Ethics, Incentives and Culture in Financial Institutions David - - PowerPoint PPT Presentation

Ethics, Incentives and Culture in Financial Institutions

David Vines Economics Department and Balliol College Oxford University Conference on Professional and Ethical Standards in Banking Loughborough University May 21 2016 david.vines@economics.ox.ac.uk

1 Introduction

• At the beach on Australia, what is the problem……..?

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Actually, the Problem is:

– There has been a breakdown of trust in financial markets – A “renewal in the social contract” of finance is needed – This requires a “change in culture” – But what does this mean?

….How to find out what this means…. ….and what to do about it …..?

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….go back to Oxford….

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….ask people to dinner in College….

………set up a seminar within the Balliol Interdisciplinary

Institute……..and then edit a book…..

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2 Capital Failure

The Problem

– There has been a breakdown of trust – A “renewal in the social contract” of finance is needed – Requires a “change in culture” – But what does that mean?

Our research on this problem

– Builds on Capital Failure (N. Morris and D. Vines, OUP, 2014) and Firm Commitment (C. Mayer, OUP, 2013) – Research is interdisciplinary, drawing on neoclassical economics, behavioural economics, philosophy, history, evolutionary biology, law and regulation. – Aim is to provide practical guidance on how to achieve change, through action at individual, firm and regulatory and legal level

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…trustworthiness is central …

Our First Key Claim

– Econ 101 is a key problem – A conception of the world as composed of selfish interested individuals proceeding in a selfish manner – This led direction to the First Fundamental Theorem of Welfare Economics – That led directly to the efficient market hypothesis

• that allowed untrustworthy behaviour
• led to the spectacular errors of light-touch regulation

Our Second Key Claim – Pursuit of selfish objectives, by self-interested individuals, will not give rise to trustworthy outcomes. – It only gives rise to weak trust; by contrast, we seek strong trust – We believe that these ideas provide us with the intellectual equipment to go beyond “ box-ticking” in thinking about ethics and financial reform

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3 Encouraging Trustworthy Behaviour

Trustworthiness requires three things:

• competence.
• truth-telling about relevant facts,
• promise keeping,

Modern economists have argued that trustworthy behaviour can be sustained by self-interested individuals, acting in selfish ways through the pursuit of reputation, in the context of repeated games.

• Philosophers have long thought that such reputation-seeking behaviour only

enables a shallow and unreliable form of trust to emerge. – Such behaviour is vulnerable to cheating. – Also vulnerable to possibility that promises will be abandoned if things change.

• Which changes will turn out to be “material” in a court of law?
• Like these philosophers, we do not believe that a trustworthy financial sector can

re-emerge merely as a result of individuals – and firms – carrying out calculations about how to pursue and defend their reputations [But not all researchers agree with this …..see Section 8 below]

We give this kind of trust the name “weak trust”

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Strong trust is needed….

Other-regarding motivations can sustain what we call “strong trust” (c.f. David Hume and Adam Smith)

• “How selfish soever man may be supposed, there are evidently some principles in

his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” (Adam Smith, The Theory of Moral Sentiments, 1759.) ⁻ These motivations can take form of altruism, or the desire for approbation or esteem ⁻ Amartya Sen calls this ‘sympathy’ ⁻ Procedural motivations are sometimes sufficient.

Framing can support strong trust and so help to improve culture.

• Some activities (eg. selling spaghetti) only need weak trust
• But many, for example doctors and fund managers, do need to be trustworthy, because

their patients and clients need to be able to rely on them in the longer term.

Framing can identify where and where ethical principles are necessary and where other-regarding obligations may be appropriate.

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...bad behaviour inefficient or outrageous?

A comparison of approaches

– The conventional approach: the problem with financial institutions is something which is to be solved inside institutions by using reforming incentives within a framework of law and regulation – Our approach: it is it something which needs to be solved by strengthening professionalism

Our approach is similar to that of the Archbishop of Canterbury

– Justin Welby proposes what is in effect moral education, – Our thinking about the endogeneity of framing may give us a way of thinking in a manner consistent with his views – One does not need to be religious to have a view that outcomes for others matter

But it may be difficult to walk on two legs at once

• The conventional approach is in danger of crowding out our approach

– cf. Michael Sandel (2012) What Money Can’t Buy – Behavioural evidence of such crowding out » child care example: putting a price on bad behaviour can remove the moral obligation to behave well

• What role for legal enforcement if both approaches are in play?

