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Corporate Governance

Emerald Article: Banking ethics Elisabeth Paulet

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To cite this document: Elisabeth Paulet, (2011),"Banking ethics", Corporate Governance, Vol. 11 Iss: 3 pp. 293 - 300 Permanent link to this document: http://dx.doi.org/10.1108/14720701111138715 Downloaded on: 30-12-2012 References: This document contains references to 23 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 1705 times since 2011. *

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Elisabeth Paulet, (2011),"Banking ethics", Corporate Governance, Vol. 11 Iss: 3 pp. 293 - 300 http://dx.doi.org/10.1108/14720701111138715 Elisabeth Paulet, (2011),"Banking ethics", Corporate Governance, Vol. 11 Iss: 3 pp. 293 - 300 http://dx.doi.org/10.1108/14720701111138715 Elisabeth Paulet, (2011),"Banking ethics", Corporate Governance, Vol. 11 Iss: 3 pp. 293 - 300 http://dx.doi.org/10.1108/14720701111138715

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Banking ethics
Elisabeth Paulet

Elisabeth Paulet is based at ESCEM, Poitiers, France.

Abstract Purpose Since the 1980s, the global nancial system has faced several crises that have led regulators to consider new conjectural and structural problems. These crises (new technology bubbles, the sub-prime crisis . . .) have led economists and nancial analysts to the following conclusions. First of all, systemic risk has increased during the last 30 years, which had led regulators to devise rules to evaluate information more efciently. Second, the recent collapse of stock markets despite the national rescue measures shows the importance of preventative procedures. The third point is that aggressive capitalism has demonstrated its limits. The aim of this paper is to show that regulation is a necessary but not sufcient condition to ensure the efciency of banking institutions, nancial markets and the management of companies. Design/methodology/approach Through the analysis of the Swiss banking sector, the paper provides an insight for banks to satisfy social pressure on more ethical behavior. This case could be an example for another functioning for nancial institutions. Findings By refocusing on their core business, banking institutions will be capable of realizing prot and creating value for the community. Practical implications The arguments discussed in this paper could be of interest both for professionals and academics willing to solve the antagonism between prot and ethics: prot can be compatible with social value added. Originality/value Banking and nance is not an ethics free zone. By changing their behavior, banks can improve their credibility on the market and renew the condence towards clients. Keywords Banks, Business ethics, Regulation, Economic uctuations Paper type Research paper

The superior person understands rightness; the inferior person understands prot (Confucius).

Since the 1980s, the global nancial system has faced several crises that have led regulators to consider new conjectural and structural problems. After a period of expansion for the world economy, the cycle has gradually moved towards a steady rate of growth. This has led to a revision of economic and nancial objectives. The emergence of new partners like China, India . . . has increased the amount of liquidity necessary to support economic development. Pressures on primary goods have led to a general increase of prices and the return of ination for most developed countries. These uctuations of prices have made speculative strategies more viable. At the same time, investors have adopted attitudes that are increasingly more risky. Financial scandals (Enron, WorldCom, Parmalat . . .) and several crises (new technology bubbles, the sub-prime crisis . . .) have led economists and nancial analysts to the following conclusions. First of all, systemic risk has increased over the last 30 years. To solve this problem, regulators have come up with rules to evaluate information more efciently (cf. implementation of IFRS). The

Received December 2010 Revised February 2011 Accepted February 2011

DOI 10.1108/14720701111138715

VOL. 11 NO. 3 2011, pp. 293-300, Q Emerald Group Publishing Limited, ISSN 1472-0701

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current crisis shows that these rules were far from adequate. Auditing agencies, in charge of evaluating information and risk for both enterprises and banking institutions, have failed to provide investors and regulators with adequate data regarding the quality of their clients. These agencies should be made more independent in order to guarantee their efciency. Secondly, the recent collapse of stock markets despite the rescue measures taken (both in the USA and in Europe) shows the important role of preventative actions in ensuring nancial market stability. At the moment, both governments and regulators are making an enormous effort to re-establish the proper conditions for an effective functioning of the real economic sphere. Therefore, re-creating a condent atmosphere for our international world appears to be a delicate problem to solve; if a long term strategy is the better way to restore condence, realizing it is difcult in a system where prot is the main objective for most investors. Third, aggressive capitalism has demonstrated its limits. The bankruptcies of several banks in Europe, coupled with global debt have led to an enormous amount of liquidity whose primary use was essentially speculative investment. The crisis has shown that it is necessary to reconsider this form of capitalism to re-establish a new base of stable market forces for enterprises and economic agents. Hence, a more sustainable approach could be considered in order to reach not only economic efciency but also global social welfare. The aim of this paper is to demonstrate that regulation is a necessary but not a sufcient condition to ensure efciency of banking institutions and companies management. An orientation towards more social responsibility and ethics will ensure conditions of stability for both investors and companies.

