By Kenya Confidential Financial Editor, Nairobi, October 19, 2018
Given the falsity of the assumption about the power of self-interest to self-regulate, bankers have a responsibility to assess the contribution that their bank is making to systemic risk that affects the whole of society and not merely their own shareholders. Put starkly, we should be able to trust bankers not to destroy the whole economy
Trust and integrity are highly valued moral goods, not only in banking but in business generally. Indeed, little commercial activity would be possible without them. Moreover, many scandals and crises, including the current financial collapse, are blamed on the lack of trust and integrity.
In discussing these matters, however, it is all too easy to invoke pious platitudes about the need for trust and integrity in banking and to make earnest appeals for a restoration of these qualities. A more rigorous treatment of the subject, however, would address questions about what is morally required of bankers and why these requirements arise.
Banking is different from other business activities in morally relevant ways, and so we must consider the distinctive roles that trust and integrity play in banking. In addressing such questions, we must deal with the fact that banking has changed significantly during the past few decades.
The failures in the banking system are not due solely to a loss of integrity and trust, and their restoration would not solve all the problems. However, trust and integrity are still important in modern banking. So I propose to examine what trust and integrity mean in this new world of banking and what role they play.
I begin by identifying some features of banking that make it different from other businesses and business activities. Although banks are businesses, their distinctive character is evident in many ways, including how they are chartered, governed, regulated, and operated.
Being a banker is commonly considered a special role that invites admiration, as well as some suspicion and resentment. And the banking system is generally conceived as both a necessity for an economy and a danger to society. Indeed, President Thomas Jefferson is said to have commented, that “banking establishments are more dangerous than standing armies.”
What is it about banking that accounts for these differences from other business pursuits?
One distinctive feature of banking results from its unusual status with respect to markets. In capitalist systems, markets are the main venue for economic activity; they are the arenas in which buyers and sellers exchange goods and firms engage in production. A key element of markets is the use of contracts as the chief device for executing discrete transactions.
Contracts have the important moral property that they do not depend for their force on trusting the other party. With legally enforceable contracts, we can engage in exchanges or transactions with anonymous parties with the confidence that they will perform as expected. In the absence of a well- functioning legal system, however, with unreliable contract enforcement, trust becomes critical.
Indeed, trust can be understood as an alternative to legally enforceable contracts as a means for engaging in market activity. That is, we must trust others in situations where reliable contracting is not feasible.
The same point applies to the concept of fiduciary duty, which is of critical importance in banking. Fiduciary duty is explained, by some, as a device for filling gaps in incomplete contracts. In corporate governance, for instance, an officer or director owes a fiduciary duty to shareholders but not to any other group.
One explanation for this single-minded focus is that every other group participates in the productive activity of a firm by means of complete, legally enforceable contracts. Thus, employees, suppliers, and debt capital providers secure a return on their various inputs by using contracts that do not depend for their force on any duty that is imposed on the firm’s managers.
These groups relate to a firm solely through a market. Share- holders, by contrast, cannot write complete contracts with the firm that specify in detail how officers and directors should behave. The solution to this difficult contracting problem is to impose a fiduciary duty that obliges management to use shareholder interest as the objective in all decision-making. According to this view, imposing a fiduciary duty is a second-best solution to a problem of incomplete contracting.
Traditional banking is conducted to some extent in a market through contracting, but banks are not market actors in the same way that a grocery store, for example, buys food from suppliers and sells it to customers in arm’s-length economic exchanges or transactions in a market.
Nor does a bank resemble a manufacturer that purchases inputs in a market from suppliers, including labour and capital, and transforms them into an output in the form of a product that is sold to customers. What, then, do traditional banks do?
Traditionally, banks served as intermediaries in fulfilling four critical functions in an economy:
- Payments, providing a means for transferring money from one party to another;
- Savings, providing a means for people to safely place money that is not needed for current consumption;
- Lending, making loans from savers’ deposits to customers in need of funds for consumption or investment purposes; and
- Risk bearing and risk shifting. In particular, banks bear the risk involved in using savers’ deposits to make loans to borrowers and shift the risk from depositors to the bank’s shareholders.
The service that banks provide in the payments system is largely a contractual fee-for-service business, although customers and recipients must trust that this service will be performed reliably and properly. Lending, too, is largely governed by contracts insofar as loan agreements specify the obligations of each party and, in particular, of the borrowers to repay the loan with interest.
In the lending function, banks are the vulnerable party that must trust borrowers to repay, although the need for trust is reduced when a loan is secured by collateral and a legal right to fore- close is available. Trust is critical primarily in the relationship of savers or depositors and the bank to the extent that the money in question must be kept secure in the loan process and made readily available to be returned on demand.
