Bernardo M. Villegas
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Key Ethical Issues in Finance (Part 2)

          There are talks that the world economy may yet see a repeat of the East Asian Financial crisis of 1997 to 2000 or worst the Great Recession of 2008 to 2012.  It is feared that the troubled economies of countries like Argentina, Venezuela, Turkey, South Africa and a few others may contaminate the rest of the world as happened when some East Asian countries like Thailand, Indonesia, and South Korea in 1997 pulled down many other countries as far away as Brazil.  Complicating factors are the trade war that the U.S. is waging against China as well as the uncertainty of the way Brexit is going to be managed.  It is important more than ever that world leaders consider the guidelines proposed by a Vatican document on certain ethical principles concerning the present economic-financial system if we are going to attain long-term financial stability in the global economy.

         The document points out that the current globalization of the financial system requires a stable, clear and effective coordination among various national regulatory authorities, with the possibility, and at times, the necessity of sharing binding decisions promptly when required, whenever there are threats to the common good.  There should be complete transparency regarding whatever is traded in order to eliminate every form of injustice and inequality, thus assuring the greatest possible equity in the exchange.  There should be a clear definition and separation among banking responsibilities for the management of credit, of the ordinary daily management of credit, of investment of savings, and of mere business.  These clear distinctions can avoid situations of financial instability.  There should also be the maximum amount of information possible, so that every agent can protect his or her interests in full, and with complete freedom.  Every agent should be informed if his or her capital is used for speculative purposes.  There should also be full information about the degree of risk and the adequate price of the financial products to which one subscribes. 

         The document lists the morally questionable activities of financial advisers in the management of savings.  These are an excessive movement of the investment portfolio commonly aimed at increasing the revenues deriving from the commission for the bank or other financial intermediary; the lack of a due impartiality in offering instruments of saving, which, compared with some banks, the product of others would suit better the needs of the clients; the scarcity of due diligence or even a malicious negligence on the part of financial advisers regarding the protection of related interests to the portfolio of their clients; and the concession of financing on the part of the banking intermediator in a subordinate manner to the contextual subscription of other financial products issued by the same, but not convenient to the client.

         Hopefully, the world has learned from the disastrous consequences of the financial derivatives which brought the global economy down during the Great Recession.  These financial products were created for the purpose of guaranteeing an insurance on the inherent risks of certain operations often containing a gamble made on the basis of the presumed value attributed to those risks.  At the foundation of such financial instruments lay contracts in which the parties were still able to reasonably evaluate the fundamental risk on the basis of which they wanted to insure.  Unfortunately, in some types of derivatives (particularly the so-called securitizations), it was noted that, starting with the original structures, and linked to identifiable financial investments, more and more complex structures were built (securitizations of securitizations) in which it was increasingly difficult, and after many more of these transactions almost impossible, to stabilize in a reasonable and fair manner their fundamental value.  Every passage in the trade of these shares, beyond the will of the parties, distorted the actual value of the risk from that which the instrument must depend.  All these encouraged the rising of speculative bubbles, which had been the important contributory cause of the recent financial crisis.

         It is clear that ethical principles were completely ignored in the creation of these financial products.  The uncertainty surrounding these products, such as the steady decline of the transparency of that which they assured, still not appearing in the original operations, made them continuously less acceptable from the perspective of ethics that is respectful of the truth and the common good.  This complete disregard for truth and transparency transformed these instruments into a ticking time bomb ready sooner or later to explode, poisoning the health of the global markets.  There was a complete ethical void which became more serious as these products were negotiated on the so-called markets with less regulation (over the counter) and were exposed more to the markets regulated by chance, if not by fraud, and thus decoupling them from the vital life-lines and investments in the real economy.

         The Vatican document also made an ethical assessment of the use of credit default swaps (CDS).  These were particular insurance contracts for the risk of bankruptcy that permitted gambling at the risk of the bankruptcy of a third party, even among those who did not take any such risk of credit earlier.  The market of CDS, in the wake of the economic crisis of 2007, was so huge that it represented almost the equivalent of the GDP of the whole world.  The spread of such a kind of contract without proper limits encouraged the growth of a finance of chance, and of gambling on the failure of others, something completely unacceptable from the ethical point of view.  In fact, the process of acquiring these instruments by those who did not have any credit risk already in existence created an unhealthy moral environment in which persons started to nurture an interest in the financial ruin of other economic entities, and in some extreme cases, actually conspiring to actively cause such business failures.

      These considerations on some ethical dimensions of global and domestic finance should make it clear that there is need for adequate public regulation of financial instruments but more importantly for a campaign to motivate financial executives in the private sector to actively promote the common good of their various stakeholders as part of their responsibility as ethical human beings.  We have to reject the assumption of the advocate of free market economics that the only motivation of people in business is to maximize the profit for their shareholders.   It is about time that we topple down the idol of the free market economy. For comments, my email address is bernardo.villegas@uap.asia.