1. Globalization, banking institutions and regulation: the evolution of their role in the context of the current crisis
Nowadays, banks have seen their contribution to investment and their place in the nancial markets change. Their universal structure has enabled bankers to undertake all types of activities. This trend has induced an increasing protability for most institutions, in particular for the biggest ones (for more detail see Ayadi et al., 2002; Paulet, 2005). From the 1980s to the beginning of this century, nancial institutions have played an important role in the nancing of company projects. This is largely due to the favorable economic context and the administrative facilities given to newly created rms allowing them access to liquidity for productive investments. The recent volatility of markets has reversed the trend in favor of banks. However, this is not a new phenomenon. Several speculative bubbles have occurred in the last 30 years: 1. Financial Krach nancier 1987. 2. Asset depreciation in Japan in 1990-1991, affecting the nancial and property sector. 3. General property and banking crisis at the beginning of the 1990s (savings and loans in the USA, UK, the Scandinavian countries, Credit Lyonnais). 4. The Mexican crisis 1994-1995. 5. The Asian crisis 1997-1998. 6. The Russian crisis 1999. 7. The NTC crisis from 2000 to 2003. 8. The Argentina crisis 2001. 9. The credit and information crisis (cf. Enron. . .) from 2002. 10. The subprime crisis from 2007 on. During these events, it can be seen that the primary function of banking institutions, to grant credits and assume risk, was sacriced in order to concentrate on maximizing prot. The sub-prime crisis constitutes a more important episode in this trend, from which two main

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conclusions can be drawn: rstly, banks have created an amount of money greater than the liquidity really needed by the global system (Artus and Virard, 2005), secondly, they have transferred risk to private agents, risk that should normally be supported by the banking institutions. On the other hand, the expansion period was good for speculative investment. Individual agents wanted to make as much prot as possible. To satisfy this demand and to attract new clients, banks were in a difcult position. On the one hand, they had to propose products whose protability was high enough to maximize the anticipated returns of investors while at the same time responding to societal pressures by proposing more nancial products. The main objective of these products is to realize safe investment on a long-term basis (the so called social responsible investment). This new orientation, though valuable, is not so easy to undertake. Banks are involved in a very competitive environment, which sometimes obliges them to adopt risky attitudes. This alternative was the source of conicts between the banks, the investor and the individual stakeholders. The banks major aim is to maintain their market power; that of the investor is to benet from the favorable situation on the nancial markets; and the individual stakeholders want to favor productive and social values over speculative prot. How has the system worked in concrete terms? Which group were dominant in imposing their criteria on the economic system as a whole? If competition is weak, each bank will have a tendency to use its market power to increase interest rates on loans and to reduce those remunerating deposits. Thus the more concentrated the system, the more capable it is of generating high prots (Altunbas et al., 1997). In short, an increase in size does not necessarily entail an increase in nancial prots. The theoretical analysis centers on the relation between size and banking cost. The core of the argument is based on the capacity of diversied banking institutions to acquire the information necessary to maintain their solvency. Hence, the ensuing cost is lower for universal banks than for specialized establishments due to the role of economies of scale from which they benet due to their size (Paulet, 2009). But it is well known that pressures for high return on investments were essentially made concrete by investment banks. How can we explain this situation? Most clients of investment banks are big enterprises and nancial institutions: they bring their liquidity to the investment bank (deposit side) and the bank offers access to equity capital markets and debt capital markets (nancial participation and syndicated credit). Therefore, their off balance sheets are less important than a universal bank as most derivative products are part of their core activities and are included in the balance sheet. This explains their sensitivity to the subprime crisis. This also gives some evidence for the direction taken by universal banks towards risky and speculative investment to satisfy the requirements of the competitive environment. In other words, more of an emphasis was put on making nancial placements more protable than ensuring safe investments in the long term. An ethical attitude has been of minor importance for agents for more than a decade. Furthermore, the monopolies coming from merger acquisitions in the nancial sector have been undermined by the arrival of new suppliers of nancial services to the market. This has affected both the level of prices at which the banking products are supplied and their prot margins. The enormous increase of derivatives and the role played by off balance sheet items have generated instability in the banking system. The subprime crisis illustrates this point perfectly by showing that specialized institutions like investment banks have used securitization process to transform non-performing loans into junk assets. The inter-connection between institutions and nancial markets has contributed to the transfer of systemic risk from the US to Europe (Aglietta and Rigot, 2008). Hence, as the inter-connection of nancial markets accentuates contagion phenomena, the next question is therefore threefold: 1. Is it possible to evaluate and prevent the systemic risk? Is regulation sufcient to prevent a new crisis? 2. Does the current crisis appeal to new considerations regarding the core business of a banker in the twenty-rst century? Which part can be given to sustainable nancial products?