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….an alliance amongst reformers…..?

Many religious people has expressed dismay at financial misbehaviour

– But the problem needs to be approached from a secular standpoint – Of course we can agree with Pope Benedict that morality is ignored by the economic approach to this problem. – But is it unhelpful, in a secular society, to think of policies of financial reform as being underpinned by religious belief – Statements like the following not helpful as an underpinning for reforms:

“Scripture enables us to derive precepts which will guide good behaviour”

– Such precepts are not of use to those who are not believers – Religious scripture should, instead, be used to contribute to the reform discussion in the way that any other written source can be used :

• What is very helpful is that those who are religious set out precepts

for good behaviour can be underpinned in secular ways, i.e. which can be justified according to secular morality:

– Act utilitarianism (including appeal to altruism, esteem, approbation) – Kantian duties (connected to a contemporary appeal to “values”)

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4 An research strategy and an implementation strategy

In Capital Failure we set out a four-step implementation strategy designed to promote trustworthiness; i.e. to promote competence, truth-telling and promise-keeping. The components of this strategy are:

(1) the definition of appropriate obligations; (2) the identification of corresponding responsibilities; (3) the creation of mechanisms by which these responsibilities are carried

• ut and enforced; and

(4) the holding to account of those involved, in an appropriate manner. Our continuing research seeks to find ways in which these four components might pursued at three ‘levels’ of society:

• in relation to the individual;
• In relation to the corporate firm; and
• In relation to society at large.

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..three levels of enquiry….

1. Understanding the underpinnings of strongly trustworthy behaviour, at the individual level, by those who work in the financial services industry

– Building professionalism – Research: psychology, in behavioural economics, moral philosophy and ethics

2. Identifying how corporate firms within the financial sector might become institutions in which such strongly trustworthy behaviour can take place.

– Changing Corporate governance – Research: corporate governance and industrial archaeology.

3. Examining how such strong trustworthiness might emerge in the relationships between the financial sector and the wider society at large.

– Moving towards a greater degree of self-regulation within a supportive legal framework – It will also include work on how the legal and regulatory system impacts on trustworthiness, and on which legal and regulatory tradition is best suited to this purpose.

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5 The Individual Level: fostering professionalism

Trustworthy behaviour at the personal level requires that those in finance behave in a professional way, as most doctors do.

• Criteria suggested by the philosopher Robin Downie (1990) are helpful in

defining what this means. A professional:

1. Of course, possesses specialised knowledge, and specific skills, based upon a particular knowledge base. 2. In addition, provides a service to clients which is sustained by a continuing relationship, built upon a sense of concern for the interests of clients. carried out with integrity

• integrity is a character trait cannot be successfully pursued as an end in

itself, or effectively feigned, by a selfish individual. 3. Is well-educated beyond his/her narrow field so that good judgement can be brought to any relationship with a client. 4. Is independent of sectional or other interests 5. Is able to provide an authoritative voice in public discourse in his/her subject area.

Our research will explore how to achieve this for individuals in various parts of the financial services industry.

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Whether a person will act in a professional manner in relation to a particular activity depends on how the activity in question is framed .

• Individuals have other-regarding’ motivations

– including the desire for esteem, for approbation of others, and genuine altruism.

• But individuals – of course – also have selfish motivations of the kind which

economists have long emphasised

• Sustaining professionalism in relation to certain activities – eg being a doctor -

requires that these activity be framed as one in which other-regarding

• bligations are relevant

– rather than as one in which it is satisfactory to be selfish

• Norms of behaviour will constrain the way individuals frame their tasks

– Norms can ensure that individuals adopt other regarding motivations for particular problems, and can be incorporated into codes of conduct – It is important that norms reference ‘values ‘ (this effectively means articulating what these other-regarding obligations are) ,otherwise they merely become arbitrary lists

• f proscribed actions
• The process of developing norms - and codes of conduct – can support the

development of professional behaviour

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….the role of framing and social norms …

……work strand….

