Finance and Ethics. Financial Risk CHALMERS UNIVERSITY OF TECHNOLOGY ACADEMIC YEAR 2010

Transcription

1 CHALMERS UNIVERSITY OF TECHNOLOGY ACADEMIC YEAR 2010 Finance and Ethics Financial Risk Natalie Gutierrez, Ajla Talovic, Financial Risk, MVE220 Examiner: Holger Rootzén , Gothenburg [The report gives a background to why there is a need for ethics on the financial market and discusses some solutions to reducing the risks with ethical violations. Both group members have jointly written the report.]

2 Table of Contents 1. INTRODUCTION BACKGROUND ETHICAL VIOLATIONS UNETHICAL FUNDS INSIDER TRADING BONUS SYSTEMS CONCLUSIONS SUMMARY: HOW TO ACT ETHICAL ON THE FINANCIAL MARKET... 5 READING GUIDE... 6 REFERENCES 2

3 1. Introduction How far would you extend your ethical boundaries, within the law, to gain a profit? Are there any financial risks with unethical behavior, and if so what can be done to reduce these risks? Do general ethics even exist within finance? All people have their own definition of what ethics is, the most common being to determine the difference between right and wrong and being able to decide what is good versus bad. The general interpretation would be that an ethical person could be described as someone who is honest, fair and can determine the differences mentioned above. 1 These descriptions of ethics have become norms in most parts of our society and it is expected from all people to maintain them. However, with the aftermath of the financial crisis people are now questioning if the same norms are being applied to the financial world, if there is a need for a broad discussion of what is acceptable in the modern economy. Although many people agree that subprime loan, insider trading, gigantic bonuses and bank bailouts are unethical and immoral, the claim is that these actions nevertheless are tolerated within finance coincidentally as the actions result in large financial risks. One statement for this reasoning is that when money is involved there is often a tendency to only let the market decide without any responsibility from the financial operators, arguing that what is legal cannot be unethical. Current research claims that unethical behavior has increased in the financial sector, with the recent financial crisis as one important impact. However, experts are of a different opinion urging that today s financial market cannot be compared to the former ethical standards due to new business situations and more complex problems as a result. 2 For example, companies have supreme pressure to account solid results on a quarterly basis which might result in slight manipulations of financial numbers which might appear justifiable. Could it therefore be a need for an ethical evaluation in modern finance? This report will give a background why some financial operations are considered to be ethical violations and why these actions often result in great financial risks. Thereafter, a discussion will handle different solutions and the incentives to perform these violations, and try to conclude how one can act ethical on the financial market. 2. Background Ethical dilemmas and violations in finance are almost always a result of the fundamental rule of economic models, to base decisions on what will maximize one s profit and best gain one s own interests. The modern financial system is established with collaborative companies, which work together but at the same time want to maximize their own utility. The financial sector is often referred to as a service industry and most of our financial services, for example management of retirement savings and stock placements, are commonly entrusted to others because we neither have the skills nor the time to manage them equally successfully. However, without ethical boundaries this trust can easily be violated and the operators can then be exposed to extensive financial risks. Consequently a paradoxical situation occurs; on the one hand our need to entrust others to best manage our financial 1 Boatright, J. (2010) 2 McCauley, M. (2009) 1

4 service while on the other hand these same people act with selfish behavior by the above description of human nature. Most companies are able to manage and avoid ethical violations by using ethical codes and ethical offices. The codes are constituted and supervised by the corporations themselves but also by official institutions and self-regulating organizations to guarantee and encourage employees to behave ethically and responsibly by following the guidelines. If the codes are not communicated across the company or used consistently they have no value. However, these codes of ethics can also have a negative aspect if an employer has the misconception that everything that is not stated as forbidden would be acceptable Ethical Violations The most recurring ethical violations in finance are mainly due to violations of trust and loyalty such as insider trading, stakeholder interest versus stockholder interest, investment management and campaign finance. Other frequent incidences are deceives in financial agreements, bribes and corruption in governments, dishonest accounting of trades and customers profit, illegal transactions, using customer funds for personal gain. 4 To be able to answer the questions in the introduction, it is important to have a wide comprehension of why ethical violations occur and why it is important to refrain from them. The report will therefore include the ethical violations within unethical stocks and funds, insider trading and bonus systems because these examples of violations give a broad outlook of the most distinct, frequent and relevant ethical problems within finance. 3.1 Unethical Funds Ethical funds attempt in some measure to take ethical aspects under consideration when selecting which companies to invest in. It has become increasingly common to invest in funds which place the saver s assets in companies that for example prioritize environment, human rights and equality. In contrast to these, the financial market also includes funds which can be perceived unethical due to investments in among others; alcohol, tobacco, gambling, weapons, military or child labor. 5 While it is not illegal to invest in these funds, it is considered unethical so should it therefore still be accepted and what are the risks with these investments? The reason why people purchase unethical funds is, as in all other investments, to gain a profit. Most investors are aware of that these funds have questionable ethics but still choose to venture into them because these companies overall often show large potential for earnings. While making a profit, these investors are supporting issues that most people consider unethical. One example of this is the Vice Fund, a fund which only invests in unethical companies that profile foremost in gambling, tobacco, alcohol, airlines and military. These segments, such as alcohol and tobacco, are often not dependent on the economic situation which results in that the fund is not affected in any wide extend by recessions 3 Boatright, J. (2010) 4 Boatright, J. (2010) 5 Listherby, C.A. (2010) 2

