Ethics in Finance

Topics: Ethics, Normative ethics, Morality Pages: 36 (13016 words) Published: April 2, 2011
Ethics in general is concerned with human behavior that is acceptable or "right" and that is not acceptable or "wrong" based on conventional morality. General ethical norms encompass truthfulness, honesty, integrity, respect for others, fairness, and justice. They relate to all aspects of life, including business and finance. Financial ethics is, therefore, a subset of general ethics. Ethical norms are essential for maintaining stability and harmony in social life, where people interact with one another. Recognition of others' needs and aspirations, fairness, and cooperative efforts to deal with common issues are, for example, aspects of social behavior that contribute to social stability. In the process of social evolution, we have developed not only an instinct to care for ourselves but also a conscience to care for others. There may arise situations in which the need to care for ourselves runs into conflict with the need to care for others. In such situations, ethical norms are needed to guide our behavior. As Demsey (1999) puts it: "Ethics represents the attempt to resolve the conflict between selfishness and selflessness; between our material needs and our conscience." It would be an understatement to say that the discipline of finance has not been strongly associated with ethics; if anything, the two areas have been opposed to each other as mutually exclusive. Even where such an opposition is not maintained, it remains true that the ethics of finance is underdeveloped compared to the fields of business ethics or professional ethics. Most financiers have not had a strong ethical formation, whereas ethicists lack an understanding of the technicalities of financial management, and thus the situation perpetuates itself. In recent years, however, following a series of stockmarket crashes, bank scandals and the present general financial instability, there is a renewed interest in the interface between ethics and finance. Finance Ethics has thus arrived at an auspicious time, and it merits the attention that it should get as a result. Its central aim is to show that finance theory, with its assumption of self-interested opportunism and maximisation of wealth on the part of every agent, cannot explain what really happens in financial systems. Further, taught in a fundamentalist and uncritical way in business schools, the ideology behind finance theory leads to the distortion of agents' behaviour in practice, and the undermining of the proper functioning of a healthy financial system. In the globalised world of finance today, where businesses are dealing with each other often without any personal contact, the need for enforceable contracts is crucial if the whole system is not to fail. Furthermore, the problem of enforcing contracts is not purely external to the business. Firms try to create confidence in what they are doing by sending out "signals" which may or may not convince the market that they are trustworthy. "Good" firms need to send out "signals" that cannot be mimicked by "bad" firms if they are to be effective. If giving such a signal is not too costly, the good firm that gives it creates a "separating equilibrium" in which it is clear who is who to outside agents. However, such signals do have some cost, and this reduces the efficiency of the good firm. Again, at best we can have a "second-best" outcome, with a "residual loss" due to the contractual enforcement problem between agents. It is important to realise here that we are not dealing with a redistribution of income from principal to agent, but with an absolute loss from which no-one gains. Lack of information, or "information asymmetry" can make it difficult for principals to know in advance whether they can trust agents, and "moral hazard" describes the situation where it is unsure whether agents will honour or abuse the trust put in them. In both cases, proponents of finance theory would argue that firms could build a "reputation"...
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