FMGT Analysis Report
Ethical Challenges in Finance
TB 32 BS, Yr 2
Ngee Ann polytechnic
By:
Melvin Paul Singh S10053246H
Dai Ling Sylvia Phua S10052531
Ng Zhuang Ying S10052334J
Leong Bih Shean S10052895A
Jesper Tong S10052822C
[Type text]
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Introduction: Ethics
Ethics are the moral principles and standards that guide our behaviour towards other people. Ethics
represents what we should do and not necessarily what we must do. Law on the other hand are
society’s codifications for right and wrong. It signifies a set of rules in which we are obliged to
comply with.
Doing something that is illegal may result in civil lawsuits or criminal investigations but doing
something that is unethical may not attract such harsh repercussions.
In banking, ethics is a major protocol which governs how the firm acts and operates. It suggests
healthy practices the firm is committed to.
Trust is very important in the banking and financial sector.
Trust between an individual and a bank that when you deposit an amount in a current account, it
will be available for use or withdrawal whenever you need it. Trust that if the bank uses your money,
it will use it wisely. Trust that it will not mismanage its finances and consequently inflict an
unnecessary consequence onto you. Trust that should you seek information about potential
investment opportunities, specific, elicit information will be conveyed to allow you to gain a
comprehensive understanding of the financial product recommended and the risks associated with
ploughing money into that instrument.
Ethics are made up of 3 essential elements, corporate social responsibility, stakeholder interests and
the agency issue.
Social Responsibility:
To be socially responsible is to be responsible in your actions and activities towards society at large.
Banks should support corporate practices such as environmental stewardship, consumer protection,
human rights, and diversity.
An example of unethical behaviour regarding consumer protection can be seen in the recent Lehman
brothers-DBS high 5 notes saga that unravelled here in Singapore. Hundreds of Singaporeans, mainly
the elderly and uneducated group were duped into purchasing ‘high-yield, low risk’ bonds that were
‘capital protected’.
The DBS high 5 notes were protected by 8 reference entities, that is the bond was supported by 8
other banks. The bank’s customer relationship managers are normally given monthly or yearly sales
targets that they are expected to meet. In-lieu of this fact, banks and their employees are driven by
the profit making motive which overrules and overwhelms their moral judgement to make ethical
decisions. They do whatever it takes to hit those sales and increase revenue because their profits,
bonuses, and work status depend directly on those issues.
It fashions a dark indescribable motive to act in a manner that is selfish and wrong. These customer
relationship managers [CRM] misrepresented the features of the financial product stating that it was
100% capital protected and insisting that it was a low-risk investment. They betrayed the trust factor
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placed upon them by clients. With the financial fall-out, Lehman Brother’s one of the 8 reference
entities crashed, smashing the stability of the High 5 notes and reducing its value to a near zero
level.
Reports from a series of newspaper articles suggested that individuals such as Madam Chin, lost
large sums of money from the misrepresentation made by the bank’s staff. Madam chin lost
$125,000 in her CPF savings which she was harvesting for her retirement. She now has to start
building her wealth from scratch again and she is already 45 years old.
This is an example of banking employees abusing the trust given to them by ordinary members of
the public for their own personal financial gain. They place their own personal goals ahead of the
ultimate financial goal of the firm which should be about maximising the value of the firm or at least
the shareholders wealth. This is known as the agency issue.
Banks are large corporations that traditionally deal with financial services and lending activities. As a
corporation, the business organisation is regarded by law as being a separate legal entity. This
means the employees or the business firm are entitled to limited liability. They cannot be held
personally liable for any of the debts or actions of the company, they are generally shielded due to
this rule which regards the company to be a ‘person’ in it itself.
As a result of this separation between the company and its workers and the workers and
management from shareholders, lies in the grave danger of unethical behaviours, that might stunt
the growth of the firm.
Since these employees have no real interest in the firm, they are motivated by monetary gains and
make decisions that will yield personal profit.
This has been one of the major setbacks of the free market model established by Milton Friedman.
The Financial Services Authority [FSA] summarizes the biggest downfall of this system by stating that
people tend to have an ‘exaggerated faith in rational and self-correcting markets’ that is that people
have this misconception that firms try to be ethical because long term rewards for the company
depend on such actions. While this might be true, as the reputation of the firm depends on ethics
and its actions, the fruits and rewards will be reaped by the company and not the individuals running
the company.
The combination of a device such as the separate legal entity and free market model essentially
means that people are given the freedom to do what they want to in order to maximise profits. This
is why the present financial crisis, the depression and all other wars and major events have occurred.
It is greed and a lack of basic ethical rationale that leads to massive exploitations hurting hundreds
of thousands of lives in the process.
Ethics assumes that you will do what is right because you know it is right rather than it being forced
upon you via legislation.
Unethical behaviour creates problems and regulation serves to solve these problems.
With reference to the DBS High-5 Bonds case, the Singapore Consumer Protection Fair Trading Act
was revamped from preventing this nasty situation from arising again in the future.
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Financial institutions are now required to state the specific terms and conditions that are attached to
each financial product. The information must be understood by the client. A lack of mention of any
details that would have affected the initial decision to purchase the financial product could result in
a civil action.