5 but can rather increase at these times. 6 This fact is one important reason to why investors can somewhat compromise their ethics and decide to purchase these funds. However, it is not always as obvious as in the case of the Vice Fund whether stocks and funds are striving to maintain ethics. For example, in some cases it is not common knowledge if a clothing company endorses child labor or if a subsidiary is receiving earnings that then go towards producing weapons. Most people choose to not invest in unethical funds, such as the Vice Fund, but when discussing these grey zones it can be impossible to decide the individual s responsibility and what in fact can be considered unethical behavior. 3.2 Insider Trading The most frequent ethical violation in finance is insider trading, which occurs when trading is based on taking advantage of information that is not official or available to the public. It does not implicate that the trade has to result in a profit to be accounted as a violation. The insider has knowledge about an intended arrangement which will change the price fixing on the market, for example a purchase offer, a bankruptcy or a change in interest, and uses this information for personal gain through a shortterm trading. 7 However, does insider trading always result in risk-taking on the financial market? To perpetrate insider trading is very simple and coincidentally in most cases impossible to prove, which is probably the main reason for why the law of insider trading has not served as a norm for how to act on the financial market. A number of researchers and economists claim that another key reason is that it works against the law of nature in financial market, in other words to obtain better information than other participants of the financial market and the participants questioning if something profitable can be immoral. Therefore many defend insider trading as operable and a useful method in the free market and consequently not immoral. For example an analyst receives an annum paycheck to discover information before anyone else, if he finds something enough in advance he receives a bonus but if he finds it just before it occurs then the revelation is immoral and punishable. For participants of the financial market it is therefore in some cases difficult to draw the line between which actions are legal opposed to illegal, and especially between what is ethical and unethical. 8 There are consequently two ways of approaching the questioning whether profiting from information from insider trading can be ethical or not. The perspective of the shareholder wealth maximization is that so long as the winners exceed the losers, then the profiting from the information is ethical. This approach could be an explanation to why insider trading is the most common ethical violation in finance. Since in almost all cases there is no visible loser of the trade, the criminal does not have to be confronted by individuals who have been harmed by the actions. Furthermore, there is rarely any economically damage and if so, it is divided by many participants and therefore barely noticeable. The other perception focuses on the process rather than the results; if the process is ethical then profiting from the information is also ethical Bonus Systems With the consequences of the financial crisis many are now questioning the ethical aspect of bonus systems. The discussion is foremost about whether it is acceptable for bonus payouts to be financed by 6 Listherby, C.A. (2010) 7 Boatright, J. (2010) 8 Affärldsvärlden. (1999) 9 Affärldsvärlden. (1999) 3

6 tax payers and if the executives are worth what they are paid considering the risks they take with money that in actuality belongs to shareholders. The public perception is that it is highly unethical for the executives of a bankrupt company to receive and be rewarded with bonuses, financed by tax payers for incurring losses. The fact that many employees have been fired in favor of bonuses to corporate CEOs and board members is an additional factor in the ethical debate. Furthermore, it is believed by many that one main reason for the financial crisis was the high risk-taking done by banks in the search for fast transactions. 10 In summary, do bonuses encourage unethical behavior? From the executives the answer is that they need the most skilled people running these firms and for that they need compensation or they will go elsewhere. The opponents however state that the bonus systems often reward unethical and wrong behavior, by for example issuing bonuses to the largest volume of mortgage contracts instead of to the number of safe mortgage volume, thus rewarding conducts that will harm a company s health and ultimately the entire economic system. 11 One statement is conclusively that there is no incentive system that will not inspire a wrongful behavior for which it was not intended to. Therefore, the claim is that bonus systems encourage a greater risk-taking and unethical behavior, by increasing deals with high risks since it can amount to a bonus for executives and investors in the financial sector. The statement is based on the viewpoint that a high salary will contribute as a motivation to work as reasonable as possible whereas receiving a bonus conducts unethical behavior, by for example being more aggressive or leaving out certain details from a contract. Additionally, they claim that there is no further value by the highly paid bankers and traders to the economy at large, but rather that the money would better serve the economy if a large portion was to be returned to the stakeholders. Finally, there is a belief that unethical people will act unethical regardless of bonuses Conclusions To conclude, the reason why ethical violations occur is in almost all cases because there is a need to make a profit, an opportunity exists and it is possible to rationalize the action. The need is partially based on greed and wanting to maximize ones profit but the need also increases when faced in more desperate times. What is important to take under consideration is therefore, among other factors, the individual s responsibility to maintain ethics in finance. To be able to that, one has to understand that the only way to profit is from someone else s loss and that financial risks will always occur with ethical violations. It is customary and acceptable on the financial market that while someone wins, another one loses. However, the ethical question that the individual needs to answer is; which risks are morally acceptable and is it ethical to profit from these risks under all circumstances? The similarity between most ethical violations, and all the ones that have been mentioned, is that the ethical violator takes risks which will result in a loser who has not been a direct participant of the transaction. The abstract financial market loses credibility and reliability within insider trading, tax payers have to fund bonus systems of corporations that have failed and the earners of unethical funds are financed by negative effects on non-participants. Before acting on greed or wanting to maximize ones profit, the individual therefore has to decide who the potential loser will be to be able to take ethical responsibility. 10 Gilani, S. (2009) 11 Gilani, S. (2009) 12 Gilani, S. (2009) 4

