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Friday, 4 November 2016

Restoring trust in finance: Competition or moral motivation?

Blogpost: Alexandra Zeitz, St. Antony’s College, University of Oxford

Speaker: Gordon Menzies, University of Technology, Sydney (with Donald Hay and Thomas Simpson)

Chair: David Vines, Balliol College, University of Oxford

Banking suffers from a trust problem. A post-crisis YouGov study found over 70% of respondents agreeing that “Banks aren’t doing enough to get us out of this economic crisis which they helped cause”. In his PEFM seminar in Michaelmas term, Gordon Menzies (University of Technology, Sydney) presented research on the means of restoring trust in banking, arguing that greater competition alone cannot increase public trust in banks. Instead, Menzies argued that bankers’ motivations must be addressed; in order for banks to earn stakeholders’ trust, they must invest in ethics education and professionalization as measures to encourage moral motivation.

Banking did not always have the distrusted reputation it has today. Menzies began his presentation with a history of late 19th to mid-20th century “gentlemen bankers” in Britain. These bankers enjoyed a well-respected reputation for conservative and reliable banking based on personal relationships and close knowledge of their customers. Bankers’ pay was moderate, and the business was not characterized by the cross-selling and conflicts of interest that are now pervasive. 

This all changed with “Big Bang” deregulations in the late 1980s. Menzies pinpointed these reforms in financial markets as leading to changes in British banks’ motivations and behavior. Risk-taking increased rapidly, as did bankers’ remuneration. This risk-taking on its own is not morally objectionable, as Menzies pointed out. Bankers’ behavior can be thought of as a “right to be rogue,” a right purchased with the high returns acquired through risky investments. Investors and customers may countenance rogue behavior as long as it yields them substantial returns.  Nonetheless, one may still object to banks’ behavior, either because returns to customers do not sufficiently offset costs or because stakeholders that aren’t customers are adversely affected by the externalities of banks’ actions. How then to moderate banks’ risk-taking and mitigate reckless behavior? Menzies and co-authors model this in terms of a monopolist choosing not to exploit the full benefits of their monopoly. 

Under which conditions will a monopoly firm not charge its customers the highest rate that the monopoly allows them, and instead pass some of the benefits of the monopoly on to customers? Conventionally, economists expect that only competition from other firms can bring down the prices charged by monopolists. 

However, Menzies argued that policies to encourage greater competition are difficult in many industries and close to impossible in finance. For competition to actually drive down prices and improve the quality of services, badly performing firms must be allowed to fail just as badly performing employees must be forced to exit. Yet to protect the stability of the financial system, banks are protected from precisely such failure, including through recent reform measures that increase banks’ capital and ring-fence retail banking. 

Under these conditions, Menzies and co-authors argue, competition policy is unlikely to be effective in moderating banks’ behavior and restoring trust. Instead, banks must rely on shaping the motivations of bankers, encouraging the internalization of moral guidelines that stress the impact of actions on a range of stakeholders. As such, a focus on moral motivations harkens back to the era of “gentlemen bankers,” with expectations about bankers’ conduct and morally encouraged restraint. Menzies argued that moral motivations could be addressed, in part, through greater professionalization of banking.

A profession, such as medicine and the law, is distinguished by specialist skills, a relationship to a client who is vulnerable and needs beneficence, and a critical practical skill. While banking may meet these criteria, it has not organized itself as a profession with a clear moral code. Menzies suggested that self-certification and an oath of service might be valuable tools in crafting a professional identity. Further, de-linking pay from performance could be helpful in signalling banks’ trust in their employees and encouraging observance of moral motivations. 

The move from moral restraint to greater recklessness in banking has been costly, argued Menzies, leading to greater systemic instability and costs for individual customers. The public has responded by losing faith in their banks. To truly address this, competition policy is unlikely to be effective, and motivations must be shaped at their root. Ethical reform is difficult, but the likely benefits are substantial.

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