It is generally accepted that there is a direct connection between risk and reward in the financial market place: the higher the risk, the greater the reward. That equation often tests the ethics of market participants who, like markets, become dysfunctional when ethical behaviour is displaced by a consuming desire to make a buck. At that point they begin to see both regulators and their customers as adversaries.

The Importance of Ethical Capital

Financial markets are far too large, innovative and diverse to be fully regulated by governments. Ethical behaviour by participants is necessary to ensure fair and efficient financial markets. Participants must possess an internal set of ethics that act as a natural regulator of the levels of risk that they are willing to assume. In the marketplace for financial services, to avoid unacceptable losses, buyers of financial services need to determine the existence and extent of the commitment of financial services providers to their clients (their ethical capital) as well as their commitment to a particular strategy (their intellectual capital). Long-term investors are best served by firms that have the greatest amount of ethical capital.

A current topic for discussion and debate in the financial press is moral hazard, i.e., the propensity of financial firms to believe they are protected from outright failure by third-party guarantees and to take excessive risks, treating their equity capital as a call option. If firms are rewarded for taking large risks then employee pay is enhanced, but if the risks come home to roost it is the firm’s shareholders, other capital providers and finally governments, or other innocent third parties that must absorb the losses. The ability to put the losses to an innocent third party presents the moral hazard.

Widespread ethical compromises pose more danger than occasional catastrophic failures

Business press headlines are too often about theft and fraud within the investment community: the scams of Bernie Madoff and Earl Jones are two prime examples. Economic downturns seem to bring out both the best and the worst in people. Press reports that once focused on the success of corporate giants such as Enron and Worldcom later turn to decrying their failure. But what is wrong with a process that allows failures of markets, firms or managers to reach such enormous proportions before they are detected? In fact, headline failures are the “black swan” events arising from unethical behaviour. Ethical values are not just about controlling the negative tail risk of ethical behaviour that cause a few people significant hardship. They are also needed to control the vast majority of activity, in order to prevent infections of entire industries, such as the subprime mortgages debacle has demonstrated. Ethical values have a much greater impact when they control smaller risks over a much broader range of transactions.

A traffic accident is devastating and tragic for the few who are involved, but a simple traffic jam can cause extreme inconvenience and inefficiency for thousands of innocent drivers. A more pervasive and devastating process has been evident in the residential mortgage crisis in the U.S. and Europe. This was the result of millions of transactions and thousands of firms fudging numbers, values and risks. What conflicts of interest were present to allow this to happen? Far more money was lost and far more people were hurt than from all of the headline frauds of the past century.

The message is simple: catastrophic failures capture the headlines but are not as damaging as widespread ethical compromises. Think of nations whose economic vitality is sapped by millions of small corrupt actions. The hidden costs of corruption in the long run outweigh the short-term benefits achieved. Headlines speak to the lack of values and ethics in the financial world but it is their nature to focus on the catastrophic issues instead of on sliding corruptions of values.

Ethics are the bedrock of a fiduciary relationship. They produce a level of trust on which all financial transactions, big or small, take place in a modern financial system. If fiduciaries’ day-to-day behaviour generally becomes less ethical then the small changes would be vastly more expensive and more damaging to the modern financial world than the outcomes caused by a few bad apples, however outrageous they may be. Catastrophic failures are more important to the overall system in the lessons they teach than in their direct costs. Financial transactions are ultimately based on mutual understanding and trust. And that trust is only developed through a solid set of ethical behaviours backed by regulation and law.

A strong code of ethics and standards of practice guides and provides a clear sense of direction

In today’s technological world the English language evolves rapidly with words such as ethics taking on a broad meaning depending on the user. In today’s lexicon “ethical investing” is often used to refer to the characteristics of the investments being made, e.g., those that are environmentally friendly and sustainable. I tend to use a more narrow definition of ethical investing – investing that is aligned with the CFA code of ethics: “Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the profession, and other participants in the global market place.”

One of the compelling reasons that caused me to seek and retain my professional designation as a CFA charterholder was the organization’s strong commitment to stand for and to teach a code of ethics and standards of conduct. I remember well my Level III exam, in 1983, which had a large part of it dedicated to the examination and understanding of ethical behaviour within the investment community. Then, as today, the ethics of the investment community were under the microscope. Investment professionals have always been entrusted with the fiduciary responsibility for other people’s money. The investing public put their futures in our hands and far too often some members of the financial services industry fail them.

