unethical behaviour?

Partly perhaps, because of ignorance and prejudice. Most people have very little understanding
of finance, and throughout history its practitioners and their core activities – lending, borrowing
and speculative trading – have been seen as morally distasteful. Nowadays everybody who has a
bank account is a lender, everybody with a pension or life policy is a speculator, and most of us
are also borrowers, but the moral stigma somehow remains. There is more behind the bad
reputation of finance than that, however. While it’s difficult to get a meaningful measure of such
things, the financial sector almost certainly is much more prone to ethical lapses than other
business sectors. There may be a problem of perception but there is a real problem as well, and it
is a problem that refuses to go away, despite the best efforts of firms and regulators to address it.

This situation prompts a number of questions. The first and most important is: what can be done?
Good intentions are clearly not enough and while there have been all sorts of suggestions, from
enforced restructuring of the banking sector to capping bankers’ bonuses and from enhanced
compliance regimes to the requirement that bankers swear some kind of hippocratic oath, none
of these seem particularly promising. We need to come up with something better, and to do this
we need to ask two further questions. What kinds of ethical problem are we up against here? And
what is it about the financial sector that gives rise to these particular kinds of problem?

The Problems

Like any other business, or any other competitive activity, finance has its share of fraudsters and
cheats, its Madoffs and Levines, but this is not the heart of the problem. What is characteristic of
ethical lapses in finance is not intentional, but unintentional wrongdoing – not immorality so
much as moral oversight or neglect. Three kinds of problem in particular stand out.

What is characteristic of ethical lapses in finance is not intentional, but unintentional

wrongdoing.

The first, and the most characteristic of the sector, is exemplified by the mis-selling of complex
derivatives (Goldman Sachs’s Abacus products or the customised swaps sold by Bankers Trust
in the 1990s), the manipulation of sell-side research and IPOs, the misrepresentation of financial
assets and liabilities (off balance sheet SIVs, inappropriate mark-to-model valuations or
Lehman’s Repo 105s), LIBOR rate-fixing, etc. In all these cases and many others it is clear from
the outside – and clear in retrospect even from the inside – that the actions taken were wrong.
But they didn’t seem wrong to those engaged in them at the time. They were perceived, perhaps,
as stretching the rules, but not as breaking them, and it was the rules of the game, the technical
norms, that were perceived as relevant, not the social and moral norms that underpinned them.
Ethics just didn’t enter into the matter – and that was precisely the problem.

The second kind of problem, and the kind that impacts most immediately on the public, is
exemplified by the mis-selling of personal or small business financial products: split caps,
endowment mortgages, personal pension plans, payment protection insurance, etc. No-one here
set out to deceive. By and large all those involved set out to provide a genuine service to the
customer. But the people who designed the products failed to think through the possible
consequences, and the people who sold them on the ground simply didn’t know enough about
them to know whether they were or weren’t appropriate.

Both the financial labour market and the market for financial services are demonstrably
inefficient and competitively highly imperfect.

The third kind of problem is not generally recognised as a problem within the sector, but needs to
be recognised if progress is to be made. Its main public manifestation is in the debate over
bankers’ bonuses, but the underlying issue is much broader. It can be summed up in two
contradictions. First, the core function of the financial sector is to secure the most efficient
allocation of financial capital across the productive economy, but its most significant
achievement over the past 30 years has been the large scale extraction of financial resources
from that economy. Even in the wake of the financial crisis, financial practitioners have not only
been getting richer than anyone else but also getting richer at the expense of everyone else.
Second, the core value of the sector is the maintenance of free, efficient and perfectly
competitive markets, but both the financial labour market and the market for financial services
are demonstrably inefficient and competitively highly imperfect. Again, no-one has sought
intentionally to bring this about, but that doesn’t mean it’s not a problem.
  The Causes

These kinds of problem don’t arise because the people going into the sector are any less ethical,
or any less ethically attentive, in themselves, than those going into other sectors. They may be
motivated to make money rather than to save lives but that’s not exactly unusual in business, and
most are attracted to finance simply because they’re good at it. Like anybody else they want to
advance their careers and make money, but like anybody else they also start out with a
predisposition in favour of a principled, moral approach. They believe that people should in
general behave ethically, and they include themselves in that. Moreover, although there may be
some fuzziness around the edges, they have a pretty good idea of what is right and what is wrong
and when it comes to a conscious choice they would prefer to do what is right.

The problem is that it doesn’t generally come to a conscious choice, and the root of that problem
is in finance itself, in the norms and values inherent in financial practice and the way these affect
people’s behaviour. Two sets of factors stand out, one relating to the nature of money and the
financial system, and the other to the norms and techniques of financial practice.

