Ethical standards and cultural assimilation in financial services - - PowerPoint PPT Presentation

Ethical standards and cultural assimilation in financial services

Alan Morrison1 John Thanassoulis2

1University of Oxford 2University of Warwick

john.thanassoulis@wbs.ac.uk

May 2016

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 1 / 34

Introduction

The financial crisis of 2008–09 cast a harsh light upon a number of practices in the financial services sector: Subprime mortgage lending; LIBOR fixing; Forex fixing; PPI (Payment Protection Insurance). And even more recently: Mis-selling passive investment vehicles as active fund management.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 2 / 34

Widespread concern that the culture in Finance is bad

Supervisors note that they cannot rely solely upon formal regulations to moderate such behaviour. ⇒ cultural standards & “tone from the top” are critical. Despite the focus, “cultural failure” seems to be an endemic feature of

• banking. [e.g. Dudley of NYFed, Pope Francis & Archbishop of

Canterbury] A consensus that executive pay has contributed to problems in the financial sector; and this has led to substantive fines (Forex $10bn, LIBOR $9bn). Behavioural problems seem specific to banking and linked to ‘moral failure’. (e.g. propensity to lie and experimental evidence).

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 3 / 34

Ethics are essentially contested

Despite ease with which commentators identify moral failings, philosophers have been arguing about what is right for more than two millennia. Virtue (e.g., Aristotle (2009), MacIntyre (2007));

For Aristotle, virtue is inconsistent with many commercial activities.

Utilitarian tradition due initially to Jeremy Bentham (2007 [1789]).

For Bentham an action is right when it generates an increase in the aggregate level of individual well-being.

Kantian duty ethics, are duties which exist before we understand the context and do not depend upon that context (Kant (2012 [1785]).

An example is the duty to tell the truth. We interpret as a duty not to harm the customer.

Kant would never countenance lying; Bentham would accept its desirability in some situations.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 4 / 34

Modelling Ethical Dilemmas

A principal employs two agents to provide a service to consumers. There exists a practice, P, which each agent can invoke and which raises profits with some probability. P may harm consumers a lot, or a little.

E.g. fix LIBOR; or sell PPI.

The agents face a moral dilemma: whether or not to invoke P

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 5 / 34

Modelling Ethical Dilemmas

A principal employs two agents to provide a service to consumers. There exists a practice, P, which each agent can invoke and which raises profits with some probability. P may harm consumers a lot, or a little.

E.g. fix LIBOR; or sell PPI.

The agents face a moral dilemma: whether or not to invoke P Senior agents have better knowledge of the harm which can be caused by P. Junior agents can observe the adoption decision of their senior.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 5 / 34

Modelling Ethical Dilemmas

A principal employs two agents to provide a service to consumers. There exists a practice, P, which each agent can invoke and which raises profits with some probability. P may harm consumers a lot, or a little.

E.g. fix LIBOR; or sell PPI.

The agents face a moral dilemma: whether or not to invoke P Senior agents have better knowledge of the harm which can be caused by P. Junior agents can observe the adoption decision of their senior. The principal can use optimal remuneration contracts to sway the agents’ choices. Consumers can be sophisticated (maybe as in LIBOR fixing); or naïve (maybe as in PPI). Behavioural norms may be passed from senior to junior ⇒ culture

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 5 / 34

We study moral agents who subscribe to two ethical traditions

1

An interpretation of Bentham’s act-utilitarianism; An agent is more ethical to the extent that he places a higher weight upon the Benthamite utilitarian welfare measure from the act, and a lower weight upon his own concerns.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 6 / 34

We study moral agents who subscribe to two ethical traditions

1

An interpretation of Bentham’s act-utilitarianism; An agent is more ethical to the extent that he places a higher weight upon the Benthamite utilitarian welfare measure from the act, and a lower weight upon his own concerns.

2

An interpretation of Kant’s duty ethics; An agent is more ethical to the extent that he places a higher weight upon avoiding harm to the customer, and a lower weight upon his own concerns.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 6 / 34

Our rationale for modeling ethical choice in this way:

1 Easier to incorporate in an economic model in which actors maximise

something.

2 Many modern economists accept Bentham’s ethical stance by

identifying welfare with aggregate surplus.

