The issue of trust has come to the fore once again with the current sub-prime mortgage and financial sector crisis. The crisis has been fueled by a breakdown of trust caused by the inclusion of mis-priced mortgage risk in structured products. When claims on sub-prime mortgages were turned into assets for investors to buy, the risk in these sub-prime mortgages was not properly priced within the asset. The incorrect valuation of the asset was thus carried from the mortgage lending sector into structured products in the financial sector which were then inappropriately rated as AAA assets in many cases, based on the erroneous assessment that these assets had low-risk, strong value characteristics.

Thus a multitude of new investment vehicles and assets that embodied a breach of trust was created. These assets were bought by financial institutions and by people all over the world. Eventually, a critical mass of sub-prime mortgage holders faced upward interest rate adjustments on their mortgages, and many, who could not afford the higher mortgage payments began to default. The defaults affected the value of claims on the mortgages, which were now embedded in the structured assets created at the start of the process. Since the risk in claims on these assets had been mis-priced, the defaults had the effect of revealing this breach of trust.

The value of assets linked to these mortgages began to collapse to reflect this risk. Unfortunately, over time most financial institution balance sheets had become linked in some way with these mis-priced assets, and it became difficult for buyers of assets to trust the value quoted by sellers in a given transaction. This created a credit crunch, since banks could no longer lend to each other by trading in assets. Interbank trading was at risk of grinding to a halt. Central banks had to intervene with liquidity injections (trust-worthy money) to enable a basic level of transactions to take place in the financial system.

It is evident, therefore, from the current crisis how an apparently minor decision and action by relatively few people, clearly intended to boost assets sales and profits (something they were hired to do), has in the absence of appropriate ethical safeguards, spread and transformed over time into a global financial crisis. How important a role does trust play in this story? Was trust equally, more or less important than the strategy or the business model used? Was it less significant than the process of executing the model? Today, in the midst of this financial crisis, most risk managers would argue that trust played a central role. When trust broke down, the system broke down with it.

Traditional business writings state that in firms and organisations, results are the product of strategy and execution. The role of trust is often underestimated. Recently, however, Stephen Covey demonstrated in “The Speed of Trust,” the central role that trust plays in all business transactions. He argues that trust is the “hidden variable” in the formula for organisational success. The traditional results formula is: Strategy x Execution = Results, while explicitly including this “hidden” variable, trust, gives a clearer picture, where (Strategy x Execution) x Trust = Results. Results are then deliberately recognized as the combined effect of strategy and execution, which is either diminished or enhanced by the level of trust.

A MATTER OF TRUST
As seen with the current crisis, trust affects two outcomes: speed and cost. When trust diminishes, transaction speed declines due to reluctance of market participants to carry unknown risks. In addition, as new risk is estimated, factored into the pricing of transactions and “managed,” transaction cost rises. One of the key roles for government authorities in resolving the current crisis is in finding an effective way to re-establish trust in mortgage and financial markets, by helping to restore acceptable risk pricing and valuation of assets traded in these markets.

This crisis has shown that when there are significant problems with the valuation of assets involved in transactions, and no means of pricing risk appropriately, trust tends to zero or negative values, bringing transactions down to a virtual halt (zero speed) and raising the potential cost of each transaction substantially. As a result, the value of strategy and execution in achieving results becomes marginalised by the absence of trust. Had there been an ethical code of conduct which was being enforced and held sub-prime lenders and financial sector designers of structured products accountable, this would have served as a check, safeguarding the public against the development of the current crisis. Consequently we would all have had a crisisfree summer, and the economy would not be facing recession.

Ethics plays a central role is solidifying trust in market transactions. The financial sector involves an array of financial activities that affect the welfare of business and the public on a day to day basis. The public has to trust the financial system to safeguard their money, assets and life savings if they are to place them within the system. The public recognises that there are abundant opportunities for those working in the financial sector, who are entrusted with the responsibility of managing other peoples’ money, to betray the public trust placed in them. They therefore have to trust that the system will not allow this to happen.

While there are safeguards and checks and balances to protect public money, these are not always fool-proof, and the reality is that ethical considerations do come into play, when gaps in safeguards surface. In the same way that doctors have an obligation to safeguard the interest of their clients, and take an oath to this effect, professionals in the financial sector should have the same obligation to the public, their clients, to safeguard the long-run health of global financial transactions and the economy. Under the current business-legal framework, however, the law requires financial sector professionals to put the interests of shareholders above all else. This single-minded pursuit of profit maximisation encourages a short-sighted perspective that has its drawbacks as it encourages companies to marginalize the interests of their clients.

It is shortsighted because while it enables short-term gains for companies, it also builds up the basis for a public perception of recurring crises and being “repeatedly swindled.” This generates increasing potential for a backlash from the public (from clients as a collective), in the long-term. Hence, the argument is made by many for a more ethics based business environment. This would mean more ethics training in business, better enforcement of existing ethical codes and in-built ethic-based systems that use transparency to further discourage unethical behaviour. Regulators require an automated monitoring system that will help to ensure that agreed ethical principles are enforced by management and boards.

We need to start thinking about innovative approaches, such as including in the system design, electronic in-built programs of checks and balances in financial markets that will send automated alerts directly to both managers and oversight bodies, when agreed ethical standards and safeguards are breached. Such monitoring systems should be able to safeguard the integrity of the system and protect against gaps and loopholes in the implementation of financial transactions.

Currently, in the financial system there are various measures in place to safeguard the public interest, such as legal prohibitions against fraud and manipulation. It is clear, however, that these continue to fall short as evidenced by repeated instances of fraud leading to crises. John R. Boatright of Loyola University, Chicago in his book Financial Ethics provides recent examples, such as the securities-law violations of the late1980s with junk bond issuances that compromised public interest, and the mail and wire fraud scheme of the mid-1980s, and in the 1990s the Salomon Brothers government securities bid rigging scandal.

There was also the Orange County case against Merrill Lynch for concealment of risk, and the Nick Leeson – Barings Bank case where the former engaged in unauthorised trading leading to huge losses, likewise with a Daiwa Bank trader. All these scandals and crises are due to ethical breaches by individuals employed in a sector. These breaches have in turn compromised the welfare and interests of the public.

It is clear that basic, logical lessons need to be re-learnt by the financial sector work force:

- Honesty and integrity in financial transactions do matter – they promote trust

- Providing information that is full, fair and accurate wherever this is expected helps to preserve the integrity of the system. The converse undermines it

- Boards should not allow the erosion of due diligence over time – the costs are too high

- Regulation via effective monitoring needs to become an integral part of the system Enforcement is equally important. A more effective system of ethical safeguards or checks and balances has to be developed – preferably automated to some extent so that personal judgment clouded by personal interest does not limit transparency. This is the challenge.