As capital markets globalise, economies increasingly compete to offer investors the most favorable investment environment. Among other conditions, investors seek trust-based capital markets and strong protection of property rights. Each of these is both a function of ethics and a necessary condition for efficient markets. Even on a strict market-based analysis, ethics in finance are integral to well-functioning capital markets. An important feature of trust-based capital markets is the existence of laws that address, among other things, the publication of investment related information, information asymmetries among investors and potential conflicts of interest in the investment field. In trust-based capital markets, investment decisions are based on the investor’s analysis of material information relating to an investment. From an ethical point of view, it is important that information provided to investors is true and complete.
These criteria are equally important for market efficiency. If investment decisions are based on untrue or incomplete or information investment analysis will be flawed, which is likely to lead to inefficient allocations of capital. A level playing field is an important feature of trust-based capital markets. It is unethical for investors to benefit from information asymmetries, such as selective disclosure and insider trading. Furthermore, to the extent above-market investment returns are based on private information rather than superior analysis, markets will be distorted. For capital markets to be trust-based, third party analysis, such as investment research and ratings, must be impartial. This involves addressing potential conflicts of interest within capital markets institutions including investment banks, research firms and rating agencies.
In addition to ethical concerns about misleading investors, biased analysis can lead to inefficient investments that are based on conclusions not properly drawn from all available information. Trust-based capital markets encourage investors to make efficient investment decisions based on reliable information within a competitive environment. Property rights complement trust-based capital markets by fostering confidence that investors will be free to enjoy the fruits of their investments. Strong property rights protection involves minimising interference with private property, defining property rights broadly, maintaining an independent judiciary and taking steps to eliminate corruption. These conditions help control regulatory risk, which is the risk that the law may change against a party’s interests, and legal risk, which is the risk that a party may be found to have liability to another party.
Like other sources of investment uncertainty, regulatory risk and legal risk can lead to inefficient allocations of capital, as risk-averse investors tend to punish uncertainty with conservative valuation discounts. Ethical governments avoid interfering with private property in the absence of a compelling reason. Regulatory risk is reduced, and markets are more efficient, when regulatory change is undertaken only with reference to pre-specified policies and following appropriate notice to affected parties. In addition to physical assets, the scope of property rights should include intellectual property and financial assets if only because theft of any asset is unethical. Protecting intellectual property also encourages research and development, which can drive future economic growth. Similarly, protecting financial assets encourages financial innovation, which can help reduce market risk.
Judicial independence is a necessity from an ethical perspective. It also stimulates confidence that courts will uphold property rights, in turn facilitating the efficient management of legal risk. Corruption is a source of legal uncertainty that can result from unnecessary regulation and the delegation of discretionary powers to individuals. In over-regulated markets there is a tendency for individuals to seek to profit from their positions and businesses to seek to avoid regulatory hurdles. The results are bribery, which is an inefficient use of capital, and uncertain application of the law, which imposes inefficient legal risk. Ethical issues are a common denominator of trust-based capital markets and property rights protection. Trust-based capital markets and strong property rights protection foster an attractive investing environment, which draws in capital and facilitates the strengthening of these important institutions. Ethics in finance are a catalyst for this virtuous cycle and a potential accelerator of economic prosperity.