CHAPTER 18

Ethics in Banking and
the Financial-Services
Industry (FSI)
Chapter 18
1
LEARNING OBJECTIVES

To understand …








1. Ethics and how society uses ethics
2. Concern about lack of ethical behavior in banking and the
FSI
3. Unethical behavior in banking and the FSI as fraud and
negligent misrepresentation
4. Value maximization requires ethical behavior
5. Incentive-compatible contracts
6. Markets in terms of efficiency, failure, and information
costs
7. Ethics in information
8. Agency in law versus agency in the theory of the firm
Chapter 18
2
CHAPTER THEME

Ethics is the discipline dealing with what is
good and bad and with moral duty and
obligation. Moral, institutional, and
legal guidelines determine how societies
use ethics. From a pragmatic view, legal
guidelines and the role of government
(e.g., the federal safety net) are important
determinants of how people behave. Since
incentive-compatible contracts work, use
them to encourage ethical behavior.
Chapter 18
3
DENNIS WEATHERSTONE ON
CHARACTER

“What really matters more than anything is
character. The character of our people
determines the quality of our institutions,
which means that trust and confidence in
our ethical standard is paramount. True
character is often revealed under pressure.
The moments when I learned who could be
trusted to come through in times of crisis are
some of the most memorable of my life.”
Chapter 18
4
Let Markets Work

As bankers, regulators, and deposit insurers
move into the twenty-first century they need
to prove to the world that all the talk about
character and ethics is more than just
rhetoric. Actions speak louder than words.
Moreover, the main action that needs to be
taken is simple -- let markets work. The
central thesis of this chapter, and a recurring
theme of this book, is that markets work
Chapter 18
5
11 September 2001


This day and its aftermath tested the
character of the American people and
its friends
We and they passed with flying colors
of red, white, and blue!
Chapter 18
6
What is ethics?

Webster's (Seventh) gives the following definition of
ethic or ethics:





1. the discipline dealing with what is good or bad and
with moral duty and obligation
2a. a set of moral principles or values
2b. a theory or system of moral values
2c. the principles or conduct governing an individual or
group.
For our purposes, let's focus on ethics as the
principles of conduct governing participants in
the financial-services industry (FSI), including
bankers, customers, regulators, deposit insurers, and
any other interested parties
Chapter 18
7
Ethics as Conflict Resolution


View in terms of the principal-agent
model
What is versus what ought to be

Smith [1992] says: "... the primary aim of
economics is to describe and predict
human behavior, not prescribe it" (p. 23)
Chapter 18
8
Unethical Behavior
(Box 18-1)

Unethical behavior calls for conflict resolution
or, from a financial economics' perspective,
more incentive-compatible contracts.
Regulatory loopholes also can create
problems. For example, the General
Accounting Office revealed a major
unintended consequence of the (goodintensioned) Gramm-Leach-Bliley Act: a gap
in money-laundering enforcement authority
that kept regulators from examining bank
securities affiliates for more than a year
Chapter 18
9
Money Laundering and
Tracking Terrorists

Box 18-2 shows what large international
banks, prior to 11 September 2001,
were doing to combat money
laundering in private-banking
operations, which has important ethical
implications related to criminal and
terrorist activities outside the banking
system
Chapter 18
10
Plato on Right and Wrong


“... there is a true right and wrong, which is a
universal principle for all times. We do not make
values or truth; we find them; they do not alter with
races, places or fortune. Thus there are two worlds;
the world of absolute beauty, and the world of
opinion, with its conventions and delusions. This is
the root of dualism in Plato's philosophy ...
Plato, as a modern-day banker, would say that it is
truly wrong for providers of financial services to
discriminate on the basis of race, religion, sex, or
age
Chapter 18
11
Economic Decision-Making and
Discrimination in Ordinary Usage

Since the kind of discrimination that
disturbed Plato and that disturbs ethical
human beings today is the way in which
most people think about discrimination
(i.e., prejudging), we can call it
discrimination in ordinary usage
(e.g., all Arabs are terrorists is a false
prejudgment)
Chapter 18
12
Economic-Decision Making

It is based on opportunity cost or the value of an
alternative foregone action -- the "next best"
alternative. This kind of discrimination" is, in fact,
the heart of financial management. It is not
discrimination in the sense of prejudging but in the
sense of differentiating, discerning, distinguishing, or
separating on the basis of economic and financial
characteristics. The key point is that this kind of
economic decision-making can be justified on the
basis of opportunity cost, one of the most
fundamental concepts of economics
Chapter 18
13
WHY STUDY ETHICS IN
BANKING AND THE FSI?