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3. Could prudential agencies have a leading role in that process? These are the questions we intend to discuss now.

2. The delicate arbitration between regulation and ethics rules in business management
One cannot doubt that banks bear a large responsibility for the current nancial situation. They were perfectly aware of the nature and the extent of the continued exposure to their off balance risk and the asset based securitization (ABS) they carried on their balance sheet. The explosion of these new products and actors as discussed in the previous section has contributed to the increase of the global level of risk and to the emergence of systemic risk. This excessive disintermediation and the large amount of liquidity on the market could then be considered the origin of the global nancial crisis that affected both banking institutions and nancial markets. Speculation in real estate and nancial innovations, which enable the banks to sell rights to the mortgage payments and related credit risk to investors through a process called securitization, have led to a considerable increase of systemic risk (Buiter, 2008). As a consequence, the crisis caused panic in nancial markets and encouraged investors to take their money out of risky mortgage bonds and to put it into commodities. This trend contributes to the food price crisis causing food problems in countries that rarely faced such difculties like Egypt. It was not without inuence on the oil price increase: nancial speculators seeking returns removed their money from equities and mortgage bonds and reinvested their liquidity into raw materials. On the whole, the last decade has created optimal conditions for the following: 1. First, a general increasing level of risk both for nancial markets and banking institutions all over the world. 2. Second, a transfer of nancial problems to the real domain at the origin of the current recession. 3. Third, a complete re-consideration of our capitalism model: strong pressures are put on governments and regulators to give more importance to transparency and ethics in the business world. We are therefore faced with the following question: were the nancial infrastructure and regulatory framework adequate? Three points will be outlined for discussion. First, the back-ofce infrastructure has been hard pressed to keep up with the speed of innovation. Second, nancial intermediaries lagged behind in strengthening their internal risk controls. This was amplied by poor risk governance structures. Finally, given the complexity and rapidly changing nature of markets, there has been a tendency towards self regulation or light regulation leaving the monitoring to market participants. As a consequence prudential regulation has been shown to be inadequate, not just in retrospect but also in outlook for the future. The pillars of Basle II have been criticized, in particular because of their reliance on the opinion of rating agencies and also on an internal model to determine the level of reserves to be imposed on banking institutions[1]. Despite the fact that regulators intend to take into consideration the different risks that banks have to face, the global trend of instability over the last two years proves that this was inefcient. In light of this situation, the solution could be to allow central banks to force banking institutions to over-capitalize in order to be capable of assuming all or part of their losses in times of crisis, which is exactly the objective of the proposition for Basle III. One country has already taken this initiative: Switzerland. Some institutions, which could be qualied as ethical banks, have gone beyond this requirement. Unlike traditional banks, the geographical scope of ethical banks is rather limited and their business activities are far less diversied. In general, they refuse to participate in the speculative operations of the nancial market because they consider that this economic logic is responsible for many international crises, social inequalities, ecological problems, etc. As a consequence, the main activities of ethical banks are

