Duvvuri Subbarao: Ethics and the world of finance

Keynote address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
Conference on “Ethics and the World of Finance”, organised by Sri Sathya Sai University,
Prasanthi Nilayam, Andhra Pradesh, 28 August 2009.

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Thank you for inviting me to participate in this unique conference on “Ethics and the World of
Finance”. This topic would have been relevant at any time. But it is particularly so, given the
current financial crisis which has called into question the ethical foundation of the financial
world. It is also fitting that we are discussing ethics and the world of finance at Sri Sathya Sai
University. The worlds of faith and economic development are profoundly intertwined, in both
precept and practice. At heart, the strongest link is the aim to foster greater social justice.

Ethics and the world of finance – the canvas

I must admit I have not thought about ethics and the world of finance deeply or systematically
before confronting the challenge of addressing this conference. And as I tried to collect my
thoughts, several questions came to mind. How do we, as individuals, approach issues of
ethics and values? Are our approaches different in our personal and professional lives? Are
issues of ethics different in the financial sector? What are the ethical issues thrown up by the
current crisis? Has economics, as an academic discipline, lost its value base? Is that the root
cause for the malaise in the financial sector? How do we in the Reserve Bank interpret our
mandate towards ethical standards and values in all that we do? These questions cover a
fairly large canvas; and my scholarship and experience are clearly not adequate to cover that
entire canvas. But I will address some of these questions in my limited capacity and time.

The power of context

We – all of us – confront ethical issues and dilemmas every day and we deal with them by
our own standards. All of us know it is a constant struggle between sticking to the straight
and narrow path of ethical virtue and succumbing to temptation. As individuals and families
we manage this struggle in our own different ways, drawing the line for ourselves as we
weigh the trade-offs.
A follow on question is, are our ethical standards of honesty, sensitivity, fair play and values
absolute or do they change depending on the context? We all know that some people are
more honest than others. But the question is, is an honest person honest all the time, or does
her sense of honesty depend on the trade-offs in the specific context of a dilemma?
Empirical psychology tests show that there is not a tight circle of honest people and another
tight circle of dishonest people.
In his best-selling book, “The Tipping Point”, Malcolm Gladwell argues that something like
honesty is not a fundamental trait, but is considerably influenced by the situation. There are
specific situations so powerful that they can overwhelm our inherent predisposition. To
buttress this argument, Gladwell cites a landmark set of behaviour experiments by two New
York based researchers, Hugh Hartshorne and M.A. May. Hartshorne and May administered
several types of tests to eleven thousand school children over the course of several months,
all designed to measure honesty. The tests varied by subject, design, level etc. and the
results are therefore quite robust. Some of the test results are obvious. A few children never
cheat, and a few always do. Less intelligent children cheat more than smart children. Older
children cheat more than younger ones. Girls cheat about as much as boys. Some test
results though are less obvious. For example, performance of children varied as between
class-room exams and take home exams. Some children cheat in arithmetic but not in

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spelling tests. The surmise of this extensive behaviour experimentation was that between the
binary extremes of a few who never cheat and a few who always do, there is a large grey
mix. Some people cheat if there is an opportunity; some cheat if the stakes are high enough;
some cheat if the chance of getting caught is small.
What do the above results mean for our value systems as individuals in our personal lives
and in our professional lives? Do we have double standards? Are we more strict about
breaking a self-imposed standard in our personal lives but do so with less pangs of
conscience in our professional lives? I believe such compartmentalization is not valid.
Individuals carry their ethical standards and values everywhere, and how they resolve
specific dilemmas and issues is determined not so much by the personal and professional
domain of the dilemma but by the power of context that Gladwell cites.

Ethics in the financial sector

Let me now turn to the issue of ethics in the financial sector. 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. As we have seen time and again, dishonest schemes where
trust is breached implode and come crashing down. Two come to mind immediately, though
there are, of course, many more. There is Nick Leesson, the British trader who single-
handedly caused the collapse of one of England’s most venerable banks in the mid-1990s;
and there is the more recent case of Bernie Madoff, the former head of the New York Stock
Exchange, whose Ponzi Scheme robbed millions of individuals of their life savings and looted
the treasuries of charitable institutions involved in building social capital.
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.
Even as this debate frowns on moderation, I believe the view that people in the financial
sector are inherently less ethical than those elsewhere does not stand the test of empirical
scrutiny. Yes, there may be larger temptations here given the money that can be made, and
perhaps even bigger opportunities. But once again, it is the power of context that Malcolm
Gladwell talks about that is relevant. It is not that professionals in the financial sector are
inherently less ethical, but given the environment of the financial sector, there may be larger
incidence of unethical behaviour. Consider, for example, Dennis Levine, the Drexel Burnham
Lambert investment banker who was convicted of insider trading in one of Wall Street’s
biggest scandals. According to him, it was just so easy. In seven years he multiplied a paltry
$40,000 into $12 million, and all it took was a 20-second phone call to an offshore bank a
couple of times a month – may be 200 calls in total. He was confident that the elaborate veils
of secrecy plus overseas bank privacy laws would protect him. Closer home there is the

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recent case of Satyam which allegedly window dressed the company accounts for over ten
years, betraying the trust of all its stakeholders.
John Stuart Mill said that if we make men honest, good and decent, then they will make
themselves honest, good and decent engineers, doctors and teachers, and may I add,
financial sector professionals. The financial sector is, after all, a reflection of the society in
which it operates. So, the approach to bringing ethical values into finance has to begin not by
special efforts to enforce or regulate ethical standards in finance, but by fostering a value
system in society at large.

