By Michael Lewis
Finance – specifically the voluntary transfer of capital from those who have it to those who need it for the purpose of creating and maintaining a business enterprise which rewards its investors, employees, customers and vendors, and the community at large – is a noble undertaking. Without such a mechanism, human progress would be stagnant, technological advancement erratic, and existing social systems intractable. The willingness of those who dare combined with those willing to accept inordinate, sometimes unknown risks of capital loss, has stimulated enormous benefits for mankind generally, reducing the physical burdens of daily existence, extending life, and inspiring the spirit of adventure. Financial activities are essential, but are they ethical?
The lure of riches
The love of possessions and the insular pursuit of treasure to acquire possessions has been recognized as a human failing since the beginning of civilization. The Apostle Paul, in his first epistle to Timothy at the Christian church in Ephesus, declared, “For money is the root of all evil.” Recognizing that some men would be unable to resist the temptation of riches, the Quran declared in Sura 2:188, “You shall not take each others’ money illicitly, nor shall you bribe the officials to deprive others of some of their rights illicitly, while you know.”
It seems that some men, despite the admonishments of religion and the existence of laws, have always used guile, fabrications, and fraud to separate other men from their money, generally with the promise of great wealth, power, or benefits to the investor. Wealth, earned or inherited, does not protect its master, nor reduce the appeal of greater gains. As Ben Franklin noted, “The more (money) a man has, the more he wants. Instead of filling a vacuum, it makes one.”
The likelihood of being tricked or scammed as an investor has always been present; Dr. John Bridges advised in 1573 that “a fool and his money are soon parted.” Investors learned about banks and falsified financial documents from the Irish brothers James and John Sadier in 1856, and also learned difficult lessons about “goldbricks” – bricks of lead coated with gold – from American promoters of Western mining properties in 1880s, as well as the folly of trying to purchase national monuments and landmarks (Brooklyn Bridge, Grant’s Tomb, Statue of Liberty) from American George C. Parker.
In recent years, the names of Barlow Crowes (England), Satyam Computers (India), and Enron (United States) are reminders that finance and investing remain perilous activities in a community of greedy men, evolving laws, absent ethics, and overworked, underfunded regulatory bodies.
Ronald A Duska, Post Chair of Ethics and the Professions at The American College, proposed five reasons why ethical lapses occur:
- Self-interest sometimes morphs into greed and selfishness. According to Duska, “If you accumulate for the sake of accumulation, accumulation becomes the end, and if accumulation is the end, there is no place to stop.”
- Some people suffer stunted moral development. Business schools erroneously teach that the fundamental purpose of a business is to make money, focusing on shareholders while ignoring other stakeholders (customers, employees, the community).
- Some people equate moral behavior with legal Behavior. Laws are enacted due to the breakdown in moral values. Some people subsequently follow the letter, not the spirit, of the law.
- Professional duty can conflict with company demands. Reward systems can incentivize immoral, even illegal actions. Management professionals know that you get the results that receive the highest compensation. For example, if a risky investment pays five times the commission of a safer, more appropriate investment, the risky investments will fly off the shelves.
- Individual responsibility can wither under the demands of the client. In an effort to please a client, some employees bend the rules, for example, passing on insider information or approving questionable transactions.
The finance industry’s standard response to charges that the industry is unethical, is to assert that illegal or unethical acts occur infrequently and are limited to a minuscule number of industry participants. Representatives point out that the industry is very, very large, with trillions of dollars of assets and billions of transactions every year, omitting the consequences of unethical, illegal activities which can stagger economies and wreak hardship on millions of innocent bystanders. However, blind faith in the integrity of the nation’s financiers and the trust that Wall Street will “do the right thing” has been proven folly time and time again.
Regulations replace ethics
By 1913, the United States had become the world’s largest economy, replacing the British Empire. Spurred by vast natural resources, the completion of national railroad system, a vibrant emigrant population, and the evolution of large-scale corporations able to use mass production manufacturing and scientific management, the country’s economy boomed, as did its appetite for funds to finance the new companies and industries. The banks of Wall Street delivered millions of dollars in new capital to the emerging enterprises…keeping a significant proportion of the funds for themselves in the process.
Lacking national laws or regulation, the finance industry was essentially self-policing, deterred minimally by individual state blue laws and often ignored Exchange regulations. Scams, frauds, and insider stock pools flourished as new, unsophisticated, inexperienced investors began “playing the Market” – unscrupulous stock brokers and investment bankers gleefully described them as “sheep to be shorn.”
The stock market crash of 1929 ushered in the Great Depression, an economic sinkhole that toppled governments, ruined businesses, and devastated families. Almost half of America’s banks failed and unemployment approached 30 percent in an era where most families had a single wage earner. Some historians believe that the Great Depression’s impact in Germany with one in four workers unemployed and skyrocketing inflation led to the rapid rise of the Nazi party and its leader, Adolf Hitler.
Whether the stock market crash was a stimulus for the Depression or a portent of the excesses in existence at that time continues to be debated. There is, however, unanimity that efficient markets require open and honest disclosure, as well as valid information. Left to their own devices, many financiers in the early 1900s failed to exercise basic business ethics, profiting by providing false information, failing to disclose critical relationships, and committing frauds to such a degree that external regulation was necessary to restore faith in the world’s financial markets.