3 Several studies indicate that real-world managers use an act-utilitarian

yardstick when resolving ethical dilemmas (e.g. Fritzsche and Becker (1984) and the literature which followed). We cannot adjudicate between different conceptions of right ... but we can generate positive predictions about the real-world impact of managerial morality.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 7 / 34

Findings for sophisticated consumers – e.g. LIBOR

If agents resolve ethical dilemmas using act-utilitarian principles then:

Principal incentivises cultural assimilation. Juniors copy adoption decision of the senior agent. Principal encourages senior ethical decision and so educates junior.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 8 / 34

Findings for sophisticated consumers – e.g. LIBOR

If agents resolve ethical dilemmas using act-utilitarian principles then:

Principal incentivises cultural assimilation. Juniors copy adoption decision of the senior agent. Principal encourages senior ethical decision and so educates junior.

For agents who have a duty not to harm consumers then:

Cultural outcomes are more diverse and depend on parameters:

1

Cultural assimilation implies senior bonused on own and junior’s success.

2

Acceptance and rejection cultures both possible: junior incentvised to ignore senior’s adoption or otherwise of P.

P is invoked insufficiently from a surplus-maximising regulator’s point

• f view.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 8 / 34

Findings for naïve consumers – e.g. PPI

Whatever the ethical tradition followed by the agents, profits rise as the ethical scruples of the agents decline.

If agents resolve ethical dilemmas using act-utilitarian principles then:

If the ethics of both agents are weak enough then adoption of P will exceed the aggregate surplus maximising level.

Bonuses for high profits grow.

Culture of acceptance of P can be dominant when ethics are weak.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 9 / 34

Findings for naïve consumers – e.g. PPI

Whatever the ethical tradition followed by the agents, profits rise as the ethical scruples of the agents decline.

If agents resolve ethical dilemmas using act-utilitarian principles then:

If the ethics of both agents are weak enough then adoption of P will exceed the aggregate surplus maximising level.

Bonuses for high profits grow.

Culture of acceptance of P can be dominant when ethics are weak.

For agents who have a duty not to harm consumers then:

The full spectrum of cultural outcomes remains possible: cultural assimilation, rejection and acceptance. There can be too much or too little of P for an aggregate surplus maximising regulator.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 9 / 34

Related Literature

To our knowledge we’re the first to embed philosophical ethics into a con- tracting model and so study the interaction of ethics, the profit motive, remuneration and culture. Transmission of cultural norms: Schein (2004), Swidler (1986), and Patterson (2014) Culture without compensation:Kreps (1990), Crémer (1993), Crémer, Garicano, and Prat (2004), Carillo and Gromb (1999, 2002), Van den Steen (2010a, 2010b) Compensation without ethics: Inderst and Ottaviani (2009) Compensation and financial stability: Thanassoulis (2012, 2013), Fahlenbrach and Stulz (2011), and Efing, Hau, Kampfkotter, and Steinbrecher (2015)

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 10 / 34

The model

A business run by a profit-maximising principal with a senior agent, s, and a junior agent, j, who provide a service to customers. The value v of the service to any customer is v ≡ N (¯ v, 1/τv); each time it provides the service, the business earns a profit π ∈ {π, ¯ π}, where P [π = ¯ π] = p. We write ∆π = ¯ π − π.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 11 / 34

The model

A business run by a profit-maximising principal with a senior agent, s, and a junior agent, j, who provide a service to customers. The value v of the service to any customer is v ≡ N (¯ v, 1/τv); each time it provides the service, the business earns a profit π ∈ {π, ¯ π}, where P [π = ¯ π] = p. We write ∆π = ¯ π − π.

There is a new practice P:

Adoption of P raises the probability of high profit to p + ∆p < 1. P may be harmful: if so customer suffers c > 0. Ex ante probability that P is harmful is h > 0.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 11 / 34

The model

A business run by a profit-maximising principal with a senior agent, s, and a junior agent, j, who provide a service to customers. The value v of the service to any customer is v ≡ N (¯ v, 1/τv); each time it provides the service, the business earns a profit π ∈ {π, ¯ π}, where P [π = ¯ π] = p. We write ∆π = ¯ π − π.

