A Matter of Trust: The Practice of Ethics in Finance

Paul Kofman (PhD, Erasmus University Rotterdam) was appointed Professor of Finance at the University of Melbourne in 2001. In 2012, Professor Kofman became Dean of the Faculty of Business and Economics. Paul’s research interests and publications are in quantitative and behavioural finance and the regulation of financial markets. He was one of the founding directors of the Australian Research Council–funded Financial Integrity Research Network. With his colleague Clare Payne, Paul introduced one of the first online subjects at the University of Melbourne, ‘Ethics in Finance’. With his colleague Sean Pinder, Paul also designed and developed the first Coursera MOOC specialisation, ‘Essentials of Corporate Financial Analysis and Decision Making’, in partnership with BNY Mellon.

Clare Payne (BA LLB, Macquarie University) specialises in the field of ethics in business. She commenced her career as an employment lawyer and then managed the Integrity Office of a global investment bank. Clare was a founding director of The Banking and Finance Oath, a not-for-profit that advocates a Hippocratic-type oath for those in finance. Clare is also a Fellow of The Ethics Centre and an Ambassador for Tobacco Free Portfolios. Clare was awarded the Inaugural Ethics in Finance Prize by the Observatoire de la Finance, Geneva; is a World Economic Forum Young Global Leader; and has been recognised by the Australian Financial Review and Westpac as one of their ‘100 Women of Influence’. As a former marathon swimmer, having swum solo around Manhattan, Clare has raised significant funds for the not-for-profit sector and continues to be actively involved in addressing a range of social issues.

A

MATTER

OF

TRUST

THE PRACTICE OF

ETHICS IN FINANCE

PAUL KOFMAN & CLARE PAYNE

MELBOURNE UNIVERSITY PRESS

An imprint of Melbourne University Publishing Limited

Level 1, 715 Swanston Street, Carlton, Victoria 3053, Australia

[email protected]

www.mup.com.au

First published 2017

Text © Paul Kofman and Clare Payne, 2017

Design and typography © Melbourne University Publishing Limited, 2017

This book is copyright. Apart from any use permitted under the Copyright Act 1968 and subsequent amendments, no part may be reproduced, stored in a retrieval system or transmitted by any means or process whatsoever without the prior written permission of the publishers.

Every attempt has been made to locate the copyright holders for material quoted in this book. Any person or organisation that may have been overlooked or misattributed may contact the publisher.

Cover design by Design By Committee

Typeset by Megan Ellis

Printed in Australia by McPherson’s Printing Group

National Library of Australia Cataloguing-in-Publication entry

Kofman, Paul, author.

A matter of trust: the practice of ethics in business/Paul Kofman, Clare Payne.

9780522871708 (paperback)

9780522871715 (ebook)

Includes index.

Finance—Moral and ethical aspects.

Economics—Moral and ethical aspects.

Social responsibility of business.

Payne, Clare, author.

For those who need a little faith, or encouragement.

CONTENTS

Foreword by Dr Simon Longstaff AO

Foreword by Greg Medcraft, Chairman, ASIC

Author’s Note

Introduction—What’s Going on?

1 Money for Nothing—Reputation, Trust and Ethics (by Paul Kofman)

In the Public Eye

A Cause for Distrust

What Price Economic Growth?