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concentrated on credit distribution and savings. They therefore focus on the original credit business of banks, applying to the projects they nance not only an analysis based on nancial performance but also on social and/or environmental screening. Particular attention is thus given to ecological housing, organic agriculture, renewable energies, small and medium-size companies, etc. (for a more detailed characterization of ethical banks see Relano, 2008). Hence these banks, which refuse any participation in the nancial market except for the purpose of renancing, have increased their capital leverage despite the fact that they have no need (e.g. Table I). Several comments can be made on these gures. If we initially focus on the case of big banks, one notices immediately that the magnitude of this ratio has improved during 2008 as a result of public cash injections, but it still remains weaker than that of smaller institutions. There are several reasons for this. First of all, we should remember that the smaller the bank, the lower the loss of protability. The amount of loss they have to face prevents them from constituting a substantial level of capital. Second, the loss of clients from big banks has induced a decrease in their liquidity. Third, the participation of big banks on the international market has increased their market risk and constrained these institutions to reconstitute provisions for improving their risk-weighted capital ratio. In the case of domestic-oriented (regional banks and Raiffensen banks) and ethical banks the situation is quite different. In fact, for them the contrary argument applies: their losses have been insignicant, they have gained clients, and they continue to concentrate their activities on the real economy of the domestic market. Their level of capitalization is thus more signicant, particularly in the case of regional and Raiffensen banks, namely because their size and infrastructure enables them to raise more funds. Were the economic environment to worsen again, their loss absorption capacity would thus be much higher than that of big banks. Therefore, although they were not in real need of increasing their capitalization ratio, they have reinforced it on their own initiative to reassure their clients of their global stability. As Table I shows, ethical banks are particularly noteworthy in this regard, with an increment of 2 percent during 2008. These institutions have thus followed the recommendations of the Swiss National Bank despite the fact that, from the point-of-view of the present-day regulatory framework, they were not obliged to do so. Short sightedness is another failing of our nance system. Investments, the new approach taken by rms and nancial institutions to gauge their progress based on market value (IFRS), reinforce the situation. Instead of leading to more stability, they contribute to more uctuations in the evaluation of corporation performance (Solomon, 2007) and also to an increase in market risk. Hence regulatory actions to reduce or control risk may turn out to be pro-cyclical, only serving to feed the downward spiral. Moreover, regulation induces costs by purchasing assets at above re-sale prices but below hold to maturity value (to use Chairman Bernankes terms). Hence regulation is always a palliative to market failure with punctual actions where crisis has occurred. Regulation is then the correct answer as long as it is temporary and ex post. This justies partly its inadequacy ex ante to prevent the crisis. What are the main issues of this debate? First the capitalist system has to redene its main goals. Over the last year, it seems that nancial questions about economic and social factors were prevalent. The demand to introduce more ethical and social values in the business world corresponds to the preoccupations of individual economic agents, who are waiting for a real change in the global world. As Cowton rightly mentions, regulation, in this way, can be a means of Table I Risk-weighted capital ratio
Regional banks (%) 2007 2008 13.7 14.5 Raiffeisen banks (%) 18.7 18.8 Ethical banks (%) 12 14 Big banks (%) 10.7 12.6

Source: SNB and annual reports 2007 and 2008

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developing and supporting an ethical culture, not just a substitute for it (Cowton, 2002). The solution will then be to privilege long-term perspectives. If the concept of prot is not questionable, its use is a matter for discussion. More transparency and more protection as regards nancial investments are required. Productive participations should replace speculative assets. The intention is to ensure that ethics is in nance, not just around it (Cowton, 2002). In that context, ethics may be seen as a necessary complement to legislation and regulation, even though it may be incompatible with maximizing value for the owner. Taking into consideration ethical rules could lead to a situation closer to maximizing social value than economic prot. It will induce a change in behavior in the long term and add social values to economic factors. Even if some will argue that creating social values could generate unnecessary cost, the company or nancial institution could object that the benet for becoming more ethical is being identied as a well respected entity, capable of renewing competitive force within its industry. The consequence of this new attitude is the denition of new codes, new rules for a better understanding of market forces that leads not only to prot but also to collective social welfare. As a whole the last argument proves that an ethical attitude could lead to a positive issue, contrary to the Keynesian position on animal spirit[2]. Moreover, in the long term, protability from social responsible investment and that produced by traditional assets are comparable. Hence, the conicts arising between speculators and productive investors do not exist anymore.