There is a new practice P:

Adoption of P raises the probability of high profit to p + ∆p < 1. P may be harmful: if so customer suffers c > 0. Ex ante probability that P is harmful is h > 0. c > ∆p∆π , ˆ h ∆p∆π c (1) P is surplus reductive in expectation if h > ˆ h.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 11 / 34

Timings

At time t = 0, the practice P emerges, and the principal offers a remuneration scheme to the agents. The principal makes take-it-or-leave it fee offers φs and φj to the customers of the senior and junior agent,

• respectively. Each agent acquires one customer. The customer commits to

pay the fee. At time t = 1, the senior agent receives her private signal σ of the practice’s type, and makes her private invocation decision Is. The junior agent observes Is. At time t = 2, the junior agent makes his private invocation decision Ij. At time t = 3, customer benefits and business profits are realised. The time 0 remuneration contracts are executed.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 12 / 34

Agent knowledge and contracts

The senior agent s receives a private signal σ ∈ [0, 1] about P; junior does not. High signals σ are suggestive of a harmful practice:

σ drawn from FH(·) if the practice is harmful, and FL(·) if it is not. Assume fH(σ)/fL(σ) is strictly monotonically increasing in σ. Assume that fL(1) = 0 = fH(0), so extreme signals reveal type with certainty.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 13 / 34

Agent knowledge and contracts

The senior agent s receives a private signal σ ∈ [0, 1] about P; junior does not. High signals σ are suggestive of a harmful practice:

σ drawn from FH(·) if the practice is harmful, and FL(·) if it is not. Assume fH(σ)/fL(σ) is strictly monotonically increasing in σ. Assume that fL(1) = 0 = fH(0), so extreme signals reveal type with certainty.

Contract variables

Profits are verifiable, customer benefits are not. The junior agent moves after the senior agent and cannot affect her

• profits. His contract is therefore (wj, wj).

Senior agent’s contract is a four-tuple: (wsj, ws

j , wj s, wsj).

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 13 / 34

Agents’ Objective functions and ethical standards

u = (1 − ε)w + εe(w, v). (2) Parameter ε ∈ [0, 1] is agent’s ethical commitment; Function e is agent’s ethical standard:

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 14 / 34

Agents’ Objective functions and ethical standards

u = (1 − ε)w + εe(w, v). (2) Parameter ε ∈ [0, 1] is agent’s ethical commitment; Function e is agent’s ethical standard:

1 For an act utilitarian evaluating P

eAct

• E [surplus due to act]

= E [surplus accruing to bank] − E [cost to customer] .

results Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 14 / 34

Agents’ Objective functions and ethical standards

u = (1 − ε)w + εe(w, v). (2) Parameter ε ∈ [0, 1] is agent’s ethical commitment; Function e is agent’s ethical standard:

1 For an act utilitarian evaluating P

eAct

• E [surplus due to act]

= E [surplus accruing to bank] − E [cost to customer] .

2 For an agent with a duty-based ethical standard to evaluate P

eDuty −E [harm to the customer] .

results Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 14 / 34

Equilibrium definition

An equilibrium of the model comprises:

1 Remuneration contracts

• wj, wj
• and
• wsj, ws

j , wj s, wsj

• between the

principal and the agents;

2 A strategy θs (σ) for the senior agent that depends upon her private

signal σ;

3 Strategies θ1

j and θ0 j for the junior agent in the respective cases where

the senior agent does and does not invoke P; Such that each agent’s strategy is optimal given the other’s, and the remuneration contracts maximize the principal’s expected income given the agents’ strategies.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 15 / 34

Preliminaries

We solve the game by backwards induction.

Lemma

For any level εs of ethical commitment, the senior agent’s posterior assessment η(σ) of the probability that P is harmful is increasing in σ. A consequence of the monotonicity of fH(σ)/fL(σ): a higher signal renders the senior agent more confident that P is harmful.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 16 / 34

Preliminaries

We solve the game by backwards induction.

Lemma

For any level εs of ethical commitment, the senior agent’s posterior assessment η(σ) of the probability that P is harmful is increasing in σ. A consequence of the monotonicity of fH(σ)/fL(σ): a higher signal renders the senior agent more confident that P is harmful. Senior agent expects P to increase aggregate surplus precisely when η(σ) ≤ ˆ

• h. (Equivalently σ ≤ ˆ

σ η−1(ˆ h)).

Proposition

The senior agent adopts a cut-off strategy, under which she adopts P if σ < σ∗

R and rejects P if σ > σ∗ R.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 16 / 34

Further preliminaries

The junior has posterior belief as to the harmfulness of P given by hI

j .

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 17 / 34

Further preliminaries

The junior has posterior belief as to the harmfulness of P given by hI

j .

Proposition

The junior agent adopts a cut-off strategy, under which he adopts P if hI

j < h∗ j,R, and rejects P if hI j > h∗ j,R where

h∗

j,R hR + 1 − εj

εj ∆p c (wj − wj). (3) and hR

• 0,

R = Duty, ˆ h, R = Act. (4)

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 17 / 34

Further preliminaries

The junior has posterior belief as to the harmfulness of P given by hI

j .