Ethical Positions

Conclusion

2 Better Days—The Social Contract (by Clare Payne)

A Move to Professionalism

Changing Expectations of Business

Adjusting Measures of Success

Conclusion

3 Something So Strong—Foundations of Trust (by Clare Payne)

The Roles and Limits of Regulation and Legislation

Good Governance

Individual Accountability and Self-regulation

Conclusion

4 The Twist—Duties (by Clare Payne)

Duties and Obligations

Fiduciary Duties

Duties as an Employer

Duties to Stakeholders

Conclusion

5 Into Temptation—Conflicts of Interest (by Paul Kofman)

Knowing Your Conflicts of Interest

Classic Conflicts in Finance

Managing Conflicts of Interest

Conclusion

6 One Step Ahead—Evolving Challenges (by Paul Kofman)

Innovation—Fintech and P2P

Brexit and the Rise of China

Reaching out to the Unbankables

Conclusion

7 Take the Pressure Down—Ethics Informing Practice (by Clare Payne)

Ethical Awareness

Good Practices

Ethical Leadership

Conclusion

Conclusion—Get It Right the First Time

Acknowledgements

Notes

Index

FOREWORD

by Dr Simon Longstaff AO

Uncomfortable as it may be for those concerned, the media’s focus on unethical conduct within banking and finance underlines the importance of the industry to society (and not just the economy). The truth is that public concern about the ethics of society’s bankers reflects a general understanding of a simple fact: banking really matters. For centuries, and in the face of enduring controversy about issues like usury, banks (and associated financial institutions) have been meeting basic human needs. Insurance has enabled members of the community to spread the burden of risk. Credit has allowed individuals and organisations to invest in their dreams and the prospect of a better future. Savings facilities have allowed stable stores of wealth to be held safe. In combination, financial institutions have played a vital role in enabling prosperity—not just for the few but the many.

All of this has been built on a foundation of great private and public utility combined with trust. It was (and remains) an extraordinary thing that a promissory note written in Pisa could be presented half a world away, in London, with every expectation that it would be honoured. It is extraordinary that people will entrust a banker to receive and hold the bulk of their wealth, in the certain belief that it will be returned when called for.

The whole edifice of banking and finance has been built on a surprisingly fragile foundation of confidence. That is why the scandal is so great when bankers (and their institutions) are revealed to have acted in ways that betray trust. It matters not that the perpetrators are relatively few in number. It matters not that the majority of people in the industry feel just as betrayed as the hapless victims among their customers. When the foundations of trust are undermined—even just a little—then the whole structure is rocked.

Of course, it does not help that the industry has often organised itself along lines that support (and sometimes drive) unethical behaviour. Remuneration policies, product design, a million small signals embedded in the ordinary structures of banking, have played their role in divorcing technical mastery from ethical restraint. For the most part, the adverse results have been unintended, often overseen by people of exemplary character and good will. But that is no excuse, and does not undo the great harm that offsets the considerable good to be found on the balance sheet of banking and finance.

Unfortunately, the industry (along with many others) ultimately has failed to understand that ‘ethics’ is vastly different to ‘compliance’. The latter can be achieved in conditions of ‘dumb obedience’. The former requires much more—the development and maintenance of a culture in which every participant possesses and employs a constructively critical mindset. It requires leaders who never accept the status quo simply because ‘everyone does it’ or because ‘it has always been done this way’.

To embrace ‘reflective practice’ as part of what it means to be a banker requires both sound judgement and moral courage. This book makes the case for choosing to be that kind of banker—and how it should be given practical effect.

FOREWORD

by Greg Medcraft, Chairman, ASIC

Trust is a business asset. But building trust with customers has become far more challenging in the current environment, partly because the way in which customers interact with businesses has changed. Our commercial interactions are no longer, as they once were, with people we know directly. We now use digital technologies to transact, search for information, share our personal details—taking a leap of trust that we are safe and our best interests are accounted for. These same digital technologies allow word-of-mouth and feedback to be magnified by social media, so customers can let businesses—and the wider community—know if they have met or exceeded expectations, but they will also let them know when they have crossed the trust line. Listening to the crowd and its messages through various channels requires a degree of accountability on the part of our institutions, and on our part as professionals.

As my term as Chairman of the Australian Securities & Investments Commission comes to a close, I reflect on how this book, A Matter of Trust, can help us understand how to build and sustain business trust, or rebuild it once it has been lost.

Clare Payne and Paul Kofman have set out to examine trust from many angles: how a fall in trust in our financial entities has a corresponding fall in reputation, the social contract we as consumers grant these institutions, good governance principles, the duties to customers and shareholders, situations where conflicts of interest can arise and how they can be managed, possible ways forward, and how ethics can be a pathway to better practice. This multidimensional approach to examining trust reflects the complexity of doing business today. Creating a sustainable business is not only about the quality of the product or service that is delivered. It is also about the quality of an organisation’s conduct, how it operates internally and represents itself externally. If the conduct of a business and its values are not aligned with customer outcomes, it is easy to see how a trust deficit will emerge, and this will impact the long-term sustainability of a business. Trust must be built through a company’s brand and reputation, which is a logical result of how it treats its customers and looks after their interests.

