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CHAPTER 18. Ethics in Banking and the Financial-Services Industry (FSI). LEARNING OBJECTIVES. To understand … 1. E thics and how society uses ethics 2. Concern about lack of ethical behavior in banking and the FSI

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Chapter 18


  • Ethics in Banking and the Financial-Services Industry (FSI)

Chapter 18

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

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

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

Let markets work

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

11 september 2001

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

What is ethics

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

Ethics as conflict resolution

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

Unethical behavior box 18 1

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 (good-intensioned) 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

Money laundering and tracking terrorists

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

Plato on right and wrong

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

Economic decision making and discrimination in ordinary usage

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

Economic decision making

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

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

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

Principles established by the caux round table table 18 1

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

Application of the principles

Application of the Principles

  • These principles apply to the following stakeholders of a business:

    • Customers

    • Employees

    • Owners/Investors

    • Suppliers

    • Competitors

    • Communities

Chapter 18

Set of contracts theory

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

Maximizing value and the role of ethics

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

Social responsibility

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

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

Fraud and negligent misrepresentation

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

Five cumulative common law tests for fraud

Five Cumulative Common-Law 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

Ethics in banking and the financial services industry fsi

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

The s l mess

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

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

Index of economic freedom

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

Ten key areas of economic freedom

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

    Causes of market failure

    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

    Public stewardship fiduciary relationships and the principal agent 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

    Faithful versus unfaithful agents

    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

    How agency differs in law and in the theory of the firm

    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

    Legal agency

    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

    Fiduciary duty

    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

    Issues in fiduciary duty

    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

    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

    The challenger disaster

    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

    More and do you see 11 september 2001 similarities

    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

    The role of money politics in risky business

    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

    Banking and the fsi

    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 risk-taking. Taxpayers should expect the costs of regulation to be minimized. Failure to do so constitutes misregulation

    Chapter 18

    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

    Incentive compatible contracts

    Incentive-Compatible Contracts

    • Kane [1996c] argues that fair and efficient regulation requires society to demand a chain of incentive-compatible 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

    A sequential five step procedure for resolving conflict

    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

    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

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