Proposition

The junior agent adopts a cut-off strategy, under which he adopts P if hI

j < h∗ j,R, and rejects P if hI j > h∗ j,R where

h∗

j,R hR + 1 − εj

εj ∆p c (wj − wj). (3) and hR

• 0,

R = Duty, ˆ h, R = Act. (4)

Lemma

h1

j (σ∗) ≤ η(σ∗) ≤ h0 j (σ∗)

senior rejection is bad news about P.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 17 / 34

1 h ˆ h h∗

j,R

h0

j

h1

j

η ˆ σ σ∗ Acceptance Cultural Assimilation Rejection 1

Figure: Junior agent strategy regions.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 18 / 34

Optimal contract for junior

Principal selects remuneration contracts (wj, wj) and (wsj, ws

j , wj s, wsj) to

implement cut-off values h∗

j and σ∗.

These choices determine the organisation’s culture. Assume wj ≥ wj, wsj ≥ wj

s, ws j ≥ wsj.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 19 / 34

Optimal contract for junior

Principal selects remuneration contracts (wj, wj) and (wsj, ws

j , wj s, wsj) to

implement cut-off values h∗

j and σ∗.

These choices determine the organisation’s culture. Assume wj ≥ wj, wsj ≥ wj

s, ws j ≥ wsj.

Lemma

For R ∈ {Act, Duty}, the principal can implement any h∗

j,R ∈ [hR, 1].

The cheapest way is to set wj = 0 and wj = wj

R(h∗ j,R)

εj 1 − εj c ∆p (h∗

j − hR).

(5)

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 19 / 34

Optimal contract for junior

Principal selects remuneration contracts (wj, wj) and (wsj, ws

j , wj s, wsj) to

implement cut-off values h∗

j and σ∗.

These choices determine the organisation’s culture. Assume wj ≥ wj, wsj ≥ wj

s, ws j ≥ wsj.

Lemma

For R ∈ {Act, Duty}, the principal can implement any h∗

j,R ∈ [hR, 1].

The cheapest way is to set wj = 0 and wj = wj

R(h∗ j,R)

εj 1 − εj c ∆p (h∗

j − hR).

(5) Bonus pay can be used to mitigate an agent’s moral objections to P. But wages rising in profits ⇒ pay must expand beliefs for which P adopted.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 19 / 34

Optimal contract for senior

The principal can incentivise any cutoff σ∗ ≥ σR

• 0,

if R = Duty; ˆ σ, if R = Act.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 20 / 34

Optimal contract for senior

The principal can incentivise any cutoff σ∗ ≥ σR

• 0,

if R = Duty; ˆ σ, if R = Act.

If incentivising j cultural assimilation

Bonus on team success: ws

j = wj s = wsj = 0 with

wsj = εs 1 − εs c ∆p (η(σ∗) − hR) 1 2p + ∆p ;

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 20 / 34

Optimal contract for senior

The principal can incentivise any cutoff σ∗ ≥ σR

• 0,

if R = Duty; ˆ σ, if R = Act.

If incentivising j acceptance

Bonus on senior success: wj

s = wsj = 0. And wsj, ws j satisfy:

(p + ∆p)wsj + (1 − p − ∆p)ws

j =

εs 1 − εs c ∆p (η(σ∗) − hR) .

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 20 / 34

Optimal contract for senior

The principal can incentivise any cutoff σ∗ ≥ σR

• 0,

if R = Duty; ˆ σ, if R = Act.

If incentivising j rejection

Bonus on senior success: wj

s = wsj = 0. And wsj, ws j satisfy:

pwsj + (1 − p) ws

j =

εs 1 − εs c ∆p (η (σ∗) − hR)

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 21 / 34

Equilibrium with sophisticated investors

Definition of Sophisticated Investors

Customers are sophisticated if they correctly anticipate the equilibrium of the game and are prepared to pay the expected value of their services in that equilibrium.

intuition Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 22 / 34

Equilibrium with sophisticated investors

Definition of Sophisticated Investors

Customers are sophisticated if they correctly anticipate the equilibrium of the game and are prepared to pay the expected value of their services in that equilibrium.