Two themes of this book are that banks operate in
the financial-services industry (FSI) and that banks
are still the kingpins of the FSI. Bear and
Maldonado-Bear [1994] expand on these themes and
provide the linkage to ethics. They write:

Commercial banking is the cornerstone of America's
financial system. How it is set up and how it operates are
matters not only of enormous economic significance but also
of legal, political, social, and ethical significance. How
American banking fares determines in some consequential
degree how every American citizen fares -- as well as a
sizable number of people living in other nations (p. 239,
emphasis mine).
Chapter 18
14
AN INTERNATIONAL CODE OF ETHICS
FOR BUSINESS: THE CAUX PRINCIPLES


Since banking is a business like any other
economic activity, government guarantees
notwithstanding, a general code of business
ethics should apply to it
The purpose of the first international code of
ethics for business, established by the Caux
Round Table, is to set "a world standard
against which business behavior can be
measured" and in the process to establish a
yardstick which individual companies can
write their own ethical codes
Chapter 18
15
Principles Established by the
Caux Round Table (Table 18-1)







1. The Responsibilities of Businesses: Beyond
Shareholders toward Stakeholders
2. The Economic and Social Impact of
Businesses: Toward Innovation, Justice, and
World Community
3. Business Behavior: Beyond the Letter of the
Law toward a Spirit of Trust
4. Respect for the Rules
5. Support for Multilateral Trade
6. Respect for the Environment
7. Avoidance of Illicit Operations
Chapter 18
16
Application of the Principles

These principles apply to the following
stakeholders of a business:






Customers
Employees
Owners/Investors
Suppliers
Competitors
Communities
Chapter 18
17
Set-of-Contracts Theory

This stakeholder view of a business parallels Jensen
and Meckling's [1976] theory of the firm as a nexus
of contracts. This managerial perspective stresses the
importance of managers getting incentives "right,"
meaning "compatible" across the stakeholders of any
enterprise. Incentive-compatible contracts
accomplish this task. Kane [1996e] says that
incentive compatibility exists when a set of
contracts (explicit and implicit) designed to promote
the "common good" leaves individual stakeholders
unable to gain an advantage from other members of
the group, even if they violate the "rules of the
game."
Chapter 18
18
Maximizing Value and the
Role of Ethics

Firms cannot maximize long-run values
if they engage in unethical behavior,
that is, total market capital = financial
capital plus reputational capital.
Although short-run excess profits can
be earned by unethical behavior, market
and civil penalties ensure that they are
not sustained once bad faith is revealed
Chapter 18
19
Social Responsibility

In a free economy, Friedman [1962] captures
what the "social responsibility" of a business
should be:

... there is one and only social responsibility of
business -- to use its resources and engage in
activities designed to increase its profits so long as
it stays within the rules of the game, which is to
say, engages in open and free competition without
deception or fraud (p. 133)
Chapter 18
20
COMMON LAW AND
FINANCIAL FRAUDS

Common law is a legal system based upon
rules deduced, mainly by judges, from the
customs and institutions of the people and
related to their sociopolitical/economic
conditions. The legal concepts of fraud and
fiduciary (trust) relationship bring common
law "as close as it gets" to dealing with the
unethically opportunistic behavior found in
banking and the FSI.
Chapter 18
21
Fraud and Negligent
Misrepresentation

Legal definitions of these terms focus on
breaches of duties of trust and managerial
stewardship. The law, in many cases,
distinguishes between being negligent,
careless, or mistaken from being
fraudulent or dishonest. Although
violations of these codes can be labeled as
morally wrong, common law provides a legal
system for prosecuting financial fraud
Chapter 18
22
Five Cumulative CommonLaw Tests for Fraud





1. A conscious misrepresentation or concealment of
the truth
2. An intent to benefit by causing another party to
rely on the untruth to his or her detriment
3. The misrepresentation was material
4. An intent existed to cause the other party to rely
on the misrepresentation to his or her detriment
5. That the other party did believe, rely, and suffer
provable harm
Chapter 18
23
More …


