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Thursday, 6 November 2014

Rebuilding trust in financial services

Alexandra Zeitz (Global Economic Governance Programme, University of Oxford)

PEFM hosts Nicholas Morris and David Vines, introducing their 2014 book Capital Failure

Has finance has lost its sense of moral opprobrium, the ethical compass of the profession? So argued Nicholas Morris and David Vines in their October 27 PEFM presentation introducing their 2014 book Capital Failure: Rebuilding Trust in Financial Services, also offering proposals of how to encourage trustworthy behaviour.

Analyses of the 2008 financial crisis, whether by regulators or industry insiders, have predominantly treated the crisis as a consequence of market failures. Morris and Vines, however, argue that at the root of these market failures are problems of trust. Crucially, they claim that regulations alone will not be sufficient to restrict risky behaviour, since imbalances in information and expertise mean regulators will be repeatedly outwitted and outstripped.

How to regain and sustain trust in the financial industry without relying exclusively on regulation? Morris and Vines consider changes in incentives (they are in favour of removing the subsidy to risk-taking provided by lenders of last resort and introducing greater liability for directors for excessive risk-taking) and innovations in corporate governance (see, for instance, Colin Mayer’s recent PEFM seminar and 2013 book, Firm Commitment). However, they ultimately argue cultural shifts are essential.

Calling for a change in banking culture is not new; much of popular discourse has concentrated on decrying an environment that rewarded ill-advised risk-taking. Morris and Vines’ contribution is innovative and insightful in drawing on a wide range of inter-disciplinary evidence to provide a framework for improving trustworthiness through a cultural shift.

Building on evidence from other industries and theoretical contributions from philosophy and social psychology it is possible to conceive of measures to encourage other-regarding behaviour within the financial industry. Even Adam Smith, frequently caricatured as merely an 18th century antecedent to ‘greed is good’, pointed to the innate potential for altruism:

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 (Theory of Moral Sentiments, 1759)

Morris and Vines identify four concrete measures to institute other-regarding behaviour in finance: (1) defining obligations, (2) identifying responsibilities, (3) establishing mechanisms (including professional associations, codes of conduct and ethics risk management systems), and (4) crucially, holding people to account for their performance.

Professionalizing the financial industry appears central to any normative shift; both the presentation and following discussion repeatedly made comparisons to doctors and lawyers who are bound to an ethical code of conduct enforced by professional associations. A critical difference in the financial sector appears to be that training is provided by the industry itself (young analysts decamping for six weeks to New York for instance) rather than by impartial universities as in the case of medicine and law. How could education in finance be restructured so as to introduce a sense of the ethics of the profession at an earlier stage?

Reforming ethical culture among management is a particular priority. Discussion after the seminar focused on the effects of ethical leadership and Morris and Vines argued for a complete separation of retail and investment banks (beyond the Vickers accounting barrier) so as to avoid ‘cultural leakage’ between different types of financial institutions.

Restoring trust in financial services seems critical, for both political and market reasons. As the discussion at Monday’s PEFM seminar illustrated, Morris and Vines’ book is a helpful contribution to identifying means of doing so.

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