Proposition

When the firm’s customers are sophisticated and agents are act utilitarians, the principal sets wages equal to the outside option of zero, irrespective of the state of the world. Then σ∗ = ˆ σ and the junior agent’s investment decision is culturally determined: cultural assimilation.

intuition Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 22 / 34

Sketch proof

Consider optimal contracting if incentivising cultural assimilation. The surplus which can be extracted is: S Ass = 2(π + ¯ v + (p + ∆pFh(σ∗))∆π − hcFH(σ∗)) Note that ∂S Ass

∂σ∗

is positive for σ∗ < ˆ σ, and negative for σ∗ > ˆ σ.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 23 / 34

Sketch proof

Consider optimal contracting if incentivising cultural assimilation. The surplus which can be extracted is: S Ass = 2(π + ¯ v + (p + ∆pFh(σ∗))∆π − hcFH(σ∗)) Note that ∂S Ass

∂σ∗

is positive for σ∗ < ˆ σ, and negative for σ∗ > ˆ σ. Next determine wage payments. Show W Ass

s,R is increasing in σ∗ for σ∗ > ˆ

σ, and declining in σ∗ for σ∗ < ˆ σ.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 23 / 34

Sketch proof

Consider optimal contracting if incentivising cultural assimilation. The surplus which can be extracted is: S Ass = 2(π + ¯ v + (p + ∆pFh(σ∗))∆π − hcFH(σ∗)) Note that ∂S Ass

∂σ∗

is positive for σ∗ < ˆ σ, and negative for σ∗ > ˆ σ. Next determine wage payments. Show W Ass

s,R is increasing in σ∗ for σ∗ > ˆ

σ, and declining in σ∗ for σ∗ < ˆ σ. As W Ass

j,Act = 0 it follows that, conditional on opting for the cultural

assimilation region, ΠAss is maximised at σ∗ = ˆ σ

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 23 / 34

Sketch proof

Consider optimal contracting if incentivising cultural assimilation. The surplus which can be extracted is: S Ass = 2(π + ¯ v + (p + ∆pFh(σ∗))∆π − hcFH(σ∗)) Note that ∂S Ass

∂σ∗

is positive for σ∗ < ˆ σ, and negative for σ∗ > ˆ σ. Next determine wage payments. Show W Ass

s,R is increasing in σ∗ for σ∗ > ˆ

σ, and declining in σ∗ for σ∗ < ˆ σ. As W Ass

j,Act = 0 it follows that, conditional on opting for the cultural

assimilation region, ΠAss is maximised at σ∗ = ˆ σ Finally repeat for acceptance and rejection regions, and show profits bounded above by those secured from cultural assimilation.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 23 / 34

Intuition

Sophisticated customers pay exactly their expected income from the firm’s service. The principal earns the total expected surplus from service provision, less the expected value of any wages. The expected surplus is maximised if the senior agent invokes P whenever σ ≤ ˆ σ and the junior agent’s invocation decision is culturally determined. Because every agent has non-zero ethical commitment, the principal can induce this behaviour by paying all agents a zero wage. Because this contract maximises surplus and minimises expected wage payments, it is identified as optimal.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 24 / 34

Equilibrium with sophisticated consumers

Proposition

Suppose that the firm’s customers are sophisticated and that agents feel a duty not to harm the customer. Then σ∗

Duty < ˆ

σ with η(σ∗

Duty) < ˆ

h/(1 + εs/2(1 + εs)), and the principal uses bonus contracts with wages above zero for agents whose ethical standards are low enough. Equilibria with junior agent cultural assimilation, acceptance, and rejection are all possible.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 25 / 34

Equilibrium with sophisticated consumers

Proposition

Suppose that the firm’s customers are sophisticated and that agents feel a duty not to harm the customer. Then σ∗

Duty < ˆ

σ with η(σ∗

Duty) < ˆ

h/(1 + εs/2(1 + εs)), and the principal uses bonus contracts with wages above zero for agents whose ethical standards are low enough. Equilibria with junior agent cultural assimilation, acceptance, and rejection are all possible. Sketch proof for Kantian duty ethics case: Consider each cultural region separately as above. Calculate S Ass, W Ass

s,Duty and W Ass j,Duty.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 25 / 34

Equilibrium with sophisticated consumers

Proposition

Suppose that the firm’s customers are sophisticated and that agents feel a duty not to harm the customer. Then σ∗

Duty < ˆ

σ with η(σ∗

Duty) < ˆ

h/(1 + εs/2(1 + εs)), and the principal uses bonus contracts with wages above zero for agents whose ethical standards are low enough. Equilibria with junior agent cultural assimilation, acceptance, and rejection are all possible. Sketch proof for Kantian duty ethics case: Consider each cultural region separately as above. Calculate S Ass, W Ass

s,Duty and W Ass j,Duty.