• Behavioural research

– Experimental research suggests that some environments ‘permit’ people to be dishonest

• Evidence that a banking frame can produce more dishonest behaviour

by bank employees (Fehr, et. al.) – But there is little work on the reverse: on how to encourage people to be honest. – Natalie Gold (2014) suggests that trustworthy behaviour depends both on framing and on the values held by a person, or their ‘type’.

• Those people who value honesty will become trustworthy when a

situation is framed as a matter of honesty, and conversely – This suggests that producing cultural change will require both an change in change in framing and a change in values. – This conjecture is at present speculation.

• But this hypothesis can be tested in experimental work
• We will first of all start from theory, and develop hypotheses for testing. And

we will then go on to take the principles which emerge from proposals for regulatory reform, and put them to the test.

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6 The Corporate Level: fostering the Responsible Corporation

Trustworthy behaviour at the institutional level requires that profits are not put ahead of corporate purpose. ⁻ Profits are a product of, not a purpose of, corporations ⁻ Sustainable firms have long-term objectives which focus on the delivery of product rather than the profit which this produces Structure of ownership, and governance, of a firm bears on its ability to pursue its purpose. – Requires a move away from shareholder value maximisation which concentrates on profits – Requires a focus on the interests of other stakeholders, including employees, customers and the wider community. – Such a move will enable firms to ‘do well by doing good’ – Such a move is – of course – also necessary if the required change in culture at the individual level is not to be driven out bythe cost-cutting impiosed byb a profit-seeking board. Board reform is necessary: need a move towards a more ‘responsible’ form of corporation

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7 The Social Level: fostering a better Legal and Regulatory system

Fiduciary obligations impose duties of loyalty to clients – But fiduciary duties have been progressively eroded and turned into contractual obligations,

• This alters the nature of obligations
• It opens up opportunities for the imposition of risk on clients

– There is a need to clarify the nature of duties and remedies, and to reverse the replacement of fiduciary duties by contractual obligations Need move towards a system of law which

• supports the responsible corporation (as described above),
• sustains the development of professionalism (as described above)

Such a system of law needs to be exhortative as well as punitive It also needs to open the way for self regulation

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…. Self Regulation: the new Banking Standards Board

• We can identify three ways in which this institution might be

helpful.

(i) Such an institution will assist with the professionalization of those who work within the industry.

Including in the development of norms and codes of conduct

(ii) Such an institution will provide industry wide pressures to ensure that governance, culture and regulation are not all geared towards competitive, market-based, solutions but come to ensure an industry- wide focus in ensuring that clients’ needs are met (iii) Such an institution will be helpful in guiding, and giving advice, on legal and regulatory reforms of the industry.

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8 How to underpin the ideas in this talk?

• Some want to retreat from the ideas presented here:

they claim that weak trust can give outcomes that are

• bservationally equivalent to those obtained through strong trust
• Evolutionary games story – in which ‘good’ outcomes might be a ‘focal point’
• This ‘economistic’ approach refuses to think about motivations or obligations
• But some want to go further than the ideas presented here
• They argue that strong trust may need to be built upon “moral sentiments” (c.f.

Hume & Smith) and /or “ethical principles” (cf John Rawls & Robert Mass)

• Such ethical principles are about the nature of interactions between people
• They can be used to underpin other-regarding motivations, but can go beyond them
• Such ethical principles can give rise to behaviour which is costly, but helpful to
• thers, they might do this even without other-regarding motivations

⁻ Amartya Sen calls this ‘commitment’

• Crucially, any ethical principles need to be based on social practices

⁻ Our moral sentiments are about the social practices in which we engage. ⁻ We may seek a ‘reflective equilibrium’ concerning ethical principles through a process of public consultation and discussion (John Rawls) ⁻ the devil is in the detail.

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9 Conclusion

We have articulated a four-part strategy for establishing the trustworthiness of the financial sector.

(1) the appropriate definition of obligations; (2) the identification of corresponding responsibilities; (3) the creation of mechanisms by which these responsibilities are carried

• ut and enforced; and

(4) the holding to account of those involved, in an appropriate manner.

Our research on this strategy will operate at three levels:

• On encouraging professionalism at the individual level
• On reforming corporate governance to reduce adverse effects of a focus
• n shareholder value
• On establishing a better legal and regulatory framework

The (abstract) ideas which underpin these (practical) proposals are still the subject of (intense) discussion

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