Ethics in Finance

Ethics in finance is concerned with the issue of how criteria reflecting the general good and in excess of formal legal or contractual obligations are incorporated into corporate financial decisions. Key areas of application are in remuneration and conduct of agents, informational asymmetry and disclosure and the degree to which ethical considerations are priced in capital markets and in companies’ internal investment evaluations.

Ethical concerns have a long history in finance, both theoretical, as exemplified in the writings of Adam Smith, the father of the market economy (Smith, 1976) and practical, as evidenced by eighteenth- and nineteenth-century Quaker businesses such as Cadbury’s, Clarks, or Rowntrees renowned for the cradle to grave care shown for employees. Although traditionally motivated by religious beliefs, the ethical stance of modern day businesses are more likely to be motivated by concerns over the environment, justice, equal opportunities, and human and animal rights. Anita Roddick’s Body Shop is particularly active in pursuing such issues.

Ethical concerns are somewhat at variance with finance theory, which rests on a core assumption of profit maximization or the maximization of shareholder value. In practice many companies adopt policies that appear to sacrifice profits for other objectives including esteem or reputation, public duty or responsibility or to reflect a corporate culture in which no advantage is sought which would impose undue losses on stakeholders such as customers, suppliers, or employees, who have no contractual power to enforce such consideration.

Proof that ethical behavior is inconsistent with the various versions of the wealth-maximization paradigm used in finance is more elusive. If businesses frequently sacrifice available profit opportunities in recognition of the losses they imply for other parties, or preempt the shareholder’s choice by distributing shareholders’ funds to charitable causes or disadvantaged suppliers, then profit maximization seems implausible as the only or even main element in the objective function. But ethical behavior may not result solely from altruism. It is possible that an ethical stance is simply another dimension in the competitive armory alongside marketing, new technology, or cost management. Volvo’s investment in car safety in excess of regulatory and legal requirements (and in excess of plausible estimates of likely benefit) may have been prompted by concern for human life but equally may have been motivated by a long-sighted strategy to gain competitive advantage (and home market protection) by anticipating rather than resisting standards that now have legal force. A water supply company overhauling its supply network may consider it ethical to use BATNIEC (best available technology not involving excessive cost) as an investment criterion rather than CATNIP (cheapest available technology not involving prosecution) but whether this involves any loss of shareholder wealth depends on contingencies such as the speed with which regulations are tightened and long-term maintenance costs.

Even those companies run by Quaker philanthropists might in the same way realistically expect to recoup the cost of generous employee conditions in higher retention and productivity. Even the British companies taking pride in not paying an invoice before receipt of three reminders and a telephone call might eventually realize that they are paying for the lost interest and administration cost in less competitive supply prices.

Ethics are important in a major area in finance , agency theory (Jensen and Meckling, 1976). Agent-principal problems are widespread in finance because financial management and intermediation provides fertile grounds for conflicts of interest. Creating incentive structures for agents that reward them for optimizing outcomes for the principals or owners is difficult, and monitoring and controlling agents is expensive. An ethical agent exceeding contractual and legislative requirements may derive business advantage as a result of administrative savings for all parties. Not surprisingly professions such as lawyers and accountants emphasize codes of ethical conduct in recognition of the almost total trust clients have to invest in them.

Asymmetry of information is another fertile area for ethnical concerns. Asymmetry occurs between firms and their customers, investors and their companies and employers and their employees, with complex signaling used alongside formal reporting to convey information. Maintaining dividends to counteract the negative impact of a temporary profit reduction is one common example. If investors were not convinced that this maintenance was ethical, rather than reflecting the directors’ best estimate of the sustainable dividend level for their company, the exercise would be pointless.

The ethics of agents and intermediaries are crucial to the operations of financial markets. Agents such as investment banks, stockbroker s, or company managers have an information advantage relative to their principals which they could use to secure excessive and perhaps hidden benefits. A particular concern has been the justification for the terms and conditions of directors of public companies who effectively set not only their own salaries but also bonuses, option packages, and long-term rolling contracts. Since the directors of the institutional shareholders who effectively control public companies enjoy similar privileges the scope for unethical behavior is wide. Not only are directors’ emoluments outside shareholders’ control but they may also install further “poison pill” defense to deter reform by outside takeover.

The relation to agency and information asymmetry problems might be to increase the use of performance-based pay, but this also raises ethical concerns where the agent is then encouraged to distort the incentive scheme perhaps by putting losses into a suspense account or by misleading customers in order to get a sale. The result is a discernible move to legislate for greater accountability and disclosure of intermediaries’ commissions and company directors’ emoluments which previously were hidden from principals. There is also a noticeable trend to formalizing ethical behavior both through adoption of codes of practice and customer charters by individual institutions and by self-regulating industry associations.

Policing ethical standards, though, is difficult. The consequences of many ethical defaults are ambiguous and they impose diffuse costs on an industry or community rather than on identifiable parties. As a result unethical behavior appears victimless and even where ethical behavior is enforced by legal sanctions, as for example is the case of insider trading, proving that privileged information has been exploite d by company officers or their professional advisors is difficult, and successful prosecutions are rare. Other legislation designed to reinforce ethical standards covering money laundering or international bribery (the US Foreign Corrupt Practices Act) seem to have left business as usual, with private banking a flourishing area, reinforcing the point (Grant, 1991) that legal structures can be manipulated to facilitate unethical behavior. Bankruptcy law, originally designed to facilitate orderly repayment of obligations and to protect employees, is now frequently used to evade liabilities.