7 However, it is possible to determine that the need would be irrelevant if no opportunity to execute the unethical behavior existed. The responsibility of reducing the opportunity and risks should foremost be up to the companies. For example, due to the fact that insider trading can be impossible to prove and answer to, the most efficient way to prevent it would probably be for the companies to emphasize ethical behavior by having more strict ethical guidelines and encourage employees to behave ethically by having the board of directors modeling good ethics. Unacceptable actions would then result in loss of reputation and exclusion from the industry for the company as well as for the individual, therefore insider trading and other ethical violations would be considered more severe and the same high risktaking would not occur. Bonuses without any restrictions of ethical guidelines from the corporations can permit unethical participants to get further rewarded for their conducts. Therefore it is important that the bonus is not only based on results and performance of the individual but that the overall performance of the company is taken in under consideration and that the corporation has minimum goals for profit and growth before issuing bonuses, otherwise unintended and unethical results are often obtained. Companies that offer unethical funds should take a greater responsibility of being more open with what it is they are in fact presenting, even if it is foremost the individual who should evaluate possible losers. Finally, the last step in conducting an ethical violation is to be able to rationalize the action. That is in hindsight claiming that the action at the time was justifiable and the right thing to do, consequently diminishing the risks. In reducing this step it is important, in addition to the individual and the companies, also for the society to take ethical responsibility and encourage a general ethical culture. Other than having more evident laws and guidelines of what is ethical, one important aspect in improving ethics in finance could be to early on teach students in economics about ethical violations and the repercussions that can follow. The ethical perspectives are rarely mentioned in today s economic education and the focus is rather on how to elude rules to make a profit and not who the possible loser will be. Therefore, an integration of ethics in financial studies could be included to give an insight to ethical violations that can emerge. 5 Summary: How to Act Ethical on the Financial Market In summary, there is a need for general ethics in finance and it has to be practiced more than today. The reason for this is that participants of the financial market need to be more aware of what risks occurs when conducting unethical behavior, one risk being that unethical behavior always results in losers. If the increase in ethical violations continues, there is a great risk that the financial market will further lose its credibility and that crises will occur more often and with heavy impacts. Therefore, it is important to prevent ethical violations and for that to happen individuals, companies and the society as a whole need to take action and responsibility of maintaining ethics in finance. When participating on the financial market and questioning how far one can extend one s ethical boundaries, it is important to maintain the standard way of conducting operations and always be professional, otherwise it is easy to begin compromising one s ethics. Furthermore, while providing a financial service the participant needs to be reasonable in transactions and pricing, and have the potential loser in mind. Finally and probably most importantly, is to always be honest since that is the fundament if the financial market can work. 5

8 Reading Guide The book Finance Ethics Critical Issues in Theory and Practice by John R Boatright can be recommended for those who are interested to know more about finance and ethics, and examples of when it is important. For those who are interested in reading more about the paradox in finance and ethics the book Finance ethics: the rationality of virtue by John Dobson can be recommended. In the study How student perceptions of ethics can lead to future business behavior by Susan B. Shurden, the author has made a research in the ethical behavior of students in finance and also advises in how to act more ethical in future business jobs. References Literature: Boatright, J. (2010). Finance Ethics Critical issusue in theory and practice, New Jersey: John Wilet & sons Articles: Bonvin, J-M. Dembinski, P. (2002). Ethical Issues in Financial Activities. Journal of Business Ethics, 37(2), Patrcia H. Werhane. (1989). The ethics of insider trainings. Journal of Buisness Ethics, 8(11), WebPages: McCauley, M. (2009). The Current Financial Crisis Has Taught Us One Lesson: Ethics Need To Make A Strong Comeback. Downloaded , Listherby, C.A. (2010). Syndiga placeringar slår börsen. Downloaded: , Efendic, N. (2010). Tveksam etik när bankerna får välja. Downloaded: , Affärldsvärlden. (1999). Insideraffärer På fel sida om lagen. Downloaded: , Gilani, S. (2009). Wall Street s Bonus System Was a Major Financial Crisis Catalyst. Downloaded: Susan B. Shurden. How student perceptions of ethics can lead to future business behavior. Downloaded: