Ethics in finance: a banking supervisory perspective
Remarks by Ignazio Angeloni, Member of the Supervisory Board of the ECB,
Conference on “The New Financial Regulatory System: Challenges and Consequences for the Financial Sector”,
Venice, 26 September 2014
It is a pleasure to be in Venice today and to participate in this conference. It is particularly so, because I count some colleagues and friends among its organisers. I would like to mention in particular Domenico Sartore and Jan-Pieter Krahnen.
In the realm of banking, Venice and Frankfurt are not as far apart as they may seem. We all know that the oldest bank still in existence was founded in Tuscany in the 15th century, but few are aware that the first bank in modern times was founded in Venice almost 1,000 years ago. Unlike Monte dei Paschi, which originated from farming activities, the Bank of Venice derived, at the time of the crusades, from the need to finance the military expenses of the Serenissima. It later developed into a fully-fledged bank that remained important for centuries. Today, the hub of European banking is no longer an Italian city but Frankfurt. Frankfurt is also the seat of the new European bank supervisory authority, the Single Supervisory Mechanism (SSM), which will take on its full responsibilities on November 4th this year.
I now turn to the focus of my remarks.
As we know, this crisis has shaken the foundations of our financial system, with economic and social consequences we have not yet recovered from. Diagnoses are plentiful and point in different directions: overinvestment in real estate, excessive leverage and undercapitalisation of financial institutions, overly complex and opaque financial instruments, wrong incentives, conflicts of interest, excessive central bank liquidity, and so on. But more deeply there is, I think, an element that brings many explanations to a single one: this was, and still is, primarily a crisis of trust. Trust in business counterparties, in financial institutions, in well-functioning (let alone efficient) markets, perhaps also in the ability of regulators to successfully perform their function. If this interpretation is at least to some extent correct, it follows that this crisis will not be overcome unless and until we somehow restore trust. How can we do it?
Policy-makers globally have, all in all, responded well to the challenge. Macroeconomic policies and monetary policy in particular provided the right amount of stimulus early on. The regulatory bodies – the Financial Stability Board (FSB), the Basel Committee on Banking Supervision and especially, in Europe, the Commission, the Council and the European Parliament – have embarked on a broad-ranging reform programme. In many ways, the legislation of the financial sector has changed, or is changing, in ways that should ensure more resilience in the future. But the question arises: will this be enough?
The main argument I will try to defend is that better rules are necessary but not sufficient to restore trust; something deeper needs to happen: the underlying ethical behaviour in the financial sector has to improve as well. Now, I am very much aware that embarking on ethical discussions exposes somebody like me, whose philosophical background is scant at best, to the risk of embarrassing mistakes. But the issue is important enough that I have decided to run the risk. I will start by fixing ideas with some definitions.
For my purpose here, I will define “trust” as the propensity or disposition of individuals to have confidence in and rely on others. I will speak of “compliance” more generically than usually done in boardrooms, to mean the willingness to conform to the letter of the laws, or of any explicit and generally accepted rules. And I will refer to “ethics” (hoping that Aristotle does not hear me) as the willingness to make one’s best effort to conform also to the spirit of those laws (or rules), as commonly intended. This includes also complying with the letter of those laws that are not enforceable or whose compliance is not verifiable. My claim, plain and simple, is that durable social trust requires not only compliance but also ethics. And my second, subordinate claim is that strengthening ethics in banks is something that banking supervisors should care about.
Trust: essential for finance and banking
The key role of trust in making financial relations work has been known for a long time, long before it became a subject of academic research.
The name we use for the most basic financial relationship, “credit”, is rooted in the Latin “credere”, which means to trust – though the ancient Romans used a different word for it. Adam Smith, while advocating the social value of self-interest, also believed that economic transactions should be based on morality, or even friendship. Of course, he was writing in the 18th century, when banks were made up of few individuals. Today’s banking groups employ tens of thousands and serve a much larger number of clients – hardly a favourable environment to develop friendships. Yet the substance of Smith’s intuition survives. The basis of a successful financial transaction implies a relationship, often built in time through repeated contacts. A personal relationship cannot easily be substituted or guaranteed by a contractual one, because it implies trust that the counterparty will not only respect the formal agreement, but also act in good faith more generally in unforeseen circumstances. A contract will never be able to anticipate and incorporate all relevant future conditions.
Recently, the economic literature has refined the notion of trust and added useful empirical evidence. In a stream of papers, three Italian economists, Guiso, Sapienza and Zingales, developed the idea that trust is but one component of “social capital”, the collective “glue” that, according to sociologists, keeps well-functioning societies together and improves their performance. They argue that more sophisticated financial arrangements require a higher level of social trust to be implemented. Their empirical analyses suggest that the propensity of economic agents to use formal rather than informal credit sources, to invest in stocks and to use intermediated forms of financial investment as opposed to cash, is positively influenced by the level of trust prevailing in the area where they live.
A financial contract typically involves a commitment to settle an obligation on a future date. While in principle this promise could be enforced merely by law, this is not the case when enforcement is weak, or when – as often happens – the law is subject to different interpretations. This is especially true when less-informed households are involved, who may not know or understand all the details of the contracts. In those cases, trust is needed to make financial transactions possible. There are different degrees of trust: “personal trust” is sufficient for simpler contracts, whereas more advanced financial arrangements require “generalised trust”. In order to invest in the stock market, for instance, households need to trust a variety of intermediaries to trade on their behalf at the best prices. They must be confident that the market is fair and not manipulated, that companies release all relevant information and that management acts in the best interests of the company, and so on. Low levels of generalised trust lead to limited market participation and, as research has shown, also to a weaker response to company announcements.
What determines social trust? Exploiting evidence on the behaviour of migrants, Guiso, Sapienza and Zingales show that the propensity of individuals to trust others is determined more by their original cultural formation than by the new environment in which they relocate. They also find that differences in social capital across regions are largely explained (at least in the Italian case) by historical factors. I personally find this interpretation, though undoubtedly fascinating and consistent with findings on other forms of social capital, rather unattractive and unconvincing when applied to finance. Unattractive because by emphasising the role of educational and cultural determinants, it implies that trust levels – whether high or low – are persistent and insensitive to policy over a short to medium-term horizon. I believe policy-makers have a responsibility for fostering rectitude and confidence in the financial markets. Fortunately I also find it unconvincing, because the “cultural root” hypothesis, with its high persistence implication, does not square with some observed facts. It is evident that collective trust in certain institutions (e.g. banks, corporations or governments) can quickly erode as a result of scandals or bad performance. A recent study on Austria, a country where trust in banks is believed to be particularly high, suggests that this is explained by the financial stability record of the country. Financial crises can quickly weaken the trust in the financial sector, as revealed for example by the Chicago Booth/Kellogg School Financial trust index for the United States, which declined markedly after 2007; I do not think culture has much to do with that. The dynamics is asymmetric; trust can be undone quickly, but builds up only gradually. The Edelman Trust Barometer shows that the financial services industry is still today one of the least trusted ones. Trust in banks is higher than that in the financial industry as a whole, but since 2009, only a very small improvement has been observed. Finally, it should be noted that the impact of changes in trust on behaviour is much more rapid and marked among financial market participants than among households – witness the sudden liquidity and credit dry-ups that took place following specific episodes, like the run on Northern Rock in 2007.
Rebuilding trust after the crisis
Let me now turn to some recent developments.
Concern over issues relating to trust rose sharply, also in public opinions, at the turn of this century, due to some episodes of corporate scandals that acquired global resonance. I am referring to cases such as Enron (2001) and WorldCom (2002) in the US and Parmalat (2003) in Europe. The US authorities responded with the Sarbanes-Oxley Act (2002), strengthening standards and controls over governance, compliance and accounting, mainly for listed companies. Other countries enacted with similar legislation. In 2004, the OECD revised its Principles of Corporate Governance, which as part of the key standards for international financial stability of the FSB provide guidance for the financial sector globally. However, Basel II and, in Europe, the CRD II were weak on corporate governance: codes of conduct were voluntary, and the role of supervisors was unclear. Under-resourcing and inexperience on the part of supervisors contributed to the governance of banks not being effectively supervised.
When the financial crisis struck, weaknesses in the internal governance, controls and risk management of banks proved to be a major source of vulnerability. The policy response was led by an enlarged G20, its financial arm, the FSB and the Basel Committee on Banking Supervision. In 2009, the Basel Committee enhanced its “second pillar” by broadening the scope of risk management processes to cover all material risks; by strengthening internal processes to monitor and mitigate risks; by clearly defining accountability lines; and by establishing a link, in principle, between compensation policies and the longer-term preservation of capital; finally, in 2010, by strengthened the standards of corporate governance.
In Europe, the Basel Committee provisions were transposed in the CRD IV. The CRD IV requires Member States to adopt principles and standards ensuring effective oversight by the management body and promoting a sound risk culture at all levels. It also strengthens the corporate governance framework by requiring that the governance arrangements include an organisational structure with clear reporting lines, control mechanisms and remuneration policies that promote sound and effective risk management. The governance arrangements need to be made transparent by publishing them on the website. In addition, the CRD IV also reinforces the supervisory responsibilities; supervisors should include the review of governance arrangements, as well as the corporate culture and values of banking institutions, in the supervisory review and evaluation process. Issues pertaining to ethical conduct are relevant, but do not have a primary role in the Directive.
Very recently, the FSB has published a document on “Guidance on supervisory interactions with financial institutions on risk culture.” This work, led by Julie Dickson, head of Canada’s supervisory authority at the time and now a member of the SSM Supervisory Board, is important because of its focus on sound business culture in banking institutions, which moves a step closer to ethics, and for the role it explicitly assigns to banking supervisors. Four pillars are indicated: (1) “tone from the top”, that is, leadership by example by board members and managers; (2) accountability, that is, employees should “own the risk” and be responsible; (3) communication, meaning stimulating an independent and critical attitude among employees; and (4) incentives, requiring remuneration and career paths to be linked to how employees, at all levels, promote and apply the institution’s core values.
The FSB framework makes considerable mileage in the right direction and clearly needs more time for its full effects to be produced. Yet it appears that more is needed, especially to identify ethics as a separate component of sound business culture and to make the notion of it operational. Meanwhile, in the past two years we have discovered what are perhaps the two biggest financial scandals in history, in terms of the amounts of money involved and number of people affected: the manipulation of LIBOR (which came to the fore in 2012) and that of exchange rates (2013). In fact, whether by coincidence or not, after the crisis a surge of cases of misconduct and fraud was observed in the financial sector in both the US and Europe.
Without entering into details, two observations are in order. First, that surge was probably not a coincidence: the crisis, generating anger against the banks and their masters, created a favourable climate for these scandals to be uncovered and pursued. Second, the recent cases of misconduct suggest that reinforcing laws and regulations may not be sufficient. Some insiders have even argued that stricter regulation may exacerbate misconduct by promoting a culture of formal compliance, as opposed to one based on substantive ethical values. This is probably going too far, but a fair conclusion is that fostering a sounder ethical framework is a necessary further step, without which the new regulatory arrangements are unlikely to hold their promise.
Enhancing ethical codes
The difficult question, of course, is how to do this in practice.
Anyone who has been involved in corporate governance of some sort, in financial and non-financial institutions alike, either public or private, has experience with ethical codes. Typically that experience gives rise to mixed feelings. In principle, everybody thinks they are important and supports them. In practice, codes are often so general and high level, and difficult to implement and enforce, that their practical impact remains limited. They almost never play a central role in corporate board agendas. This is still true recently, I believe, even though attempts have been made to make ethical practices more systematic.
Useful elements to move forward can be derived by combining inputs from corporate experience, behavioural research and concrete cases from the recent crisis. Based on them, as well as, once again, on a fundamental intuition by Adam Smith, I think we can say that at the root of much unethical or fraudulent corporate behaviour is a mix of two partly conflicting sentiments: self-justification and opaqueness.
Self-justification is the array of reasons that people typically give themselves when they are about to violate laws or ethical rules. Here are some examples:
- Everybody does it
- We have always done it, so why change now
- This is how this business works
- If I don’t do it, somebody else will
- It works, so let’s not ask too many questions
- Nobody will notice and nobody will be hurt
or similar. Many humans find such self-arguments convincing enough, but at the same time a deeper voice tells them that there is something wrong; hence the need for opaqueness. The acts they embark on and the self-justifications given must not be exposed. Any risk of exposure constitutes a very powerful disincentive to misbehave.
Leveraging on this psychological mechanisms, one could establish practices whereby employees engaged in certain activities that critically impinge on trust are routinely made accountable to answer the following questions:
(1) Are you doing what you promised to do?
(2) Are you using your best knowledge and intention in doing it?
(3) Are you doing what public authorities, superiors, colleagues and business partners expect you to do, and if not why?
(4) Are you conforming to the mission and the values of your company, as they are publicly stated?
(5) Will your actions enhance public confidence in your company and in the financial sector?
Finally, and crucially:
(6) Would you behave similarly if your actions were publicly observed?