In this process, a bank serves as an intermediary between savers and borrowers, not only in facilitating the conversion of savings into loans but also in assuming the risks involved. These risks include the risk of default by the borrower and the risk of a bank run due to the maturity mismatch that results from lending savers’ short-term deposits to long-term borrowers.
However, both of these risks are shifted away from the bank by deposit insurance, which reduces the need for trust in banks because a government not only insures depositors’ savings but also assumes a monitoring role. With deposit insurance, savers’ trust in government reduces the need to trust banks.
The need for trust in banking can be understood by conducting a thought experiment similar to the question posed by Ronald Coase about firms. He asked why all economic activity could not take place entirely in markets. That is, why do firms exist at all if markets are so effective? His famous answer was that firms economize on transaction costs.
Similarly, we can ask whether all the functions of banking could be carried out in discrete market transactions. Why is contracting not sufficient to accomplish all the tasks of banks?
One answer is that banking is a continuous activity in which customers and banks establish relationships that last over time rather than engaging in discrete, one-time transactions. Many aspects of these relationships cannot be specified in contracts but depend on trust.
More significantly, banking is not a bilateral relationship between just two parties, but is a coordination activity among multiple parties. In theory, borrowers could approach a large number of savers and contract collectively with each one to borrow some of the funds needed.
However, not only would the transaction costs of this activity be very high, but also two important benefits of banks could not be achieved.
- First, there is no way, even in theory, for the savers to loan money for a fixed period of time and also have it available for return on demand.
- Second, the savers could not loan the money without bearing the risk of default.
Thus, banks serve an intermediation role that could not be achieved by contracting without them and, hence, without some degree of the trust that relationships, rather than transactions, require.
A second distinctive feature of banking is that it does not merely provide services and products in a functioning economy; it is an essential component of an economy that enables it to function. The banking system has been compared to the heart in a body, which circulates blood throughout the body and thereby sustains life.
Just as a body could not function without a heart, so an economy cannot function without a banking system. This reliance of an economy on a banking system has led some commentators to speak of banking as a utility. Mervyn King, the Governor of the Bank of England, recently called for a separation of ‘utility banking’ and what he labelled ‘casino banking’.
This utility aspect of banking creates another role for trust: to assure everyone that the essential services and products of the banking system will be maintained. We must trust bankers in the same way that we trust the leaders of basic utilities to keep the lights on and the water and gas flowing.
However, unlike these utilities, which merely provide generic commodities, banks are privy to a great deal of sensitive information, which, in fact, gives rise to the importance in banking of duties related to confidentiality and privacy and the trust that these duties require.
Despite these undeniable economic benefits of trust and integrity, I contend that they are not unalloyed goods that we should unreservedly emphasize and encourage, especially to the exclusion of more effective means to the same ends. Trust and integrity, as well as morality generally, have two crucial limitations.
First, they are difficult and costly to inculcate. Extensive social resources must be expended to ensure that all individuals in society or an institution, such as a bank, are trustworthy and always act with integrity. These moral goods are part of social capital, which, as Fukuyama observes, is different from financial capital and human capital in that it cannot be created merely by financial investment; it can only be acquired, like the virtues, from “habituation to the moral norms of a community”.
Fostering this habituation, no matter how desirable it is, requires a considerable commitment by society and its major institutions. Second, trust and integrity, along with morality generally, are unreliable. Trust can easily break down or prove illusory, and even people with integrity can sometimes act wrongly.
If our goal is to ensure that banks and the banking system operate well, it would be prudent to examine all the means available for this purpose.
What other means are available? In broad outlines, there are four major means for ensuring that banks operate well and fulfil their main functions. These are;
- Market forces,
- Government regulation,
- Institutional design, and
- Ethics or morality.
First, with respect to market forces, competition among banks for customers’ deposits and loan business provides banks with powerful incentives to assure these customers of their trust-worthiness and integrity. Given the falsity of the assumption about the power of self-interest to self-regulate, bankers have a responsibility to assess the contribution that their bank is making to systemic risk that affects the whole of society and not merely their own shareholders. Put starkly, we should be able to trust bankers not to destroy the whole economy.
Banks compete with each other over virtually every service they provide to the public and to corporate clients, not only on price and performance but also on reputation, as each bank seeks to enhance this intangible factor to achieve a competitive advantage.
The cost of a damaged reputation can be immense, and so banks have a strong incentive to manage reputational risk. Although the market for banking services is less than perfect due to increasing concentration of the industry, enough competition remains for the market to be a powerful disciplinary force.
