Wednesday, October 14, 2009

Ethical innovation

Should banks be subject to ethical review when they invent new financial products? It sounds like a recipe for red tape, but imagine if, when collateralised debt obligations and credit default swaps were created, they had been scrutinised by an ethics committee. Perhaps the financial crisis might not have been so bad.

Ethics in finance normally relates to tobacco and arms, not finance itself. But a committee in a bank or a regulator with a brief to take an ethical look at financial innovations might study the real economic and social effects of a new product
 - what it does to risk in different scenarios, where the money goes and who really pays - and then consider the wider ethical implications. It could look at negative externalities, such as systemic risk, miss-selling, or funding unsavoury activities, and ask executives to weigh them against profit.

If it finds an ethical bogey it could flag it up to investors or make recommendations to a regulator.

A financial ethics committee might have looked at mortgage-backed collateralised debt obligations containing sub-prime elements, which caused much of the balance sheet damage leading to the bail-outs, and asked whether funding the growth of unsustainable sub-prime lending was really the kind of activity a reputable bank should be supporting.

In her book about the creation of the CDS market, Fool’s Gold, FT reporter Gillian Tett tells how bankers at JP Morgan decided not to sell mortgage-backed CDO/Bistro securities because they couldn’t work out the default correlation rate, a technical term to measure how likely, when one mortgage defaults, that others in the same bundle would also default. As the safety of the supposedly AAA tranches depended on that unknown factor, the team opted out.

Sadly, other banks didn’t. An ethics committee to warn them of miss-selling might have saved them from their fate.

An ethical look at the credit default swap market might also have shown that its structure – where issuers can sell many times more insurance against a bond’s default than the value of the bond itself – creates incentives to speculate and boost volatility. Speculation is not illegal but it is not what finance was invented for. When destabilising, rent-seeking behaviour is hard-wired into a market's structure, someone ought to speak up.

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