3. Conclusion
Two conclusions can be drawn from our discussion. First, the major endeavors of banking institutions should be refocused on the collection and distribution of long term lending and retail activities. The current crisis has shown that the transfer of debt onto the nancial market can lead to an increase of risk not only for the institution itself but also for its nancial partners. Hence, banking activities have to consider retail banking as their core business and favor the nancing of productive activities over speculative ones. The second issue refers to ethical, as opposed to speculative, attitudes of agents. As Keynes already mentions, people are too ignorant to form reliable estimates of present values. Their ignorance leads to short term trading speculation rather than long term trading enterprise. To work towards the long term and adopt cautious behavior towards nancial markets is a way to favor human and social values over economic factors. This is precisely the approach currently taken by a major part of the population. One could wonder if this evolution corresponds to a circumstantial attitude that will disappear as soon as the economic trend becomes more stable. The multiplicity of collective initiative in the real and nancial world enables us to refute this argument. The emphasis at a local level to create economic and social wealth (that emerged from associations for example) and the social responsibility given to the different actors present on the economic market stress the new orientation for our global world. To adopt a sustainable strategy means to redene capitalism by introducing protability criteria not strictly focused on nancial performance but also on economic and social conditions, guaranteeing a better repartition of wealth for people. At the very least, historical evidence proves that markets and individual actions do not prevent crises from occurring. Regulation both on a national and international level should integrate mechanisms to prevent such situations and not reduce their role to the resolution of crises a posteriori. To do so, problems in the evolutions of economies and the sources of risk in the nancing of productive projects should be identied. Growth and ination but also credit trends and the functioning of nancial markets should be considered in order to enable nations to really undertake a sustainable development strategy. This was precisely the goal of this paper. Far from giving all the answers to the current situation, the intention is to lead to further research to improve our global world.

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Notes
1. Basel II is not adapted for small banking institutions as it is too costly; it is an unsuitable system for larger establishments, given that it did not succeed in preventing the last crisis. For more details see Antonicelli et al. (2005). 2. [Our decisions] to do something positive . . . can only be taken as a result of animal spirits . . . and not as the outcome of a weighted average of quantitative benets multiplied by quantitative probabilities (Keynes, 1936).

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Further reading
Altunbas, Y., Molyneux, P. and Evans, L. (2001), Bank ownership and efciency, Journal of Money, Credit and Banking, Vol. 33 No. 4, pp. 926-53. Calomeris, C.W. (2008), The subprime turmoil: whats old, whats new, and whats next, mimeo. ` le preuve de la re cession, Fondation Robert Schuman, Jamet, J.F. and Lirzin, F. (2009), LEurope a Question dEurope, No. 130, pp. 1-26. tre conside re e comme Levratto, N. and Paulet, E. (1997), La taille de la Firme Bancaire peut-elle e e GdR sur La rme bancaire: spe cicite s et enjeux organise par facteur defcience, Journe dEvry-Val dEssone (EPEE) et Paris XIII CEDI. Universite Orlowski, L.T. (2008), Stages of the ongoing global nancial crisis: is there a wandering asset bubble, IWH Diskussionspapiere, No. 11, September. Paulet, E. (1996), Universal banks and the European banking system: prospects and problems, EUI Working Paper No. 54, pp. 1-34. cialise es dans le syste ` me bancaire Paulet, E. (1998), Alternative Banques Universelles Banques Spe en, in Spindler, J. (Ed.), Contro le des activite s Bancaires et Risques Financiers, Economica, Europe Paris, pp. 45-71.

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` re des entreprises en Europe: une investigation empirique de la Paulet, E. (2003), La structure nancie du bilan, Economie et Pre vision, 2003/1, No. 157. neutralite Peterson, M. and Sirri, E. (2003), Order preferencing and market quality on US equity exchanges, Review of Financial Studies, Vol. 16 No. 2, pp. 385-415. Rym, A. (2005), The new capital requirements directive: what pieces are still missing from the puzzle?, September, available at: www.ceps.be Sabourin, D. (2004), Competition between alternative trading mechanisms, mimeo.

About the author


Elisabeth Paulet is Professor of Economics and Finance at ESCEM Business School in Tours-Poitiers. After a PhD at the European University Institute of Florence, she is now in charge of Economics, Sustainable Development Department. She is the Scientic Director of the PhD Ecricome. Her main interests are in banking structures and nancial policy of rms on a historical and contemporary level. She has published several books and articles in this eld. Elisabeth Paulet can be contacted at: epaulet@escem.fr

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