Ethics in Finance

RBIGovernor, Dr Subbarao gives another superb speech on ethics. He covers ethics in finance, ethics in economics, ethics in crisis and ethics at RBI.

On finance he says:

As I said earlier, the question is, is the financial sector different from other fields by way of ethical dimensions? Is there a greater opportunity or larger temptation to deviate from the straight and narrow path? Is the power of context more forceful here? Conversely, is it people of looser ethical standards and values who succeed in the field of finance? Again, this is a debate that defies clear cut resolution

At one extreme are people who claim that the financial system, at its heart, is about trust. Nowhere is this more true than in banking. The word credit derives from the Latin word credere, meaning to believe. Billions, indeed trillions of financial transactions take place everyday, and all of these are based on trust. Without broad based trust and presumption of honest behaviour, it would not have been possible for the financial sector to grow to its present size and importance.

At the other extreme are people who say ethics and finance are poles apart. They contend that at a fundamental level, finance is all about making money, never mind how it is made. Status and recognition are accorded by how much profit is made regardless of how it is made. It is argued that even as the millions of foot soldiers may be innocent, people who rise to positions of top management and leadership in the financial sector could not have done so without compromising on scruples. According to people given to this persuasion, there is a book called The Complete Book of Wall Street Ethics which is fat and bound and in which all pages are blank.

(Emphasis is mine) All you can say is :-)

Further he says financial sector needs to be more responsible as it has moral hazard attached to it

The crisis has also exposed an issue of moral hazard in the banking system – something that has come to be called privatization of profit and socialization of costs. Banks enjoy an implicit guarantee of government bail out. This is true regardless of whether a large segment of the banking sector is owned by the government as in our country, or whether the banks are privately owned as is the case in most countries. Governments, regardless of their political affiliations, can hardly afford to have large institutions fail. This ‘too big to fail’ syndrome enables financial institutions to take risks that, say a soap manufacturer, cannot take. If as a result banks make huge profits, they can reward themselves with generous pay packets and bonuses. And if loans sour and the balance sheets crash, no worry since the bank will be bailed out at tax payers expense.

The difference between the financial sector and other businesses is therefore quite clear. If say, a soap manufacturing company is an astounding success, who benefits? The shareholders and the management. And if it fails, who loses? Both of the above. But in the case of a bank, the story is different. If the bank is a success, who benefits? The shareholders and the management. And if it fails, who loses? Not the shareholders and the management, but the public at whose expense the bank is bailed out. The ripple effect is less pronounced but similar in the case of all institutions in the financial sector even if they are not banks.

That crucial difference, I believe, underscores the special ethical dimension of the financial sector in contrast to other businesses. Banks and financial institutions have a greater responsibility of being conscious of the obligation they have of not jeopardizing the larger public interest. What Mahatma Gandhi said, that businesses hold public money in trust, is more true of the financial sector than others.

On Ethics in Economics, he has this excellent point which sums it all:

People often forget that the godfather of modern capitalism, and often called the first economist – Adam Smith – was not an economist, but rather a professor of moral philosophy. Smith had a profound understanding of the ethical foundations of markets and was deeply suspicious of the ‘merchant class’ and their tendency to arrange affairs to suit their private interests at public expense. In his book, “A Theory of Moral Sentiments”, Smith argues that a stable society is based on sympathy, a moral duty to have regard for one’s fellow human beings. In short, Smith emphasized the ethical content of economics, something that got eroded over the centuries as economics tried to move from being a value based social science to a value free exact science.

Great insights. Dr Subbarao’s speeches are surely to look forward to.

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6 Responses to “Ethics in Finance”

  1. michael webster Says:

    This is a very interesting speech. My guess is that when a community’s size is less than around 150-160, moral hazard can be dealt with with the ordinary techniques of shaming, naming and blaming. As the size grows, our skills at handling moral hazard’s diminish and the possibility for narcissistic personalities creating great harm grows. (You may have read this, but some of your readers might find it useful: http://www.econlib.org/library/Enc/TragedyoftheCommons.html)

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