In a negligent misrepresentation, a party is
responsible at law if, in the course of his or
her business or profession, the party supplies
misinformation to others in their transactions
that they rely on to their detriment
A recipient of information is justified in
expecting the informing party to exercise
"care and competence in obtaining and
communicating information."
Chapter 18
24
The S&L Mess

The S&L mess provides numerous examples
of negligence lawsuits filed against directors
and consultants of failed S&Ls and accounting
firms that audited the zombies. Exhibit 18-1
shows the results of a $186.5-million
settlement in favor of the FDIC, RTC, and
OTS against a major accounting firm charged
with malpractice based on allegations of
negligent misrepresentation
Chapter 18
25
MARKETS: EFFICIENCY, FAILURE,
AND INFORMATION COSTS


Economic systems with free markets tend to generate
the most economic prosperity. Ancient Rome and
Greece provide examples of critical linkages between
markets and ethics. Specifically, corruption in
government and society precipitates or at least
speeds a nation's economic decline.
How does economic freedom affect economic
prosperity? A study by the Heritage Foundation
concluded that "... the main cause of poverty around
the world is not the failure of rich countries to spread
wealth through foreign-aid programs, but the
misguided economic policies of developing countries
themselves" (Holmes [1994]).
Chapter 18
26
Index of Economic Freedom

Table 18-2 lists countries according to their degree of
economic freedom: 43 countries were found to have
"free" or "mostly free" economies, 50 economies
were rated "mostly unfree," and eight economies
were classified as "repressed." The striking thing
about Table 18-2 is the strong correlation between
economic wealth (per capita GDP measured by
purchasing power parity) and economic freedom.
Figure 18-1, updated with data for 1998, shows the
relationship more clearly --countries that are most
free economically have the highest standards of living
Chapter 18
27
Ten Key Areas of Economic
Freedom











1. Trade policy
2. Taxation policy
3. Government consumption
4. Monetary policy
5. Capital flows and foreign investment
6. Banking policy
7. Wage and price controls
8. Property rights of economic output [Y = C + I + G + (X-M)]
9. Regulations
10.The black market
What are the critical factors for our purposes?
Chapter 18
28
Causes of Market Failure







Monopoly
Information asymmetry
Public goods
Externalities
Solutions:
“Invisible Hand” versus the heavy hand of
government intervention
Discuss: Airline security and preventing
terrorism
Chapter 18
29
PUBLIC STEWARDSHIP, FIDUCIARY
RELATIONSHIPS, AND THE PRINCIPALAGENT MODEL


Public stewardship is the "... very high
duty and responsibility (of each and every
insured and protected bank) to assure the
safety and soundness of the system
This call for public stewardship or fiduciary
responsibility also extends, as Kane argues,
to deposit insurers and bank regulators to be
faithful agents and, it also extends more
broadly to our notion of regulatory discipline
and thus includes Congress and the
administration as taxpayers' agents.
Chapter 18
30
Faithful Versus Unfaithful
Agents

Discussion of Disinformation and the
Role of Ethics in



1. The S&L Mess
2. The Challenger Disaster
3. 11 September 2001
Chapter 18
31
How Agency Differs in Law
and in the Theory of the Firm

The financial version of agency theory
depicts the firm as a nexus of contracts in
which agency costs are the key ingredients
for understanding behavior. Agency costs
have three components:



1. monitoring expenditures by the principal,
2. bonding expenditures by the agent
3. residual loss
Chapter 18
32
Legal Agency

Bear and Maldonado-Bear describe legal agency as
control of the agent by the principal. They argue
that the managers/directors of a firm are not,
legally, agents of stockholders because they do not
have legal authority to direct and control the
activities of the agent. They describe the "spectacle
of many thousands of 'principals' (stockholders) ...
'delegating' authority 'by contract' to one board of
directors and a few executives, ... (as) a fiction that
severely challenges any willing suspension of
disbelief"
Chapter 18
33
Fiduciary Duty


Bear and Maldonado-Bear [1994] propose the
following fiduciary concept:
... while some elements of the fiduciary
concept might well be what parties to a
corporate endeavor might reduce to a written
contract (if they could negotiate without
transaction costs) much is not. And what is
not is rooted in the law's insistence that very
special moral behaviors are expected in
particular circumstances that are beyond the
scope of all usual specific, contractual terms
Chapter 18
34
Issues in Fiduciary Duty


