Since the financial crisis of 2008-09 and the consequent 'great recession', regulatory regimes in the financial services industry have become tougher around the world. Some commentators have even said that the regulatory pendulum has swung so far that there is danger of over-regulation stifling innovation and growth of finance itself. Whether one agrees with the latter view or not there is no doubt that globally, financial service regulators are tightening the operating environment due to the scale of scandals engulfing the financial industry. From massive misrepresentations in selling mortgage related securities and derivatives to the Libor, gold and forex 'fixing' scandals to systemic tax evasion advisory services, the doyens of global finance ranging from HSBC, J. P Morgan, Citibank, Bank of America to UBS and Barclays Bank have all been engulfed and fined tens of billions of dollars. More than that, in the court of public opinion they and many more leading financial institutions have been indicted severely. It is the political backlash to the reckless disregard of public interest and extreme greed where rules were bent if not outright broken that has led to regulatory toughening across the world.
The loss of confidence in financial institutions and the finance profession has been severe. Even the role of finance in terms of economic value addition is being questioned. How much of financial innovation over the last two decades benefited the real economy and how much was simply cutting and dicing cash flows in the name of risk diversification but in actuality nothing more than speculation and passing on the real risk to unwary and unaware investors? As a percentage of real assets the value of financial assets sky rocketed - was it really justified? Some have even suggested that gulf between the rich and poor and rising concentration of wealth in the hands of very few is the result of untethered market capitalism. Regardless of the veracity of such claims, the end result is that regulators have become tougher across the board.
There are two levels of contemplation on these issues required if lessons are to be learnt and such behaviour by financial services providers curtailed so that the link between finance and the real economy is re-established on sound footing. The first level needs a real reflection regarding the theory of finance - for example, are economic agents really rational and can they ever be? Thus, can efficient market hypothesis (EMH) actually be observed in reality and consequently, do financial, market and economic models based on above assumptions require a serious rethinking?
The second level of contemplation is more serious, more difficult but, in my humble opinion, much more important. It involves a deep self-analysis of our values, motives and drives. No amount of external regulation, deterrence and penalties can really substitute self-control. Personal and professional ethics has to become the centre of our value-system if we are to check the human tendency for ever increasing greed which leads to behavior that is ultimately detrimental to society at large.
But how to inculcate ethics in our profession and in the cultures of institutions that make up our industry? The what and why of ethical behavior are clear enough. In terms of 'what', the dictionary defines ethic as a system of moral principles or rules of conduct (behaviour). Moral principles are based on people's sense of what is right and just, not simply on legal rights and obligations. The operative words are right and just, which lead us to the 'why' of ethics and ethical behavior. It is for the benefit of all, that the right thing AND the just (fair) thing be done by each person. Thus, being honest in dealing with others is ultimately beneficial to all. Putting customers'/investors' interest first is beneficial for the professional, the institution and the industry. Operating within the ambit of regulations in place is beneficial for the financial system and the confidence that the system requires for its legitimacy in public eyes.
The problematic issue is the 'how'. How can ethics be inculcated in people and institutions that make up the financial services industry? How can ethical behaviour become the standard on which overall performance of the individual and the institution is judged?
Education, of course is one way.Ideally, ethics should become part of educational curriculum at a very early stage. For the industry itself, awareness about ethics and its importance should become essential from the entry level in financial institutions. CFA Association's emphasis on ethics is an excellent example of early awareness generation for financial/capital market professionals. However, this needs to be built upon and further developed as part of organisation wide and industry-wide efforts to bring ethics at the centre of professional development.
A concurrent focus on ethics is required in the incentive structure of financial services industry. Performance appraisal and compensation should be closely linked with ethical behaviour, with incentives and high weightage for overt examples of ethical behaviour and strong disincentives for unethical behaviour.
Transparency is another very important element in encouraging ethical behaviour. Social stigma of unethical behaviour is a powerful deterrent, sometimes even more than fear of legal or regulatory repercussions. One problem in financial services business is that client confidentiality (a key factor in services provided by the industry) often allows miscreants to engage in unethical and illegal conduct that ends up damaging the very client/investor whose confidentiality was supposed to be protected. Thus, the right balance between transparency and confidentiality needs to be determined and broad consensus arrived at amongst the various stakeholders in the industry.
For example, take the question of segregation of client assets from proprietary assets in our domestic capital market or the issue of 'in-house' financing. Regulations mandate segregation of client assets and prohibit 'in-house' financing. By and large, most capital market participants follow these regulations. However, there are those who do not and when discovered, are fined/penalised. But what of those who are not discovered? In my last three and half years as MD of the Exchange, several cases of non-segregation of investor assets have come to light. All were related directly or indirectly to the 2008 global financial crisis which, in Pakistan's case, was greatly magnified due to panicky and ill-fated regulatory action of putting a floor on share prices and tightening credit lines to capital market participants just when liquidity was most needed.
This unexpected external event hit all market participants but was devastating for two types of players: (1) brokers who over-extended themselves and used their client assets when the crunch time came; and (ii) investors who obtained credit from brokers to trade in the market and refused to pay back when cash calls came. Inevitably, there was a close link between (i) and (ii) and when the broker collapsed the good, the bad and the ugly - all investors suffered. The core problem was unethical behaviour driven by greed, irresponsible risk taking and mala fide intent. The Exchange has paid out significant amount of compensation through sale of concerned brokers' assets and KSE's own Investor Protection Fund, such that 50% of investor claimants have received 100% compensation of their principal investment, especially small investors. The fact remains however that many of the larger claimants availed broker financing and got stuck when the crises hit.
The apex regulator, the Securities and Exchange Commission of Pakistan (SECP) has brought in several key regulatory changes to deter this type of behaviour and exchanges' own compliance and monitoring systems have been strengthened to watch over market participants' actions. The Stock Exchanges (Corporatization, Demutualization and Integration) Act, 2012 bifurcated the regulatory and commercial functions of exchanges to minimise possibilities of conflict of interest. Board of directors of the exchanges now have six SECP-nominated directors and only four broker directors. The SECP has also taken lead in areas of monitoring of exchanges' regulatory procedures to ensure the compliance functions are being discharged appropriately. These steps have had a positive impact but more needs to be done in order for savers and investors to regain their confidence in the capital market.
Good example by industry players is another way to encourage ethical behaviour. They are the role models for other participants and new entrants in the capital market. Examples of high professional and personal integrity and ethical behaviour by top managements and principals/sponsors of TREC holders, banks, asset management companies and non-bank financial institutions will go a long way in creating an environment where unethical behaviour is discouraged. This will be beneficial for investors, industry professionals, institutions and our society as a whole.
(The writer is Managing Director Karachi Stock Exchange Limited)
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