At ASIC, we continue to encourage organisations to reflect on their culture, and how it enables or encourages the unfair treatment of investors and consumers. A sound culture, and the conduct that can stem from this culture, is fundamental to community trust and confidence.

The Banking and Finance Oath is a project facilitated by The Ethics Centre and is an industry-led initiative, designed to highlight the founding moral and ethical principles of the industry and remind individuals of their broader commitment to society now and in the future.

As a leader of my organisation, I signed The Banking and Finance Oath. The first line of the oath is ‘Trust is the foundation of my profession’. And so it should be.

AUTHOR’S NOTE

I am very grateful that Paul contacted me when I was managing the Integrity Office of Macquarie Bank and invited me to deliver a guest lecture on ethics in finance for his students at the University of Melbourne. Paul then had the vision to offer a complete course on ethics in finance and we set out to design and develop it together. We believe that a course dedicated to ethics in finance provides a valuable contribution to a student’s education and helps prepare them as professionals, giving them a deeper understanding of their role in upholding ethical standards and respecting the integrity of financial systems.

Writing a book is a natural development of our work and interest in ethics in finance. Australia’s financial system is admired globally, and therefore a text that applies an ethical lens to the global context as well as to Australia’s systems and people, is a much-needed contribution we are pleased to have made.

Of course, Paul and I don’t always agree, perhaps no surprise with my background as a lawyer working in finance and Paul’s as an academic and then faculty dean. Paul sometimes thinks I am far too lenient on the sector (I prefer to see myself as realistic) and at times I feel he is too extreme in drawing conclusions (he might view these as considered). But through the practice of ethics we manage to find our way, and I feel fortunate to have learned a lot from an unexpected companion.

In A Matter of Trust we present to you our thoughts on ethics in finance. We believe that an ethical finance sector is crucial, and that each individual has an opportunity to make a valuable contribution. We have always been in complete agreement that this is all a matter of trust.

Clare Payne, August 2017

INTRODUCTION

What’s Going on?

From the marble trading floors of Wall Street to the dirt floor of a microfinance lender in rural Sumatra, finance touches everybody’s lives. From small personal loans to collateralised debt obligations, it promises solutions for a better, more prosperous future. But not much in life is guaranteed, and financial outcomes may not match expectations. As financial transactions span time, they are anchored by expectations of future commitments that depend on the trust between the parties involved. When that trust is undermined, it threatens the very fabric of our financial system. While the direct consequences may only amount to customer disappointment, the financial crisis of 2007–08 highlighted how all of us may be impacted indirectly when whole economies are jeopardised by financial mismanagement.

The tax-funded bailouts of major financial institutions highlighted the intrinsic moral hazard of our global financial system. Amidst the public outcry, some commentators demanded a complete overhaul of the system: the breaking up of banks, re-regulation of markets and institutions, and abolition of recent financial innovations. Yet reality dictates that it’s hard, impossible even, to wind back the financial system, its institutions and intermediaries. And would we even want to return to an imagined era of better days? After all, even the system’s most ardent critics agree that financial innovation has enabled economic development and brought prosperity.¹ But does it have the ability to do better, and perhaps convince people it can do good? To answer that question, we need to address the ethics of banking and finance.

According to public perception, financial institutions have a difficult relationship with ethics. Greed, dishonesty, fraud, disloyalty and deception are just a few of the accusations undermining trust in the sector’s ethical behaviour. Annual surveys of perceptions of professional integrity and ethics indicate that public trust in financial institutions has hit rock bottom. It hasn’t always been like that. When these surveys were first conducted in the early 1970s, bankers were still held in high esteem. They were regarded as pillars of society. You entrusted your bank manager with your life’s savings, and you could rely on that manager to honour the bank’s promises to look after your money.

