Let’s Try Free Markets…with Ethics

June was a cruel month for those in high finance and who made poor ethical choices.

The list of the month’s charges, convictions, sentences, and ethical lapses run as follows:

1. Barclays Bank fined US$450 million for manipulating the London interbank offered rate (Libor); other top tier banks are being investigated and more charges are likely to follow. Libor is set daily and is a key benchmark rate.  Messing with it is like messing with your interest payments or interest earnings, without your knowing.

2. Rajat Gupta, the former global head of McKinsey Consulting, convicted of insider trading. He gave material, non-public information (the definition of insider trading) about Goldman’s activities to Raj Rajaratnam (already serving an 11-year prison term for insider trading). Gupta leaked information to Rajaratnam on three occasions in 2008, one of them was when Goldman’s board approved Warren Buffett’s $5bn investment in the bank.

3. Allen Stanford, former billionaire and owner of Stanford International Bank in Antigua, was sentenced to 110 years in prison for running a $7 billion Ponzi scheme. He stole money from investors to finance an extravagant lifestyle in the Caribbean.

4. Philip Falcone, a once lauded hedge fund manager of Harbinger Funds, has charges brought against him by the Securities and Exchange Commission (SEC) for using customer funds to pay his taxes, manipulated markets and gave favorable treatment to certain clients. The SEC charges that Falcone fraudulently obtained $113.2 million from a hedge fund he advised and misappropriated the proceeds to pay his personal taxes.

5. Peter Madoff, the brother of the infamous Bernard Madoff, pleaded guilty to conspiracy. He helped Bernie to perpetrate the largest investment fraud in U.S. history. Investors are thought to have lost $20 billion in principal in the Madoff fraud.

6. Tai Nguyen, the president of an investment research firm Insight Research LLC, pleaded guilty to insider trading. Nguyen admitted to sharing material non-public information with hedge fund manager Samir Barai and a former analyst at Steven A. Cohen’s SAC Capital Advisors, Noah Freeman.

7. Bob Doll, Chief Equity Strategist of BlackRock Inc and a regular on CNBC, retires after his funds’ board of directors learn the investment models used for Doll’s funds were never proprietary but instead based on other firms’ models.

Libor is a core, sacrosanct number in finance

The most egregious case and the one that hits at the heart of finance and our lives is the manipulation of Libor rates by top tier banks. Libor should be an inviolable pillar in financial markets. It is the key benchmark rate at which banks borrow from each other. It is the reference rate for about $350 trillion of financial products, from sophisticated products such as interest rate swaps to commonly used products such as credit cards. Mortgage rates, savings account rates, home equity rates and a host of other interest rates a modern capitalist economy uses are based off Libor.

The rate is set daily by asking the world’s leading banks their cost of borrowing. Everyday, the rate-setting banks give their estimates of how much it will cost them to borrow in 10 currencies for 15 different lengths of time. The top and bottom rate are discarded and an average is calculated from the remaining rates.

Barclays and other suspected banks submitted artificially low Libor numbers to help other divisions in these banks make money. Specifically, traders of interest rate derivatives asked colleagues to submit false information in order to boost trading profits. When the rate submitting colleagues acquiesced and gave false Libor estimates, the derivatives trader sent an email: “Dude, I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger.” Britain’s Financial Services Authority (FSA) tracked 257 messages asking for Libor and its yen and euro equivalents to be altered. These emails paint a tawdry picture of banking. Submitted rates also were manipulated to give the appearance that everything was fine for Barclays during the financial crisis in late 2007 and 2008.

In other words, Libor, a number on which nearly everyone depends, and the veracity of which almost everyone trusts, was falsified. For profits. By a few banks. John Authers of the Financial Times, describes the manipulation of Libor rates for self-interested purposes as, “grotesque ethical failures”.

The logic of ethics education in finance

While there has been unethical behavior in finance in the past (and will be in the future), the pace, frequency, and easy acceptance and acceptability of unethical acts in finance has increased over the years. Most unethical acts also are illegal and as we have seen in the financial crisis, starting with the fall of Lehman Brothers, their consequences ripple through the global financial system.

As a result of these acts, the financial system froze and needed rescue, people lost jobs and homes, cities went bankrupt, and the Euro’s existence is threatened. Most notably, the public’s faith and trust in financial markets has fallen dramatically. First, the public has lost trust in the U.S. stock market. In March 2012, the average daily volume in equity shares was 6.59 billion shares a day, the lowest level since December 2007. Second, the public has lost trust in financial institutions. Gallup published a poll on June 27^th that shows Americans’ confidence in banks has fallen to a record low of 21%. These are the percentage of Americans saying they have a “great deal” or “quite a lot” of confidence in U.S. banks. It is a well-known and accepted fact that markets run on trust which is, not coincidentally, a moral value. Without trust, markets wither.

In other words, unethical acts have consequences.

Logically, to stop people from doing unethical acts, we must make sure they choose to do ethical acts. It follows that it is important to teach ethical reasoning and the major frameworks of ethics in addition to portfolio theory and options pricing when teaching finance. It also is essential to instill an ethical culture in the money industry. Especially in the money industry because recent psychological research finds that having money or even just thinking about money makes people more likely to be unethical. If a culture places greater value on integrity (of the system and of the individual) than on profits (performance bonuses), then one is less tempted to cheat or manipulate Libor rates.

Free Markets Plus (Ethics)

Thus, if we agree one of the causes of the financial crisis is a lack of ethics, then surely a solution to the problem of getting finance to function properly is to ingrain a greater sense of and sensitivity to ethics in the financial industry. Ethics is not the solution but a solution. For in order to right finance other factors such as risk assessment and regulation need to also improve. Risk assessment models always will be flawed and wanting. Regulations cannot carry the full burden of monitoring finance. There always will be financial innovations that cannot be foreseen by regulators, who to some degree are fighting the last battle.

Free market proponents want as little regulation as possible. Free market proponents call for self-regulation. One of the oldest and surest ways of individual self-regulation is by using a sound moral compass to act ethically. Ethics in finance is not something we should ignore or dismiss.