Ethical issues thrown up by the financial crisis

This global financial crisis has been the deepest, broadest and most hurting financial crisis
since 1929. All of a sudden, it seems like an entire super structure was built on sand instead
of rock as it was believed. We are too close to the crisis to really grasp how this crisis might,
as they say, turn out to be game changing. What the crisis has done is to cause a massive
break down of trust: trust in the financial system, trust in bankers, trust in business, trust in
business leaders, trust in investment advisers, trust in credit rating agencies, in politicians, in
the media and in the process of globalization.
When you break down the complex gamut of the causes of the crisis, several skeletons
tumble out of the cupboard. Almost all of these relate to how the financial system operated.
In a phrase that has now become daily staple, sub-prime borrowers were given loans at
teaser rates. And these borrowers were led to believe that they would never lose as the price
of the house they were buying will only keep going up. The loans were sliced and diced, built
into complex products and rated by rating agencies. Dazzled by these ratings, gullible
investors lapped up the mortgage based assets (MBA) not realizing the risk they were taking.
Meanwhile investment banks took the MBAs off their balance sheets so that they could
leverage once more and repeat the cycle of sub-prime lending.
At one level, it is possible to argue that nobody in the entire chain did anything legally wrong.
But that is too simplistic an argument. We do not govern our behaviour simply by what is
allowed by law or regulation. Our code of conduct should be held to a stricter test. Was the
behaviour of actors across the chain of the financial sector fair, ethical and moral or was it
swayed by the opportunity of making quick profit afforded by information asymmetries? Were
sub-prime borrowers adequately warned that there is a good chance that asset prices would
fall? Did investment advisers tell their clients of the risk they were taking in buying MBAs and
CDOs? Did credit rating agencies not compromise their standards and cut corners? In sum,
were professionals in the financial sector legally right, but only legally right and morally
wrong?
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

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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.

Ethical basis of economics

The crisis has also triggered an interesting, if also a soul searching debate on whether the
malaise that we have seen in the financial sector might in fact be a result of the flaws in the
direction that economics, as an academic discipline, has taken over the years.
Some of you may have read in the papers that Queen Elizabeth visited the London School of
Economics a few weeks ago and reportedly asked the economists there, “why did no one
see the crisis coming?”. The Queen’s question is understandable given the growing claims of
economics to hard predictive power like other exact sciences. Over the last several decades,
the direction of economics has been to position itself more like a natural science rather than
the social science that it actually is. As Lord Skidelsky argued in a recent article in the
Financial Times, economics tried to be more like physics with precise predictive abilities
based on mathematical models rather than like sociology or psychology where the outcomes
are determined by human behaviour and therefore beyond the pale of precise modelling and
exact predictions. Undoubtedly, the mathematical models helped economic analysis and
aided in determining optimal solutions. The trouble though was that the mathematical
abstractions got carried too far, and in the process economics lost its link with real life
situations that it was expected to study and analyze. In other words, mathematical models
became an end in themselves and assumed a life of their own.
What does value orientation to an academic discipline mean? Let me explain through two
illustrations, one that may be considered to be in the realm of theory, and a more complex
one all of us could run into in our professional lives. Suppose you are given a problem in a
test, say an accounting examination. You are asked not only to solve the problem, but also to
comment on questions such as, “was that way of accounting legal?”, “was it ethical?”, “was it
chosen because it was convenient for the firm?”. What will your take away be from such an
exam? Not just the technique of accounting, but the values that must underline accounting.
Problems in real life tend to be more complex, and reflect real behaviour. My second
illustration is a variation of what is called the ultimatum game. Say, a team of two people, A
and B, accomplishes a task by putting in equal effort, 50-50. The manager gives Rs.1000 to
A and tells him to share it between them according to their respective contributions to the
task. The rules of the game are that A can divide the money in any proportion he wants. And
B has the option to accept or reject the offer. If B accepts the proportion in which money has
been divided, both get to keep the money. If B rejects the offer, both lose and the Rs.1000
goes back to the manager. The rules put pressure on A to divide the money at least roughly
in proportion to their respective contributions. Anything markedly out of line will annoy B, and
she will likely reject the offer even if she is losing what she otherwise could have gotten. In
other words, in the face of overt dishonesty, it becomes more important for B to make A lose
rather than cut losses for herself. The ultimatum game illustrates how you cannot move
ahead in life or in business without a sense of values. Tools and concepts of ethical
reasoning belong with the other valuable instruments of financial practice.
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

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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.