Case Study: The Global Financial Crisis
Former U.S Vice-President Dick Cheney once said that the “Global Financial Crisis was not
foreseeable” and that “nobody anywhere was smart enough to figure it out”. However, the foresight
of the Sub Prime Mortgage Crisis was the consequential result of numerous ethical violations by the
banks and financial institutions in the market place.
The Agency Issue
Usually, when a person wishes to buy a house, but he/she does not have enough assets to pay the
full sum, he/she would go to the bank to get a home loan, or what we call, a mortgage.
These mortgages are often issued based certain on conditions such as the borrower’s credit
worthiness. The banker assesses the person’s credit worthiness by looking at his/her ability to meet
her loan and credit payments over the years. To do this, banks usually use a credit score to assist
them in deciding whether a not to extend credit to a person and if so in what amount.
A credit score is a number representing the creditworthiness of a person, or the likelihood that the
person will pay his or her debts. (Multi Craft Realty)
In America, a common credit score tool that is used to assess a person’s credit worthiness is the Fico
score. The FICO score provides a consolidated view of how consumers repay credit obligations,
including accounts held by other lenders. FICO scores are essentially a decision making instrument
that is used to manage risk. It helps lenders make accurate, reliable and fast credit risk decisions.
(FICO score, 2009)
The maximum FICO score given would be 850. People with low credit ratings have FICO scores below
620. These people are known as subprime borrowers. Lending money to a subprime borrower would
involve an extremely high risk. It would be literally insane to give this subprime borrower a mortgage
loan since her credit worthiness was simply too low, and the chances of him/her defaulting on
him/her loan were in turn extremely high.
However, the banks still continued to issue mortgage loans to subprime borrowers. Their goal was
profit maximization, and not wealth maximization for the shareholders. The existence of an agency
issue was obvious between the bank’s actual goal to maximize wealth of their shareholders, and the
goal of the CEO’s to increase their profits. They gave mortgage loans to subprime borrowers even
with the knowledge of the risks involved in a bid to increase the profits of the banks.
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They just wanted profits to keep increasing. One reason, as quoted by Aggarwal, was because the
“Bank C.E.O’s are compensated based on the returns they help the company to earn and this creates
a motivation to take risk."
Tabb quoted that the “Wall Street traders were thinking of the bonus at the end of the year, not the
long-term health of their firm.” For instance, the CEO of the now collapsed Lehman Brothers,
Richard Fuld Jr., earned $34.4 million in 2007, the period where the subprime market was growing at
a tremendous rate.
The banks approved these loans and took on the risk because they wanted to increase the firm’s
profits and revenues. They were ‘efficiently’ using their resources to maximize their profits – by
doing all they can to give out more subprime mortgage loans. They ignored risk, the amount of
returns and the timing of returns.
In 2006 for instance, the Subprime market was $600 billion. Subprime mortgages increased 292%,
from 2003 to 2007 (Kratz, 2007)
More Agency Issues
That was just the tip of the ice berg. We focus on AIG, one of the numerous companies that played a
part in today’s economic crisis.
AIG, American Insurance Group, is a highly decorated insurance company associated with sponsoring
one of the biggest clubs in soccer, Manchester United. It is a global company with massive financial
power.
AIG was one of the many institutions that were a part of the big financial fallout and one that played
an immense role in the fall of the U.S economy. It asked the Obama administration for a portion of
the U.S $700 Billion government Bailout money.
Instead of using that money to make up for their wrong doings and putting the money back into the
firm or at least the economy, the CEO’s and top executives of AIG gave themselves big bonuses
instead.
AIG received $182 billion dollars in Taxpayers funds and issued $165 million for bonuses
respectively.
After which they received their bonuses, the respective executives stepped down.
These firms were unethical to the very letter of the word. They placed their own personal goals
ahead of corporate goals and this is yet another ethical violation committed by the many
institutions that created the financial crisis.
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Source: http://blog.beliefnet.com/crunchycon/2009/03/the-aig-bonuses.html
That wasn’t the end of it. The banks were eager to earn even more, but with the knowledge of the
high risks involved in the subprime loans issued, they knew they had to spread the risks also known
as “hedging” so they weren’t in much ‘danger’ of experiencing technical insolvency.
Thus, banks moved on to do one of the most unethical things that they could ever do. They made
their problem, other people’s problem by spreading risk and expanding their portfolio concurrently.
Disregard for Stakeholders’ Interests
They pooled together hundreds and thousands of subprime mortgages. The pools were then
arranged in accordance to the riskiness of the mortgages from Level 1 to Level 4, with Level 1
mortgages having lowest risk and Level 4 mortgages having the highest risk.
The banks then told credit agencies to give these high risk mortgages the highest credit ratings
possible, AAA.
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A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of
debt obligations and debt instruments such as loans and structured financial products like these
Subprime mortgages. (Financial Intelligence Unit, India, 2004)
Source: http://www.insead.edu.sg/asiafinance/documents/Subprime-whenRiskManagementFails.pdf
The diagram shows that close to 88% of the issued mortgages were labelled as AAA.