More generally, economists have demonstrated how perfect markets can solve many coordination problems, such as the problem of social costs or externalities. Indeed, the philosopher David Gauthier has argued in his book Morals by Agreement that in perfect markets, there would be no need for morality at all because all transactions would take place by mutual consent or agreement.
Second, banks have long been subject to close government regulation, which is due not only to deposit insurance but also to the necessary role of government in the currency and credit systems. Unlike most businesses, where regulation serves mainly to protect the public, banking could not easily exist without close association with government.
Third, economists, such as Douglass North, have explained the importance of the design of institutions in advancing economic development and channeling market activity. Trust and integrity can be facilitated, for example, by the governance structure of banks (such as partnerships versus public ownership); by the separation of functions (such as commercial from investment banking, of banking from insurance, and mortgage origination from securitization); and by organizational features (such as the shielding of analysis from bank lending and the compensation and bonus structures). In banking, institutional design matters, and many problems can be solved by getting the design right.
Finally, ethics or morality is a major factor in guiding and controlling human behaviour, which operates in banking and other economic activity not only by providing an internal motivation for right action but also by means of formal codes and compliance programmes.
For example, an individual banker may be guided in making a right decision not only by a personal conception of right and wrong or an internal ‘moral compass’, but also by consulting a bank’s code of ethics, mission statement, or other policy documents. It is not my intention to minimize the role of ethics or morality in banking but to stress two points.
- One is that ethics or morality is not the only factor in guiding behaviour. Markets, government regulation, and institutional design are non-exclusive alternatives that should be combined with ethics or morality to form an effective deterrence and control system.
- The second point is that ethics or morality has limitations as a means of deterrence and control. As part of a complete system, it is difficult and costly to implement and is of uncertain reliability.
United States President Ronald Reagan frequently said in connection with arms control and the Soviet Union, “Trust, but verify.” This phrase emphasized the point that trust alone is inadequate and is best combined with other means of assurance. Indeed, the best system might be one that does not require much trust at all.
As a moral philosopher, I have a personal incentive to promote ethics as much as possible. However, I think it is important not to see a moral problem where none exists or to propose moral solutions where they are inappropriate.
Sociologists use the word ‘moralization’ to denote the identifying or classifying of phenomena as moral in character or as having a moral dimension. Thus, to criticize the role of the mortgage origination process in the current financial crisis as the failure of a moral duty or obligation is to engage in moralization. In this example, I think that the mortgage originators who extended mortgages to unqualified borrowers acted wrongly, so that conceiving of this case in moral terms is wholly appropriate.
People not only depend more on finance for the sustenance of their lives but have had their thinking shaped by it to produce ‘portfolio society’.
Since banks also play a valuable role in bearing risk and can have an impact on society by shifting risk to other parties, it is also incumbent on bankers to recognize their responsibility for the allocation of risk and to carefully assess what risks are assumed and shifted. Ideally, risks should be borne by the parties that can bear them most efficiently, and some recent risk shifting may be due to this search for efficiency.
For example, securitization, which transfers the risk of loans from a bank to large investors, could, if done correctly, result in more efficient risk bearing. How- ever, in the recent financial crisis, the default risk of loans packaged in CDOs was shifted to parties that did not understand the risks and consequently mispriced them.
In an effort to get beyond pious platitudes and earnest exhortations about trust and integrity in banking, I have endeavoured to explain how traditional banking is different from other businesses. First, since banking cannot be conducted solely by bilateral market contracting but serves an intermediation function between multiple parties, trust and integrity are requirements. Second, the utility character of banking also creates a need for trust due to the dependence of the economy on banking services.
It is evident that the challenge of restoring trust and integrity in banking is as difficult as it is necessary. Kenyan banks value their customers according to the amount of money in their accounts. They are least concerned about how the money is made even when it is quite obvious that it is looted from public coffers. Recent fines on banks found to have aided theft of public funds is only a tip of the monumental frauds facilitated by banks locally and internationally. Banks are the biggest conduits of illegally acquired funds.
The Central Bank last month fined five banks Ksh 392 million for violating anti-money laundering rules in respect to the handling of the National Youth Service scandal that was exposed this year.The five banks were Standard Chartered, Equity, Kenya Commercial Bank, Co-operative Bank and Diamond Trust Bank Kenya face penalties for handling 3.5 billion shillings stolen from National Youth Service.
KCB which handled Ksh 639 million was fined Ksh 149.5 million. Equity Bank transacted Ksh 886 million and was penalized Ksh 89.5 million. Standard Chartered Bank handled Ksh 1.628 billion and was fined Ksh 77.5 million. Diamond Trust Bank transacted Ksh 162 million and fined Ksh 56 million. Co-operative Bank transacted Ksh 263 million and got a penalty of Ksh 20 million.