High ethical standards in finance can both help and handicap markets. Historically the high moral hazards of the emerging banking and insurance markets could only be handled by impeccable ethical standards. Lloyds of London based on unlimited mutual liability relied on full disclosure of all material facts, underline d by the slogan “my word is my bond.” For banks the standing of directors as “fit and prop er” in the eyes of the Governor of the Bank of England was as important as a bank’s balance sheet. On the other hand modern derivatives markets only flourished when ethical aversion to speculative trading receded (Raines and Leathers, 1994).

This suggests that ethical behavior is strongest in close knit markets where loss of reputation among customers would produce irretrievable business damage. With a move to globalized rather than local markets and transaction-based rather than relationship-based culture, ethical feedback is weaker and it is indicative that mutual structure in insurance, banking and savings and loan operations are being transformed into profit-oriented quoted companies operating with formal regulatory structures.

Whether because of declining ethical standards or greater awareness by customers, in recent years there has been a major increase in compliance costs as regulators have sought to modify information asymmetry and agency problems in a range of activities including sales of financial products, securities transactions and exploitation of market power, especially by utilities. Although compliance is intended to achieve broadly ethical objectives the main thrust of regulation is on training, qualifications, and procedures rather than performance indicators.

Whether regulation removes ethical dilemmas in finance is arguable. Precisely defining what is acceptable, the minimum amount of reserves needed to safeguard bank deposits invested in a particular class of risk asset, or what must b e disclosed under accounting standards, may provide institutions with more certainty about acceptable boundaries and hence result in lower standards. Smith’s (1992) vigorous criticisms of accountants’ exploitation of existing discretion resulted in an overdue reduction in accountants’ powers to issue the kind of favorable interpretations where a transaction was exceptional when it made a loss but non-exceptional when profitable.

Table 1 Avoidance and Returns

The growing interest in ethical behavior is also a reflection of a growing militancy by interest groups, which in practice means companies and their officers act in a near altruistic way because their power and wealth makes them natural targets. Shell’s decision to take the financially attractive option of sinking the Brent Spar rig may have reflected the best scientific advice but was rapidly reversed by the imminent losses threatened by a consumer boycott of their products. Banks’ liquidations of insolvent businesses or building societies repossessing homes are routinely criticized on the grounds that they can afford the losses better than their clients and that the external costs, in terms of knock on effect on family, community, and indirectly the tax and welfare system, are likely to be substantial.

The main defense for companies is to introduce new standards of observance of environmental and other sensitive areas such as animal rights, backed with high levels of disclosure. It is evident that poor disclosure, whether of commissions, directors’ remuneration packages or the benzene content of bottled water, is increasingly a primary indicator of ethical malpractice.

Private shareholders do have an alternative route of influence and that is to invest in companies (or in mutual funds) which explicitly reject environmentally or ethically sensitive areas of activity. Areas of concern would typically be material exposure to oppressive regime (with South Africa a cause celebre in apartheid years), producing armaments or military supplies, producing or selling tobacco and liquor, participating in the nuclear industry or in industries and firms with poor records for prosecution on environmental, safety, product quality grounds, or for misrepresentation and malpractice in selling.

The financial performance of ethical firms or collective investments provides a partial answer to whether there is any conflict between ethical standards and wealth maximization, although many problems of methodology are unresolved. McGuire et al. (1988) claimed that ethical behavior produced competitive returns but the study had poor controls for size and industry membership effects. This is important since the process of screening to avoid particular ethical concerns generally excludes a high proportion of large multibusiness firms, so ethical portfolios are biased towards smaller, riskier firms expected in any event to earn higher returns.

Nor is there a clear measure of ethical strictness. An investment portfolio can be measured fairly straightforwardly for avoidance – in effect on the percentage of investment in the portfolio which does not have a given exposure and some typical avoidance and return results are shown in Table 1. These indicate that the higher the avoidance (and hence the more restrictions on the portfolio managers) the lower the returns.

Although avoidance measures are easy to calculate they cover only the negative aspects of ethical performance. Since total avoidance is available through, for example, mortgage-backed securities, investors logically are as concerned about positive objectives as negative. The Co-operative Insurance Society’s Environ Trust scores low on avoidance because it invests in companies contributing solutions in environmentally hazardous area or in companies judged as benefiting the general population in an oppressive regime.

Ultimately if any market includes ethical and ethics-indifferent investors the efficient markets hypothesis would predict that arbitrage by ethics-indifferent investors would eliminate any significant positive (or negative) excess returns in ethical securities. This is illustrated by the Maxus Investment Group which established an unethical fund in the USA specifically targeting companies with interests in tobacco, gambling, and pornography. The more interesting long-term question is whether an ethical stance increasingly constitutes new and valuable information because it tracks the risk to future profits, as legislation backed policies such as “polluter pays” redirect external costs to the company responsible.