Several sources have supported the fact that the banks instructed the credit rating agencies to give
high credit ratings to the pools of subprime mortgages, so as to increase confidence of the investors
and banks that they wanted to sell these mortgages to to.
Mark Gilbert, a Bloomberg News Columnist quoted, “The agencies get paid by the issuers to make
their supposedly objective rating.”
“Credit agencies awarded high ratings to mortgage-backed securities, giving investors more
confidence that they were safe investments.” (Bogoslaw, 2008)
More Disregard for Stakeholders’ Interests
The pools of subprime mortgages were then collated and sold to banks all over the world in the form
of bonds. The banks tried to diversify their risks, free up capital, just so they could lend out more
money. This is known as securitization.
Even Singapore bought into it, as indicated by the headline where the crestfallen Lehman Brothers
Bank had some of their bonds capital reach Singapore.
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It was clear that the pools of subprime loans did not actually have high credit ratings, and the banks
deliberately got the credit agencies to package it as such, so as to sell it off with more ease, in an act
of deception.
Investopedia.com stated that “Wall Street was there to pick up their subprime loans, package them
up with other loans (some quality, some not), and sell them off to investors. In addition, nearly 80%
of these bundled securities magically became investment grade ('A' rated or higher), thanks to the
rating agencies, which earned lucrative fees for their work in rating the ABSs.”
“They were passing on the risk to someone else through securitization,"- Aggarwal
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Source: Time Magazine
The diagram above shows a bond known as the Jupiter High V which was created through
securitization. It essentially shows how the massive losses in the Financial Crises were fashioned by
the restructuring of the subprime mortgages in to these bonds.
The banks basically used securitization to pass on the risks to other banks as they wanted more
money.
The banks ignored the interests of the society at large, and only cared about their profits. The act of
selling high risk subprime loans to investors as high credit rating bonds was itself, an unethical act on
the bank’s part.
Banks
Subprime
Borrower
Investors
The banks kept issuing subprime mortgage loans and charged the subprime borrowers a high
interest rate.
The banks then pooled the mortgages through securitization and sold them to investors at a lower
interest rate.
The banks ultimately earned the difference between the 2.
A Numerical Example:
Eg
Subprime loan given out:
$1000
Interest Charged:
10%
Interest Earned:
$100
Securities sold:
$1000
Interest Given:
5%
Interest Cost:
$50
Total profits from Earnings and Costs: $100 - $50 = $50
This process is known as a SIV or structured investment vehicle.
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An SIV is a strategy to borrow money by issuing short-term securities at low interest and then
lending that money by buying long-term securities at higher interest, making a profit for investors
from the difference (Keoun, 2008)
Each time a subprime mortgage was given out and sold to an investor, the banks earned revenue.
They ignored the long term obligations and high risks involved. They completely disregarded the
interests of the shareholders, and the stakeholders.
More Agency Issues
The banks were only concerned, in increasing their short term revenue, and ultimately bringing
home, a bigger bonus.
In 2006, Wall Street executives took home bonuses totalling $23.9 billion. Tabb said, that “The Wall
Street traders were thinking of the bonus at the end of the year, not the long-term health of their
firm.” He also added that the Wall Street Traders “were amply rewarded, presumably for managing
risk and allocating capital, which was supposed to improve the efficiency of the economy so much
that it justified their generous compensation. But they misallocated capital; they mismanaged risk -they created risk.”
Subprime Loans were given based on adjustable interest rates, and adjustable rates fluctuated
together with market rates. Hence when the market rates were increased by the American Federal
Reserves to cool the overheating economy at the time, the interest on these loans increased as well,
and the monthly payment required by the borrowers became much more expensive.
In the short term, the banks were earning tones and heaps of money. But as time passed, the
adjustable rate factor made the subprime loans more and more expensive.
In the long term, when the bills came due, the subprime borrowers did not have the money to pay
the loans, thus, they stopped paying their loans and began to default on their payments causing the
banks run up huge debts.
Cash simply stopped flowing in. Banks became really afraid to give out more loans. Investors stopped
investing too. This ultimately led to a credit crunch.
A credit crunch is a reduction in the general availability of loans (or credit) or a sudden tightening of
the conditions required to obtain a loan from the banks. A credit crunch generally involves a
reduction in the availability of credit independent of a rise in official interest rates. (Kollewe, 2008)
Conclusion:
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The global financial crisis was sparked off in the same way the DBS saga started. Bank CEO’s are
rewarded based on the company’s profits and as such, the CEO’s have an impetus to do what is
necessary to maximise the firm’s profits regardless of whether it is ethical or unethical.
It is only after the occurrence of such large scale incidents that people realise that individuals are not
driven to do what is right or ethical but instead what is in their own best interests.
The financial crisis would never have occurred if sound ethical practises such as having pay policies
that are designed to avoid incentives for undue risk-taking existed. This would reduce the motivation
to take risk and lead to less unethical behaviour. We recommend that compensation packages
should not be based on the firm’s profit maximisation ratio but instead the wealth maximisation
ratio. This forms the core of basic financial management and the implementation of this simple
arrangement would have prevented the financial tsunami that is now making waves the world over
from taking course in the first place.
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