1. To whom, exactly, is a corporate
manager's fiduciary duty owed, and
why?
2. Why does such a fiduciary duty exist
in law at all?
Chapter 18
35
CAPITAL FORBEARANCE
AND MONEY POLITICS


Let's use capital forbearance to capture the
willingness of deposit insurers/regulators to tolerate
weaker and weaker capital positions (greater and
greater risk exposure) on the part of banks and S&Ls.
Regarding the evolution of S&L losses, Kane [1993]
notes:

If one tracks the pattern of official losses, it looks as if the
FSLIC lost most of its money in 1988 and 1989. Actually its
losses start accumulating about 1965. Although amounts
fluctuated, losses were well over $100 billion at the end of
1981. Losses improved a bit in late 1982 and early 1983,
but subsequently rose until leveling off in 1988 at around
$160 billion. They did not surge in 1988 and 1989 as official
figures suggest (p. 12)
Chapter 18
36
The Challenger Disaster

Drawing on Vaughan's [1996b] analysis of the
Challenger disaster of 1986 provides insight into the
organizational failings of deposit insurers and bank
regulators during the 1980s and early 1990s. She
concludes with a lesson that fits the S&L mess as
well:

The story of the Challenger is a story of how people
developed patterns that blinded them to the consequences
of their actions and of how slight deviations from the usual
course gradually became the norm, providing a basis for
accepting additional deviations. ... It's a story that illustrates
how disastrous consequences can emerge from the banality
of organizational life [p. 36]
Chapter 18
37
More … And Do You See 11
September 2001 Similarities?


She also notes that: "Bad things do happen to good
organizations" (p. 24).
The important point,
however, and one emphasized by both Kane and
Vaughan, is that government agencies (NASA and
FSLIC/FDIC) by engaging in what Vaughan calls
"risky business" bear direct responsibility for disasters
that occur because of their actions or inactions. In
resolving conflicts of O-ring tolerance (NASA) and
inadequate capital (FSLIC/FDIC), ethical positions
were compromised
What about the roles of the FBI, CIA, NSA, etc. in 11
September 2001?
Chapter 18
38
The Role of Money Politics
in Risky Business

It is risky business to mess with O-ring
tolerances, capital-adequacy standards,
airport security, and monitoring
terrorists. A song from Cabaret says:
"Money, money, money makes the
world go round." Money politics, Kane's
term [1996b], can lower financial and
engineering tolerances
Chapter 18
39
Banking and the FSI

Banking rules and regulations impose costs
on taxpayers in two ways:


(1) if they confer monopoly power on banks (one
of the causes of market failure), then customers
pay more for financial services than they would in
a fully competitive system
(2) taxpayers implicitly finance the federal safety
net that provides subsidies to depository risktaking. Taxpayers should expect the costs of
regulation to be minimized. Failure to do so
constitutes misregulation
Chapter 18
40
PRINCIPAL-AGENT RELATIONS,
INFLUENCE PEDDLING, AND
DISINFORMATION

The risks to taxpayers from poor
regulatory performance arise from three
sources:



1. lack of transparency (in the accounts of
regulated financial-services firms)
2. opportunities for coverups by regulators
and lawmaker
3. disinformation transmitted by regulators
and lawmakers
Chapter 18
41
Incentive-Compatible
Contracts

Kane [1996c] argues that fair and efficient regulation
requires society to demand a chain of incentivecompatible contracts across the principal-agent
relations. He [1996d] suggests three specific actions
Congress could take to create incentives for fairer
and more efficient regulation:



1. Defining what information supervisory authorities are to
disclose in an operational manner free of obvious loopholes
2. Specifying criminal penalties for officials that sign off on
willful inaccuracies and nondisclosures
3. Establishing a credible enforcement mechanism
Chapter 18
42
A Sequential Five-Step Procedure
for Resolving Conflict





1. Separate the precepts behind both parties'
views from the positions themselves
2. Obtain agreement on mutual goals
regarding the precepts
3. Understand and support aspects of the
other party's reasoning and position
4. Calculate consequences of each act versus
the precepts
5. Accede to precepts but not to pressure
Chapter 18
43
CHAPTER SUMMARY

Lots of thing to think about and discuss
in this chapter. In particular, applying
the concepts and models to



The S&L Mess
The Challenger Disaster
11 September 2001
Chapter 18
44