The Securities Act of 1933, the Banking Act of 1933 (Glass-Steagall), and the following year’s Security Exchange Act formalized and legalized basic ethical behavior for those who seek money from, or manage the wealth of, private investors. The Securities Act serves the dual purpose of ensuring that issuers (and their agents, the Wall Street banks) that sell securities to the public disclose material information to investors, and that securities transactions are not based upon fraudulent information or practices.
Strong leadership of the Securities and Exchange Commission created by the Act slowly restored faith in the United States’ private finance system for the next half century. As a consequence, other countries enacted similar laws regarding financial activities in their jurisdictions.
The attack on ethical finance
By the mid-1980s, Wall Street had abandoned any pretense of ethics, social responsibility, or moral purpose, substituting in its stead an “extreme free-enterprise ideology” where maximizing profits in the short-term is the only way to run businesses. Gordon Gekko, a fictional financier in the film “Wall Street,” epitomized the ethos of finance with the statement: “Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit.”
Not all of the bankers agreed. Henry Kaufman, a preeminent Salomon Brothers economist, was quoted in the November 16, 1986 issue of “The New York Times,” “I am not sure that this whole trend makes a net contribution to society as a whole. We cannot escape the fact that we have some financial responsibility. We are not just in the business of pushing companies around.” When his fellow executive committee members disagreed, Kaufman resigned.
During the past 20 years, fraud has become institutionalized, despite the efforts of the SEC. Enron, HealthSouth, and Worldcom, aided an abetted by the country’s largest legal and accounting firms, scammed millions from the public while Bernard Madoff used and updated the tactics of an earlier Wall Street conman, Charles Ponzi. International banks facilitate the establishment of illegal offshore banking accounts established to skirt existing laws and launder illegal gains from drugs and other criminal activities. Even the Institute for Works of Religion, commonly known as the Vatican Bank, has been regularly charged with money-laundering, most recently for a mafia boss.
In 1999, the Glass-Stegall Act was repealed through the efforts of the large banks and their lobbyists who insisted that the banks couldn’t compete with other securities firms. At the time of appeal, the banks argued that they would only invest in low-risk securities and that diversification would lower risk for their customers. Many believe that repeal of the provisions separating commercial and investment banking was a major factor in the subsequent securitized mortgage-loan crash and the greatest recession since 1929.
In 2008, the excesses and unethical practices of the finance industry erupted in a series of mortgage-backed securities frauds, ultimately costing investors and U.S. taxpayers an estimated $27 billion. In a particular egregious example of Wall Street greed, multinational investment bank Goldman Sachs manufactured and sold a $545 million sub-prime mortgage-backed collateralized debt obligation (Freemont Home Loan Trust 2006-E) to investors without disclosing that the investments were likely to fail. A U.S. Senate subcommittee chaired by Senator Carl Levin found that the bank secretly bet against investors’ position and deceived investors about its own positions in order to shift risk from its balance sheet to theirs.
Dodd-Frank Wall Street Reform Act
Just as the Great Depression led to the Securities Act and Banking Act in 1933, the Great Recession resulted in passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. The new law affects most, if not all, of the financial services industry, and reinstates many of the protections of the repealed Glass-Stegall Act.
The Volcker Rule, named for a former Federal Reserve Chairman, limits a bank from trading in securities for its own account (proprietary trading) and restricts the type of investments which a bank can hold. As might be expected (and similar to their reaction to the new laws of 1933 and 1934), Wall Street has mounted a full-scale attack through its agents and friendly Congressmen to delay implementation or repeal the Dodd-Frank Act.
While much of the battle between the bankers and regulators about the implementation of Dodd-Frank will be heated and hidden in closed meetings and confidential memos, according to one political insider, “There is no doubt that banks will comply with the letter of the law, and then exploit every loophole with the narrowest reading of the letter of the law.”
Is ethical finance an oxymoron? Sadly, a review of history would indicate that the two concepts – ethics and finance – are incompatible. While many (if not the majority) of participants in the industry are well-intentioned, moral, and ethical, there has always been an element that exists outside the boundaries of acceptable behavior. For such people, according to Preet Bharara, United States Attorney for the Southern District of New York and the official responsible for policing Wall Street, “Ethical standards have been lowered to doing only what is required to avoid an enforcement action or a criminal charge, rather than focused affirmatively on doing the right thing, staying comfortably clear of the line, and earning a robust reputation for integrity and honesty.”
One of President Ronald Reagan’s favorite sayings was “Trust, but verify.” Even though information may appear reliable, one should perform additional research to determine that the information is accurate or trustworthy. According to James A. Mitchell, Executive Fellow-Leadership at the Center for Ethical Business Cultures at the University of St. Thomas College of Business, “It is your responsibility to take control of your own financial security.”
In other words, caveat emptor: Let the buyer beware.
Do you feel that ethics and finance can be compatible?
Michael Lewis is a retired executive and entrepreneur who currently writes about finance, investing, and U.S. economic policy on the blog Money Crashers Personal Finance.