All businesses deal with money, but finance is concerned exclusively with money and monetary
products, and money and morality always have been, and always will be, uneasy bedfellows.
Unlike the goods and services produced or traded in other sectors, money has no physical impact
on society, no immediate psychological impact, and no obvious moral effects. It also has no
intrinsic value and in this context little symbolic value. Its value is an exchange value, and of a
particularly pure form. Most things with exchange value – reputation and social standing, for
example – are culturally specific and tied to particular communities. Money is culturally neutral
and has a global reach. It is not tied, as goods and services are, to the context of a community,
and since moral values are essentially community values – indeed, they are what hold
communities together – money eludes them. The result is that the activities of the financial sector
are effectively dissociated from the physical and moral communities that shape all other business
sectors.

On top of this, money is itself inherently de-moralising. As the ancient Greeks already
recognised, it is the unique object of unlimited desire. The greed of the glutton or libertine is
inherently self-limiting and its immorality painfully visible, but the greed for money knows no
limits. As behavioural economists like Bruno Frey have shown, money also displaces or crowds
out emotions and moral values.1 And as the anthropologist David Graeber has recently argued, it
de-moralises personal debts and obligations.2 Our moral obligations are, in a very important
sense, non-measurable. Whatever may be paid or repaid, they can never be squared off and
closed. As soon as debts become monetarised, however, the values and obligations associated
with human exchanges are lost, and because morals are always associated with values and with
personal obligations or commitments, they are lost too.
These effects are accentuated by the norms and techniques of financial practice. The highly
technical nature of financial products and practices closes people off from wider considerations.
As in other technical fields, the technology absorbs people’s attention and presents itself as
morally neutral. The game-playing nature of financial trading also blinds people to its real
consequences: no matter what controls are in place, there is always a temptation to act as if their
were no repercussions, as if the game could just be re-set if things go wrong.

Finally, both the practices of the financial sector and the education of its practitioners are
inevitably framed by the theory and assumptions of financial economics. All people are assumed
to be financially self-seeking, opportunistic, rational and competent monetary wealth-
maximisers. They are out to make as much money as they can, with no moral scruples.

Formally speaking, this last assumption carries no moral implications. It’s an assumption as to
how people are, and neither the assumption nor the theory say anything about how people should
be. It acquires moral force, however, from the proposition – shared across the sector – that
unrestrained financial self-seeking is ultimately to the benefit of society as a whole. The
argument underlying this, which in ethical terms is an argument from rule utilitarianism, is
seriously flawed. (Very briefly, whether or not financial self-interest maximises total wealth is
unclear, but distribution effects mean that it almost certainly doesn’t maximise total utility, on
any plausible definition of that.3 ) But the proposition is deeply embedded in the culture of
finance and it provides a curious cap to the de-moralising effects of money and the financial
system. For all the reasons noted, finance is deeply amoral, but that amorality is also perceived,
within the sector, as a (morally) good thing.

 The Remedies

What, in the face of all this, can be done? Some critics of finance have argued the need for
wholesale value change. The suggestion mentioned earlier, for example, that bankers should take
an oath dedicating themselves to the interests of their customers was part of a report on
“Virtuous banking” by the think tank ResPublica, which took very much this line.4 While the
report was full of good intentions, however, it served mainly to show just how out of touch
policy wonks are with the real world. While norms and values can evolve over time they cannot
simply be re-written or re-engineered, and there is no way in which we can plausibly separate the
culture of finance from the cultural effects of money, globalisation, or economic theory.
Somehow, the solution has to come from within that context.

Proper professionalization, which is more than just some courses and letters after your
name, also brings with it enforceable ethical standards, including a clear commitment to
both the public interest and the welfare of the client.
How this might happen remains unclear, but legal and regulatory impositions have a very poor
record of success. Market forces operating through the medium of internet-based self-correcting
systems may be a more promising possibility, but that would pose ethical challenges of its own
and in the short term the inefficiencies of financial services markets pose a barrier to change. The
best hope probably lies with a process of professionalisation. There is already in the sector a
commitment to training and education, and there is an interest in reputation. When people get
rich they may still seek to get richer but they also begin to seek respectability, and in a technical
field with a monopoly of expertise professionalisation is a natural route towards this.
Professionalisation typically brings with it minimum levels of knowledge and on-the-job
training, and if applied across the sector this would itself address some of the issues to do with
the mis-selling of personal financial products. Proper professionalisation, which is more than just
some courses and letters after your name, also brings with it enforceable ethical standards,
including a clear commitment to both the public interest and the welfare of the client. Critically,
in a professionalised practice, all professionals are personally responsible for the actions of their
teams. However thoughtless or incompetent the person with whom you are dealing as a client,
there is a fully qualified named individual taking full responsibility for everything they do, or
don’t do. And while that mechanism is far from foolproof (the accounting profession, for
example, has hardly been free of ethical lapses) it provides a strong incentive for ethical
attentiveness.

CONCLUSION

This note is an attempt to defend the value of financial ethics. It seeks to achieve this purpose by
(1) examining the latent normativity of finance theory under the guise of an ‘objective science’;
(2) canvassing the debate which surrounds the almost dichotomous relationship between
philosophy and real life and its implications for application of moral reasoning in financial
decision-making; and (3) arguing that finance, like any other sphere of human activity, cannot
exist without an ethical foundation which reflects group choices in a political system.