The fundamental importance of the last question was understood by Adam Smith, who believed that an “impartial spectator” scrutinising individual behaviour was a necessary complement of the “invisible hand”. To quote:
“We suppose ourselves the spectators of our own behaviour, and endeavour to imagine what effect it would, in this light, produce upon us. This is the only looking glass by which we can, in some measure, with the eyes of other people, scrutinize the propriety of our own conduct.” (A. Smith, The Theory of Moral Sentiments, Section III.1.5.)
Putting all this into practice is evidently a challenge for supervisors, but once the logic is understood it does not seem impossible. By looking across a range of indicators and fact patterns, helped by intrusive questioning, if supervisors make the effort to connect the dots they should be able to see which banks are lax about culture and ethics. Shareholders, board members and senior management play an evidently important role in setting the example, putting in place adequate control mechanisms and enforcing them. Such processes need to be enshrined in explicit codes. Incentives of managers and staff need to be consistently aligned. The ethical framework should influence the annual appraisals and bonuses. Peer pressure and transparency help in this respect, especially when there is a risk of conflict of interests, for instance between sales employees and clients. Making commissions and reward schemes transparent would be helpful. An emphasis on ethics should also be placed on the recruitment process and career promotion mechanisms, as prescribed by the FSB.
The role of banking supervision
The current process of reform aims at changing not only regulations but also the supervisory approach. This suggests in principle a change relative to the reactive and hands-off approach of the past, and asks supervisors to use their judgement and engage in a dialogue scrutinising and probing senior management and board members. The intrusive questions listed in the last section can also play a role here. That said, assessing whether a bank has a sound risk culture and proper internal controls to promote it is not easy, as it is a broad concept. I already mentioned the high-level principles published by the FSB to assist supervisors in their assessment. Supervisors should check that mechanisms are in place and ensure that the necessary checks and balances are in place throughout the organisation, as well as proper accountability and transparency provisions.
The Single Supervisory Mechanism is Europe’s response to the post-crisis challenge to banking supervision. The SSM has an excellent chance to make a quantum leap in the quality of European supervision, in general but also from the viewpoints that I have examined here. Let me mention three reasons.
First, and most simply, the SSM entails a complete new set-up of supervisory processes at the European level. True, it will inherit the experience of the national supervisors, but all that is being thoroughly filtered and re-examined to ensure that best practices prevail and that a level playing field is established and preserved.
Second, the SSM has a fully European mandate. All supervisory processes will follow guidelines, specific regulations and specific decisions consistent with a Supervisory Manual approved by the ECB. This should result in a consistent supervisory approach and ensure an effective application of the single rulebook, also in the area of good conduct and ethics.
Third, another key characteristic of the SSM is its composition, consisting of the ECB and the national supervisory authorities. This holds at two levels: the Supervisory Board, which focuses on decisions, and the Joint Supervisory Teams, which will provide analyses and proposals and conduct the supervisory cycle for each significant banking group. This composition will ensure, in the supervisory function, the same elements of transparency and peer review that, as I have argued, are essential within the banking firm to ensure that proper conduct and ethical norms are respected. Also from this viewpoint, the system is constructed in such a way as to reduce the risk of forbearance.
Ethics are inextricably connected to the financial world as they form the basis for trust. Without trust the system is either dysfunctional or unstable or both, as the recent experience has shown.
Regulatory and supervisory reform can contribute to strengthening trust, by placing the emphasis on robust risk management systems, strong corporate governance frameworks and a sound risk culture. But in itself regulation is not sufficient, if not complemented by a sound ethical framework. As “trust comes by foot, but leaves on horseback”, it may take a while before we see results, but I am confident results can be achieved. Banking supervisors should be aware of these issues and contribute to the process.
Thank you for your attention.
- I am grateful to Jean-Edouard Colliard and Cécile Meys for excellent contributions and to Julie Dickson, Simone Manganelli, Danièle Nouy and Stefan Walter for useful comments. The views expressed here do not involve the ECB or the SSM Supervisory Board.
- In fact, the term “credit” is reported to have been used for the first time in Venice in the 15th century.
- Boatright, J. R., “Trust and Integrity in Banking”, Ethical Perspectives, Vol. 18(4), 2011.
- Guiso, L., Sapienza, P. and Zingales, L., “Trusting the Stock Market”, Journal of Finance, Vol. 63(6), 2008 and Guiso, L., Sapienza, P. and Zingales, L., “Cultural Biases in Economic Exchange”, Quarterly Journal of Economics, Vol. 124(3), 2009. See also the summary in Guiso, L., Sapienza, P. and Zingales, L., “Trust and finance”, NBER Reporter, No 2, 2011.