Now show wages are monotonic in σ∗. Demonstrate that each cultural region can dominate others for some parameter values.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 25 / 34

Junior agent duty ethics sophisticated consumer example

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 26 / 34

Junior agent duty ethics sophisticated consumer example

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 27 / 34

Equilibrium with naïve investors

Definition of Naïve Investors

Customers are naïve if they do not appreciate the consequences of P, and always pay ¯ v for the service.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 28 / 34

Equilibrium with naïve investors

Definition of Naïve Investors

Customers are naïve if they do not appreciate the consequences of P, and always pay ¯ v for the service.

Lemma

However the agents resolve ethical dilemmas, the principal’s expected profits are declining in the strength of the ethical commitment of the agents.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 28 / 34

Equilibrium with naïve investors

Act utilitarian agents

The optimal σ∗

Act > ˆ

σ if the agents’ ethics are sufficiently limited. With sufficiently weak ethics, a culture of acceptance of P is dominant.

Duty ethic agents

The principal uses bonus contracts with wages above zero for agents whose ethical standards are low enough. Equilibria with junior agent cultural assimilation, acceptance, and rejection are all possible. Any cutoff σ∗

Duty ∈ [0, 1] is possible.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 29 / 34

Junior agent duty ethics & naïve consumer e.g.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 30 / 34

Junior agent duty ethics & naïve consumer e.g.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 31 / 34

Conclusions

A contracting model in which morally aware agents decide whether or not to invoke a social practice which may harm customers. Agents motivated by their compensation contract and their moral standards.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 32 / 34

Conclusions

A contracting model in which morally aware agents decide whether or not to invoke a social practice which may harm customers. Agents motivated by their compensation contract and their moral standards. Cultural assimilation, and so importance of tone from the top emerges natu- rally; it is the equilibrium outcome when ethical dilemmas resolved using act utilitarian principles and consumers are sophisticated.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 32 / 34

Conclusions

A contracting model in which morally aware agents decide whether or not to invoke a social practice which may harm customers. Agents motivated by their compensation contract and their moral standards. Cultural assimilation, and so importance of tone from the top emerges natu- rally; it is the equilibrium outcome when ethical dilemmas resolved using act utilitarian principles and consumers are sophisticated. With sophisticated customers, bonus pay is only needed when agents resolve ethical dilemmas using Kantian duty ethics – such ethics would result in agents not maximising aggregate surplus if left to their own devices.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 32 / 34

Conclusions

A contracting model in which morally aware agents decide whether or not to invoke a social practice which may harm customers. Agents motivated by their compensation contract and their moral standards. Cultural assimilation, and so importance of tone from the top emerges natu- rally; it is the equilibrium outcome when ethical dilemmas resolved using act utilitarian principles and consumers are sophisticated. With sophisticated customers, bonus pay is only needed when agents resolve ethical dilemmas using Kantian duty ethics – such ethics would result in agents not maximising aggregate surplus if left to their own devices. Naïve consumers offer no break on profitability – the principal uses pay to encourage agents to set aside their moral scruples – cultural assimilation can happen, but it is perverse: senior encourages harmful social practices when they are sufficiently profitable.

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 32 / 34

Conclusions

PPI selling bonuses appear to be in sharp distinction to those arising in optimal contracting which are designed to provide incentives to overcome a moral hazard problem when managerial effort is not subject to contract. In our model such bonuses only undermine manager’s natural inclination to do the right thing. We don’t claim performance pay is never justifiable – but the decision to use such payments should be weighed against the possible effects they can have on ethical decisions.

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Bonuses in one UK Bank The Guardian 8 Nov 2012

“In my role as a customer adviser I had to sell 10 loans a week with seven or eight having PPI ... There was plenty of training in ’disturbance techniques’, making the customer feel anxious about their ability to repay the loan in the event of accident, sickness, unemployment or death ... If a customer refused to take PPI we had to explain to the manager the reasons given and which sales objections techniques we used. Each quarter the branch had to achieve a certain amount of sales points ... Large loans with PPI secured the most points. Our quarterly bonus depended on how many points the branch as a whole achieved. I recall that hitting 120% of target meant our bonus would be in a higher paying threshold.

...

We knew PPI was overly expensive, with some insurances costing £100 a month. There were plenty of other insurances on the market that could offer similar or more suitable cover at a much lower cost.”

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