Ethical dimensions of RBI’s mandate

I note that following my speech and that of my senior colleague and widely respected former
Governor, Dr. Reddy, this conference has scheduled two panel discussions. The first is on
the “Role of the Regulator – Governance and Regulation” and the second on the “Role of
Individual Financial Institutions and Corporate Responsibility”. I also note that the panellists
are some of the most distinguished leaders of the Indian financial sector. Both these topics
have a connection with RBI’s role and responsibilities. So, let me briefly, touch on the ethical
dimensions of RBI’s mandate.
The Reserve Bank has a broad mandate. As central banks go, I believe we are a “full
service” central bank. We are the monetary authority, we issue currency, we are the
regulator of banks and non-bank finance companies and much of the financial markets. We
regulate also the payment and settlement system. We are the debt manager for the central
and state governments and the gatekeeper for the external sector. What guides us in fulfilling
this broad mandate is a sense of institutional values and professional integrity.
Let me give a few examples. One of the core aims of monetary policy is to maintain price
stability. If we fail in that regard, there would be inflation. And inflation, as we know, is a
perniciously regressive tax that hurts the poor the most. So, by maintaining price stability, we
are safeguarding the well being of the poor in society.
We take our regulation responsibility seriously. An important guideline for regulation is to
protect the interests of depositors. We therefore ensure that banks are well capitalized,
prudently managed and that they have adequate and appropriate internal controls.
Our regulatory responsibility also casts an obligation on us of protecting the interests of the
borrowers. We need to ensure that borrowers get credit at remunerative rates of interest and
that they are not disadvantaged by information asymmetries. We advise banks not to charge
excessive/usurious rates of interest on non-priority sector personal loans and credit card
dues. We have asked that banks should communicate publically information on the
maximum interest chargeable to any type of loan or advance. We have mandated that
service charges should be reasonable and have some relation to the cost of rendering the
services. We have a system of banking ombudsman to address the grievances of customers.
I cannot claim that we are the best practice in dispute resolution, but I can claim with pride
that we try our best to be the best practice.
In recent years, we have been focussing on financial inclusion and financial literacy. The aim
of the financial inclusion campaign is to provide access to financial services to people in
remote and rural areas and poorer segments of the society. Our stress is on expanding the
reach of financial services to ensure that every household has a bank account. But the
aspiration extends, beyond merely chasing a target, to the quality of financial inclusion. Not
only should the poor have an account, but they should also be getting the benefit of the
account by way of credit and other financial transactions. The aim of the financial literacy
programme is precisely that – to educate people on the type of services that they can get
from the financial sector, on the rights that they have and on the grievance redressal
mechanism.
Finally we are deeply sensitive to the Reserve Bank’s role as the issuer of currency. A billion
plus people place their implicit faith in the currency signed by the Governor promising to pay
the bearer on demand the face value of the note. It is this faith that makes people keep the

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currency as a store of value. It is this faith that enabled us to make the transition from the
inefficiencies of the barter system to an efficient cash economy. It is this faith that underlies
hundreds and thousands of cash transactions that take place every day and keeps a sixty
trillion rupee economy going. The preamble to the RBI Act enjoins on the Reserve Bank,
among other things, of “securing monetary stability”. Maintaining the integrity of the currency
note signed by the Governor is a responsibility that the Reserve Bank treats as sacrosanct –
not just as a legal mandate but as an ethical responsibility.

Conclusion
Let me now conclude. To summarize, I have argued that all of us as individuals, families,
social communities and faith communities confront ethical dilemmas everyday, and we
resolve them in our own ways. Notwithstanding where we draw the line, we take the value of
ethical behaviour to be axiomatic. There is no evidence to show that people in the financial
sector are inherently less ethical than people in other professions. However, given the larger
temptation and more opportunities, the power of context to be short, there could be greater
incidence of unethical behaviour in the financial sector. Drawing lessons from the crisis, I
have argued that because of the very nature of the financial sector, leaders and top
management in the financial sector have an extra obligation to be sensitive to larger societal
obligations. I have raised the issue of economics, as an academic discipline, losing its value
base, and conjectured if that could be at the root of the malaise in the financial sector.
I have also outlined how a sense of responsibility to larger societal good underpins the
mandate of the Reserve Bank.
Let me also mention that the year 2009/10 marks the platinum jubilee of the Reserve Bank of
India. We have planned a number of events to mark and celebrate the occasion. The theme
of all our celebration is “how can RBI make a difference to the lives of the ordinary people in
India?”. This theme draws again from the professional value system of the Reserve Bank.
I wish this conference on Ethics in the World of Finance all success.

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