Sports are often used as an analogy for the investment industry. The fruits of winning can be enormous, both in terms of monetary rewards as well as self esteem and fame. Sports leagues put limits on how athletes can compete so that the games are fair. Notoriety sticks to those who cheat. Even though there always seem to be some failures, by and large, the public has put their faith in sports and believes that professional sports outcomes are fair. How does this translate to the investment world?

Is sportsmanship in business sufficiently robust? Temptations to cheat abound. Too often the issuing of reports and the analysis that goes into an investment is tainted by conflicts of interest. During the dotcom bubble, analysts, investment bankers and the companies they worked for were rewarded more by the companies that they wrote about than by the investors who used their services. The story was repeated within the latest real estate bubble in the U.S. Financial institutions put together derivative packages of loans they originated and then promptly sold them, with either hedged interests or no interests at all in the ongoing outcome. Investors bought them trusting in debt ratings from agencies – who had been paid by the issuer and not the buyer of the product.

The financial services industry is as competitive as any sport. The drive to win is equally strong and rewards are just as great or even greater. But the penalties of losing paid by our industry’s customers are more serious and long lasting than losing a sports game is to most fans. CFA Institute has maintained a strong Code of Ethics and Standards of Professional Conduct to help guide and give a clear sense of direction as to what ethical values and conduct should be but more is required.

A strong ethical culture may be the most enduring and important step a firm can take

Because ethics are ultimately about the behaviour of individuals, the focus on ethics and value systems cannot only be about appropriate values but must also address their implementation. A key competitive advantage for any investment organization has to be the amount of “ethical capital” that it has accumulated. An organization maintaining a clear sense of ethics and values will quickly realize that they cannot be compromised or sold without diminishing the ethical capital and the long run prospects of the organization. When profit is essential, participants are constantly being tempted to compromise in order to increase personal rewards. In the long run an individual or organization is risking its future if it compromises its fundamental beliefs and values in return for short-term profits at the expense of its customers, partners or suppliers.

CFA Institute has moved to recognize the need for reinforcing the standards that apply to individuals by introducing an “Asset Manager Code of Conduct”. The new code, when fully implemented, will go some ways to lifting the burden of ethical conduct solely from the shoulders of individuals and providing leadership by the firm. Customers should look for such codes and make sure that they are ingrained in the firm’s DNA and not just there as white washing.

Codes of conduct must also be backed up with procedures that clearly spell out the consequences of failing to adhere to the appropriate standards. The first line of defence is always an individual’s self policing mechanism, but a firm must set a clear set of procedures and consequences to define the rules and boundaries of acceptable behaviour. Ethical culture starts at the top but everyone, including customers and suppliers, must understand the importance of the standards to the long-term health of the organization. A firm committed to a value system will insist that its suppliers and customers adhere to similar sets of ethical principles and will accompany that code with enforcement practices that include whistle blowing.

Even with the revolution in communication technology and the use of computerized trading all transactions can still be traced back to decisions made by people. Those decisions need to be made within the scope of corporate values and ethics, accompanied by a self policing process. Only values developed and agreed to on a firm-wide basis will be internalized by individuals throughout the organization. Success depends on individuals choosing an ethical path of behaviour rather than relying on the use of rules and prohibitions to enforce them.

Using technology, many organizations have seized new opportunities within the areas of strategy and product development to co-create value with their employees and customers. A similar process, using similar technology, can allow development, feedback and sharing of information on ethics. The resulting transparency will support the development of strong ethical behaviour within firms supported by the knowledge that customers are fully aware of what to expect.

By starting with the CFA Code of Ethics and Standards of Professional Conduct, investment organizations can go about creating “ethical capital” as a source of competitive advantage. Given modern technology, this can easily be a co-creative process that is shared by management, employees, customers, and suppliers. It is all about creating a shared knowledge of how each participant expects to be treated by all of the others. This new knowledge base can easily be developed by building on the existing code through dialogue, access, transparency and risk assessment for each party.

A set of ethics that is held equally by all of the parties involved will be far more compelling and easier to police than one that is created only by one side of a transaction. Temptations should be drastically reduced. Fairness and efficiency will go hand in hand with the development of a shared set of beliefs. And self-policing will be robust with feedback from customers automatic and expected. The creation of a strong ethical culture may be the most enduring and important step a firm can take in ensuring its long-term success.