- Social capital is defined by Putnam as “features of social life – networks, norms, trust – that enable participants of a given community to act together to pursue shared objectives”. See Putnam, R., Making Democracy Work – Civic Traditions in Modern Italy, Princeton University Press, 1993.
- Pevzner, M., Xie, F. and Xin, X., “When Firms Talk, Do Investors Listen? The Role of Trust in Stock Market Reactions to Corporate Earnings Announcements”, Journal of Financial Economics, 2013.
- Guiso, L., Sapienza, P. and Zingales, L., “Long-Term Persistence”, working paper, University of Chicago, 2008.
- M. Knell and H. Stix, “Trust in Banks? Evidence from normal times and from times of crises”; Oesterreichische Nationalbank, mimeo, November 2009.
- See http://www.financialtrustindex.org.
- See http://www.edelman.com/insights/intellectual-property/2014-edelman-trust-barometer/about-trust/executive-summary/
- See e.g. Kirkpatrick, G., “The corporate governance lessons from the financial crisis”, Financial Market Trends, Vol. 2009/1, OECD, 2009.
- I have described the first steps of this process in Angeloni, I., “Testing times for global financial governance”, Bruegel Essays, 2008. A more recent overview is provided by Veron, N., “The G20 financial reform agenda after five years”, The US-China-Europe reform agenda, Peterson Institute for International Economics, 2014; available at http://www.iie.com/publications/papers//201405piie-cf40conference.pdf.
- Available at http://www.financialstabilityboard.org/publications/140407.pdf. Background documentation is available at http://www.financialstabilityboard.org/press/pr_131118.htm.
- LIBOR alone affects more than USD 300 trillion of financial contracts, including swaps and futures, in addition to trillions more in variable-rate mortgage and student loans; see http://www.newyorkfed.org/research/staff_reports/sr667.pdf
- Consisting in the falsification of the fixing of the conventional day-end exchange rate that serves as a reference for a large volume of forex-linked contracts. The daily turnover of the global forex market is estimated by the BIS at USD 5.3 trillion.
- An annotated list of recent financial scandals (but unfortunately a partial one, in spite of the fact that the paper was published only 5 months ago!) is provided by Erhard, W. and Jensen, M., “Putting Integrity into Finance: A Purely Positive Approach”, ECGI Finance Working Paper No 417, Appendix 1, 2014.
- Payne, C., “Ethics or bust: beyond compliance and good marketing”, in Cosgrove-Sack, C. and Dembinski, P. (eds), Trust and Ethics in Finance, Globethics.net, 2012.
- Leonid Hurwicz comes to precisely this conclusion in his 2007 Nobel lecture through an admirable but totally different argument: since compliance with the law requires enforcement, and enforcement is performed by other humans, a system without ethics (which amounts to intrinsic, not extrinsic, enforcement) is unsustainable. See Hurwicz, L., “But who will guard the guardians?”, Nobel Lecture, 8 December 2007.
- See Defining and developing an effective code of conduct for organisations, International Federation of Accountants, 2007.
- The ideas that follow draw heavily on Erhard and Jensen, op. cit., and Forstmoser, P., “Integrity in finance”, speech given at the Swiss Banking Institute, 2006, including the references therein.
- In the Theory of Moral Sentiments, Part III, Ch. 1, Adam Smith writes: “When I endeavour to examine my own conduct, when I endeavour to pass sentence upon it, either to approve or condemn it, it is evident that, in all such cases, I divide myself, as it were into two persons; and that I, the examiner and judge, represent a different character from that other I, the person whose conduct is examined into and judged of. The first is the spectator, whose sentiments with regard to my own conduct I endeavour to enter into, by placing myself in his situation, and by considering how it would appear to me, when seen from that particular point of view. The second is the agent, the person who I properly call myself, and of whose conduct, under the character of a spectator, I was endeavouring to form some opinion. The first is the judge; the second the person judged of. But that the judge should, in every respect, be the same with the person judged of, is as impossible that the cause should, in every respect, be the same with the effect.”
- A similar notion – self-deception – appears to be a pervasive feature of a broad range of human and even animal actions; see Trivers, R., The folly of fools; the logic of deceit and self-deception in human life, Basic Books, New York, 2011.
- There has been discussion recently also about the possibility of asking bankers to take an oath that they will act honestly and in the interests of their clients, with a view to promoting trust in the banking sector. The “banker’s oath” has actually been adopted in the Netherlands and proposed also for the UK; see Llewellyn et al., “Virtuous Banking”, ResPublica, 2014.