Ethics in Modern Finance Theory – Our Quest

The term ‘mission’ has alas, become an institutional one – pragmatic and bland. For those dreamers among us, I will use the term, ‘quest’. Everyone has a quest, whether we consciously know it or not. Why does the word ‘quest’ fire our imagination more than the word, ‘mission’? A quest is just that little more visionary, world changing, and perhaps, quixotic. When one hears quest, one thinks of the noble. The quest of the Knights of the Round Table in Arthurian legend is to find the Holy Grail. The one who finds the Grail is the hero with the purest heart. The quest of the Fellowship of the Ring in The Lord of the Ring saga is to find the ring that rules all and then destroy it. If the ring is not destroyed, evil wins over good and the earth is lost! So much rides on the quest.

The quest then, of Seven Pillars Institute is to put ethics back into the theory and practice of finance. Quixotic – perhaps. World changing – to be sure.

For over half a century, we have stripped ethics from finance. There was no need and hence, no place for it in Modern Finance Theory (see The Long Answer). Ethics is relativistic and discursive. Finance is empirical and scientific. Never the two shall meet, or so it was thought. Over a half century, that thought has been drilled into generations of theoreticians, practitioners, and a broad swathe of society.

We are now at a new time and place in finance. The theories are no longer unassailable. The practice is questionable. We need better theories – ones that will incorporate ethics. Experience tells us, where theory goes there follows practice. It is therefore, imperative we change finance at the fundamental level of theory, in order to alter finance at the level of practice.

Where do we stand in finance theory? At this point in time, there are three conceptual systems of finance: (1) modern finance theory, (2) behavioral finance theory, and (3) Islamic finance theory. Modern finance theory, is the current theory used in most of the world. Indeed, it has served modernity well. Modern finance theory is quantitative and systematic.

Behavioral finance theory is nascent and needs further theory building. The theory explains empirical anomalies that counter the predictions of modern finance theory but still works from the latter’s framework. However, behavioral finance theory accounts for human behavior that modern finance theory neglects. Islamic finance is inchoate, unsystematic and lacks a fundamental quantitative basis. It depends on the formulas and models of modern finance theory. Islamic finance’s most imaginative, vital contribution is its unapologetic inclusion of moral principles to guide action.

It appears the three theories of finance each have a characteristic that a comprehensive theory of finance ideally requires. Modern finance theory provides mathematical rigor. Behavioral finance accounts for human and group psychology. Islamic finance is guided by moral principles. A workable finance theory that unifies without syncretism, the three features of mathematics, psychology, and ethics would perhaps be the achievement of the quest of the Institute.

This avenue is one suggestion for reestablishing ethics in finance theory. The Institute encourages more ideas that meet this end.

Join the quest.