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Friday, 14 October 2016

Ethics and cultural assimilation in financial services

Ivaylo Iaydjiev (St Antony’s College, Oxford)

Speakers: Alan Morrison, Saïd Business School, and John Thanassoulis, Oxford-Man Institute, University of Oxford

Chair: Natalie Gold, King's College London

With a string of scandals in finance in the last few years, it is not rare to hear people lamenting the decline of ethical behavior in the industry, including the Archbishop of Canterbury and Pope Francis. In their new paper, Alan Morrison and John Thanassoulis want to go further and understand the causes behind the many failures.[1] Drawing on the use of contracts of finance and their role in incentivizing certain behavior and fostering a culture, they present an elaborate model of cultural assimilation in a professional services firm.

The starting point for their argument is the moral dilemma that bankers face in acting on behalf of their clients. In considering the trade-offs of actions that are simultaneously harmful to the client and profitable to the company, traders are likely to be affected by cultural standards and the tone from the top. The question then becomes how performance pay affects such decisions and why a principal might decide to create a less ethical culture. Their model includes two versions of the actors, one based on a utilitarian Benthamite conception that focuses on increasing the aggregate welfare surplus, and the other based on Kantian duty ethics that consider actions separately from their context. 

In their model, a profit-maximizing principal uses a contract to incentivize senior and junior agents to provide a service to the consumers. There exists a possible bad practice, which agents can invoke and which raises profits with some probability, while also harming customers to a certain extent. The moral dilemma for the agents is whether they choose to invoke the bad practice. Senior agents have a better idea of the knowledge of the harm caused by the practice and decide whether to invoke it. Then their juniors observe whether seniors invoke the practice and decide themselves whether to follow or not the practice themselves, thus creating a culture within the company. The principal can affect the choices of their agents by setting optimal remuneration contracts. So what behavior norms do we see emerge?

Morisson and Thanassoulis begin by considering the case of a sophisticated customer. They will not be willing to pay more than the expected income from the service and hence the principal earns only the residual surplus after wages. In order to maximize profits, the principal incentivizes ethical (in an utilitarian sense) behavior in the agents so their actions maximize the aggregate surplus. Therefore, the principal is likely to keep bonuses low, as they have no interest in overwhelming ethical standards. In this way, an unethical and purely profit maximizing principal can run a moral firm.

The next version of the model includes an owner-manager who can decide on the contract for their agents and the fees for the customer. If the sophisticated customer cannot observe the bonus payments within the organization, owner-managers cannot insulate themselves from the temptation for extra profit and hence overincentivize their agents through bonuses to invoke the bad practice. Hence, this model comes up with the counterintuitive result that an ethical owner-manager can result in an unethical company.

Finally, Morisson and Thanassoulis consider the implications of their model in the case of naïve investors, who cannot fully appreciate the consequences of the malpractice. In this case, the principal searches for the agents with the lowest will power and incentivizes them to achieve the cheapest way of maximizing profits through high bonuses. This leads to a prediction that for example financial advisors selling services to sophisticated customers will on average have a lower bonus to fixed pay ratio than those selling to unsophisticated customers, assuming perfect information.

In addition to the utilitarian model, the authors also discuss the case of duty-driven agents and demonstrate the results do not change considerably. Such agents consider do not engage in ethical trade-offs, and hence the question of willpower becomes central. In the case of a sophisticated consumer the principal would need to provide them with bonuses to overwhelm their willpower in order for the agent to invoke the malpractice. This however would reduce the aggregate surplus and hence the profits for the principal and is unlikely to occur. However, unsophisticated customers do not provide such a ‘brake’ on principals’ profits, so principals are likely to seek out and incentivize through bonuses agents with weak willpower even under Kantian ethics assumptions. 

Morisson and Thanassoulis provide an intriguing and sophisticated contracting model in which morally aware agents decide whether or not to invoke a social practice, which may harm customers. The results suggest that with sophisticated customers and perfect information, bonus pay is not needed; however malpractice and high bonuses are likely to emerge if the owner is also the manager, if consumer information is limited, or if consumers are unsophisticated. In general, the findings would seem to accord with common sense, with the exception of the role of owner managers. The model’s prediction, that owner managed banks (such as the old-style partnerships and merchant banking models) would likely have inferior ethical results compared to banks with wide share ownership where managers are in control (such as Barclays or Royal Bank of Scotland), is not obviously supported by observed experience. An alternative model might also be considered, where it is not the customer who is in danger of being cheated by the manager, but the shareholder (the heads I win, tails you lose, problem in the risk taking bonus system). Either way, the Morrison/Thanassoulis arguments are nevertheless broadly consistent with the widespread view that bonuses—seemingly more extensive in finance than any other industry – have played a destabilizing role in the finance industry even if they may have also encouraged innovation (with more positive social benefits). 

[1] This presentation is based on their paper Ethical standards and cultural assimilation in financial Services in Social Science Research Network, July 2016.

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