Making the case for the importance of ethics in finance has never been easier. The damage wrought by unethical practices in the US sub-prime mortgage market and in the related markets in asset backed paper of varying degrees of toxicity has given rise to the worst systemic banking crisis since the 1930s. There are numerous explanations for this financial catastrophe. But few could doubt that among the causes has been a fundamental failure of ethical leadership in the boardrooms of financial institutions around the world.
The difficulty concerns the cure rather than the diagnosis. For the structure of modern banking increasingly militates against an ethical business culture. The shift from a financial system based primarily on deposit-taking and lending to a more transactional modus operandi has shortened time horizons and downgraded the relationship between borrowers and lenders. More specifically, the so-called originate and distribute model of banking has reduced the banks’ incentive to make prudent credit assessments and monitor credit risk once loans are removed from bank balance sheets.
In the mortgage market this has undermined a long-standing rule that sits well with ethical banking behaviour: know your customer. At the same time the reliance on bonuses that reward short term profits rather than profits over a full economic cycle has been all too damaging. For if incentive structures are at odds with the requirements of an ethical culture, decent values have no chance. Hence the disconnection between mission statements and ethical codes that emanate from the boardroom and the behaviour of people on the trading floors. Boards have failed to embed ethical cultures throughout the organisation and failed to persuade employees to buy into the values they are supposed to believe in.
And how, anyway, could such values be embedded when the bonus structure is rewarding people for behaviour that is at odds with those same values? This need not imply that the ethical deficit is incapable of being addressed. The regulatory response to the crisis will almost certainly change the structure of banking once again. More swinging capital adequacy requirements are in the offing, with the consequence that banking may revert to a more utility style role redolent of the 1950s and 1960s.
That is an environment in which both the business and the bonuses will be much less exciting. Boards will be more risk averse and will recognise afresh that an ethical culture is not just a protection against business failure, but something that facilitates effective decision making within the organisation, enhances reputation and attracts good recruits to the business. The snag is that some of the most talented, ambitious and greedy bankers will not wish to work in this more pedestrian and more heavily regulated environment. They will leave for less transparent and still potentially lucrative havens among the hedge funds and private equity firms.
There they will continue to engage in highly leveraged, high-octane trading of a kind that could easily expose us all to another systemic crisis. It is hard, though not impossible, to address unethical and dangerous behaviour in such areas. The key is for regulators to use a very big stick. But to do that, there is a need for far greater transparency among hedge funds and private equity firms. That would enable bad and imprudent behaviour to be controlled through lending relationships with prime brokers and banks. The message, then, is that amending the Basle capital adequacy regime will not be enough. More attention needs to be paid to incentive structures. And there has to be greater transparency in the areas where the biggest risks are being taken and where there is greatest scope for bad behaviour.