Tuesday, November 10, 2009

Function and ethics

“In every civilised nation the soldier’s profession is to defend it, the pastor’s to teach it, the physician’s to keep it healthy, the lawyer’s to enforce justice in it, the merchant’s to provide for it,” wrote John Ruskin in 1860.

What would the 19th century social thinker, subject of a thought-provoking  video by the FT's Andrew Hill, have said about banks?
My guess is that, if asked to describe the function of a bank, he would answer quite differently from modern bankers, and their answer would be quite different from what regulators and the man on the street would say. No wonder there are so many opinions about reforming the sector.

But defining the function of banks, as Ruskin did for soldiers and merchants, would help regulators and directors to keep banks on track.

The crisis showed that financial innovations tend to serve the interests of their salesmen, so testing new ideas against a firm’s economic function would allow better scrutiny of potentially dangerous or rent-seeking activities.

A modern finance executive, inspired by his MBA and director’s handbook, might say the function of a bank is to make profits for shareholders and not much else. That would explain Chuck Prince’s famous comment about having to dance while the music is still playing, in other words, keeping earnings high regardless of how they are made.

Customers, in their old-fashioned way, might say a bank’s function is to serve them by taking deposits and making loans, while businesses might mutter something about allocating investment through the capital markets, and other things. Regulators would probably look at all of these.

What is clear is that a bank’s economic function is quite different from the aims of its employees. Confusion about this feeds the idea that financial services lack integrity and the sense that people don’t understanding what the City does. It also makes it harder for managers to say if an activity is worth encouraging or not, beyond a crude assessment of whether it is profitable and legal.

Gordon Brown said this weekend that financial services need more integrity, fairness and responsibility, adding, “Nothing less than a revolution in the culture of the financial services industry is needed”.

The problem is to convince the industry to do something about it. As Federal Reserve president Tim Geithner said last year, regulation alone cannot create integrity. "That is up to the boards and shareholders".

A new duty?

One idea from the Fed is to restore 'internal market discipline' (regulatory jargon for integrity) by making bank directors accountable to depositors and to the public for wider financial stability. This would be on top of statutory duties owed to shareholders.

It is, frankly, a surprise that bank directors are not already accountable to depositors and this seems an obvious area for reform.

The second idea, of giving directors a wider public duty, is tougher. In principle, it is easy to argue that a profitable activity should be dropped if it harms the wider system. It is linked to Gordon Brown’s call to re-negotiate the social and economic contract between financials services and society since the bail-out. Or as Ruskin put it: “In true commerce it is necessary to admit the idea of occasional voluntary loss, that sixpences have to be lost under a sense of duty; that the market may have its martyrs as well.”

But how do you enforce this as a duty? If you use law, the legislation would either be too restrictive or too vague to be meaningful, say critics.

I think this underestimates our legal system. Company directors already have general statutory duties towards shareholders, interpreted in fine detail every day by the courts. They also, like everyone else, have general common law duties of care to people in society through the laws of tort.

The legal principles in tort, such as reasonable foresight, contributory negligence and standards of care, are well suited for adapting to assess the performance of a bank’s possible wider legal duties to society.

It would need a discussion about what type of remedies are suitable and who should bear them, as well as who could have legal standing to bring a suit. Obvious problems include that high punitive damages might overlap with and weaken the resolution and insurance schemes now under discussion, while over-extending the right to sue could make bank directorships unviable.

Common sense suggests restricting the right to sue perhaps just to regulatory bodies, and targeting remedies at the personal reputation of directors. This would send a message about personal responsibility to echo down through organisations, making up for the fact that no UK senior bankers have been charged or disqualified since the bail-out. And it might have more deterrent power than Fred Goodwin’s broken windows.


The integrity problem has cultural roots that pre-date the credit boom. In a 2001 lecture about ethics and the City, the former chief executive of LIFFE, Professor Daniel Hodson, warned about declining levels of honesty and ethics since the end of what he called the City's unwritten code of conduct, which was prevalent when he started in the 1960s:

“The old practices and code which dominated the ethical and regulatory environment of the City had strengths but considerable blemishes. The new City, with its global ownership and international workforce, has brought prescriptive regulation and a different approach. Such changes were inevitable, but they have ethical downsides. On balance the City is a much fairer place but in some respects it has become less honest. One could perhaps say that My Word is still My Bond, but only when the conversation is being electronically recorded...”
Bankers who remember that era agree that, when teams move frequently between banks and transactions are shrouded in disclaimers, there is less benefit in building a good name (as opposed to a name for making money, which is entirely different).

Enforced ethical standards at the top could filter down through new committees and corporate structures already in place.

For example, the transaction review committee of one big London-based investment bank is made up of heads of department who look at any deals considered to have reputational, ethical or compliance risks. A typical “dodgy” deal might be one proposed by a counterparty desperate to avoid recognizing a loss and willing to pay a fee for an otherwise unnecessary transaction. The solution might be to obtain a letter from the counterparty’s auditor, or simply to block the deal. This rarely happens, as deals whose flaws cannot be fixed are usually pulled before the committee has a chance to scrutinize them and mark the banker's report card. Internally at least, reputations do matter.

The committee is therefore a half-way house towards ethical enforcement but its remit could be extended to wider public considerations if senior management ordered it so. If this seems a big leap, bankers can take inspiration again from John Ruskin, writing long before CDOs were invented: “No man can ever know the ultimate result of a line of conduct. But every man may know, and most of us do, what is a just and unjust act”.

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