Of course, even in the days when banks were considered reputable institutions, there were occasional financial scandals, scams and poor advice. These unfortunate incidents were invariably attributed to rogue individuals who violated their bank’s code of conduct. As these were isolated incidents, severe punishment of the individual was expected to deter others, thereby upholding the trust in, and reputation of, the institution. None of that has changed, but something else did.

Sometime during the 1980s, banks turned into financial institutions, not unlike the establishment of industrial conglomerates around the same time. Growth through mergers and acquisitions, and a need for diversification of business lines, became possible and was made necessary following a wave of global financial deregulation. This deregulation boosted competition and instantly changed banks’ behaviour in protecting and gaining market share. In the global marketplace, this often involved a more aggressive stance towards gaining and generating business, and a prioritisation of shareholders’ interests over other stakeholders’ interests.

This change of attitude was acknowledged in 2002 by the CEO and chairman of Wells Fargo & Company, Richard Kovacevich, in a statement to shareholders:

We’re pleased to say more of our customers are bringing us more of their business. That’s the core of our vision—to satisfy all our customers’ financial needs and help them succeed financially … The more business customers bring us, the more time and money they save, the more loyal they are to Wells Fargo, the more interested they are in bringing us more of their business. This results in marketshare growth that generates double-digit profit growth and a higher stock price.²

As a consequence of deregulation, the financial sector prospered and proliferated. This triggered strong demand for finance professionals, more than could be met by trained supply. Prominent financial institutions became the employer of choice for an increasingly university-educated workforce. But unlike other professions, such as accounting, the qualifications bar was never set particularly high for entry to the finance profession. Motivated by very attractive salaries, perks and performance bonuses, and the sheer excitement and glamour, some adverse workforce selection was bound to happen. That may have compromised professional competence in the sector.

Have these changes made banking less ethical? The media certainly seems to suggest so. Negative coverage of the financial sector is common: an insider trader imprisoned, an investment scheme leaving pensioners bereft, a bank manipulating interest rates. Stories abound about banks repossessing mortgaged homes during economic downturns, declaring farmers bankrupt in the middle of a drought, or encouraging credit card spending despite customers being already in arrears, suggesting a ruthless attitude and scant regard for customers’ welfare. But it was only when the global economy started to be affected that populist politicians linked financial deregulation to unethical bank practices leading to systemic economic woes. As a result, bank bailouts and new regulations, including Sarbanes-Oxley, Dodd-Frank and Basel III, reset the rules of the global financial system to curtail some of its excesses.

Of course, it could just be because of our improved access to information (and social media) that only recently have these stories come to light. Not knowing about unethical behaviour does not imply its absence, and financial sector business practices may have been no more ethical in the past than they are today. But that is no excuse for current bad practice. If anything, our awareness of unethical practices should help us address the issues and where possible rectify bad behaviours.

The introduction of socially responsible investment funds that subscribe to the analysis of environmental, social and governance principles, of peer-to-peer lending platforms, crowdfunding and microfinance, are just some of the positive signs that this is happening. We could call this response ‘alternative finance’, and it might be tempting to think that it is, by construction, free from ethical pitfalls, as it was developed to counteract unethical traditional banking practices. Yet each of these new initiatives poses new ethical challenges.

Our hope is that by highlighting the importance of the public good of finance, and by empowering individuals through ethical practices, we can influence the sector for the better. We don’t seek to apportion blame for every unethical act exposed by the media. We recognise the strong and lasting contribution to societal welfare that finance has made. But we also observe its weaknesses and the opportunity to do better. Therefore, this book provides the new and experienced finance professional with a broad overview of the key ethical issues as they occur in day-to-day financial decision-making. From changing public perceptions and expectations to the pivotal role of trust, from duties and obligations to conflicts of interest and emerging ethical challenges, this book proposes a framework to make business decisions in a morally sound and ethical way.

1

MONEY FOR NOTHING

Reputation, Trust and Ethics

Paul Kofman

Reputations, which are built over time, are a record of past performance, while trust is forward-looking. A bank’s track record in delivering good, fair and reliable service helps build customer trust in its future performance. Those customers will return, and the word will spread to prospective new customers, which will enhance the bank’s future prospects. A bad reputation, on the other hand, erodes trust. It makes customers