Handbook on Ethics in Finance (International Handbooks in Business Ethics) 303029370X, 9783030293703

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International Handbooks in Business Ethics Series Editors: Luc van Liedekerke · Christoph Luetge · Alejo José G. Sison

Leire San-Jose · José Luis Retolaza Luc van Liedekerke  Editors

Handbook on Ethics in Finance

International Handbooks in Business Ethics Series Editors Luc van Liedekerke University of Antwerp Antwerp, Belgium Christoph Luetge Peter Löscher Chair of Business Ethics Technische Universität München München, Bayern, Germany Alejo José G. Sison School of Economics and Business Administration University of Navarra Pamplona, Navarra, Spain

Business ethics as a field of teaching and research has expanded and diversified tremendously over the last decade. The new research spans a large diversity of fields: corporate governance, corporate responsibility, citizenship, financial ethics, HR, international management, leadership, virtues, religion, SME’s, values based management, marketing, to name but a few. Business ethics has also turned into an interdisciplinary field, without however losing its philosophical foundation. The series identifies crucial areas in business ethics research and dedicates a handbook to it. It will draw upon the leading international scholars in each field and reflect the diversity in research methods. Each multivolume handbook contains the fundamental questions being posed, reflects the state of the art of the research at this moment as well as the most important research results over the past decade. In this we cover what has been learned as well as the major challenges we face for the future. Topics in this series are identified from discussions with leading scholars. Each Handbook will be directed and compiled by a handbook editor working in close cooperation with the series editor to ensure the appropriateness of the contributions as well as the consistency over the series volumes. The Handbooks will be published in both print and electronic versions. More information about this series at http://www.springer.com/series/10788

Leire San-Jose • Jose´ Luis Retolaza • Luc van Liedekerke Editors

Handbook on Ethics in Finance With 41 Figures and 19 Tables

Editors Leire San-Jose ECRI Ethics in Finance and Social Value Research Group University of the Basque Country UPV/EHU Bilbao, Spain

José Luis Retolaza University of Deusto Bilbao, Spain

Luc van Liedekerke University of Antwerp Antwerpen, Belgium

ISSN 2213-106X ISSN 2213-1078 (electronic) ISBN 978-3-030-29370-3 ISBN 978-3-030-29371-0 (eBook) ISBN 978-3-030-29372-7 (print and electronic bundle) https://doi.org/10.1007/978-3-030-29371-0 © Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG. The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

Any contribution to society is always positive, but as well as actually making that contribution, it is also important to explain it. This is one of the chief goals of anyone working in academia; it gives a sense of purpose to their work, and even to their lives, contributing to achieve a better society. As well as making a discovery, it is also essential to publicize it. There are a number of ways in which this can be achieved and one of them is by communicating our contributions in the form of a book, and this is the medium we have chosen on this occasion. Having published a number of articles on ethics in finance in specialist academic and trade journals and won several prizes, and after multiple conversations and meetings with experts from the field, the editors felt it was important to bring together different contributions on this field, in order to help improve the way it is managed and enhance the ensuing results. The work of editing and coordinating all these contributions has been the result of extensive collaboration. It is sometimes difficult to maintain the initial enthusiasm with which any project begins right through to its conclusion, but this is exactly what we managed to do on this occasion. Not only does the book manage to bring structure to a subject that is both relevant and impactful, it also reflects the expertise and the more human side of the authors who have collaborated disinterestedly in the work. Books are not the most common yardstick by which academic research is measured; nonetheless, the indisputable breadth which the format allows and its durability over time need to be re-assessed and taken into account. Clear advances are being made, and finding ways of grouping them together helps to make them more consistent, as well as permitting a greater overview of their full range and significance. This book offers great added value thanks to the contributions of the different authors and the inclusion of themes, perspectives, and joint reflections. It reflects the expertise and understanding any researcher and professional can have of a changing situation. As for the theme of the work, ethics and finance might initially appear to be a somewhat oxymoronic combination; indeed, there can be no doubt that distinctly unethical conduct was a major contributor to the great financial crash of 2008. Nonetheless, finance has been merely the tip of the iceberg in a broader and widely accepted thesis on the separation between economics and ethics, and between positive and prescriptive economics. The harsh reality has clearly shown the need v

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for an ethical basis in order for finance to operate optimally; otherwise, the transaction costs will be tremendous, both for society and for the financial institutions themselves (one only has to think how many such organizations have disappeared in these recent years!). However, any ethical reflection must not only look to the past; we could expend rivers of ink on what could have been done, but that will not change what actually happened one iota. Similarly, the incorporation of ethical reflections and instruments that are over a decade old will not contribute to the better social functioning of organizations. We need to address the new problems arising in financial institutions with ethical criteria, and to do that, we need to understand and anticipate them. This book identifies the main areas of innovation in ethics in the financial arena and sets out the pioneering work now being conducted in this field. An understanding of these areas of financial innovation is particularly helpful both for the financial institutions – to whom it can offer guidance on which ethical areas to concentrate on – and researchers into ethics, for whom it can spotlight focuses of interest and possible lines of research. This book does not seek to answer past questions, but rather to pose challenges for the present – challenges which, if properly resolved, can make a greater contribution from the area of finance to society in general. As well as compiling and disseminating the contributions themselves, this book specifically seeks to impact the world of finance, in order to ensure that ethical and moral aspects are included, not as an alternative but as a central and significant element. The study of ethics in the financial area has been somewhat vague to date, and in general, it has been treated in an alternative and complementary fashion. The time has now come to see ethics as a central and changing axis of finance. To do so, we have had to unlearn our previous knowledge following a financial crisis and a health crisis. We need to build a new reality in which there can be no place for finance without ethics and responsibility; we must once again lay the foundations of finance, and this book addresses the main aspects of the theme. All of the issues involved have been examined prospectively; the world is changing, and it would be entirely illogical to base ourselves on the past. In order to impact and influence finance, this book tackles different themes from a prospective point of view, predicting what the key areas and disruptive elements will be in which ethical finance can finally cease to be viewed as an oxymoronic notion. The book is divided into four parts, exploring all of the most relevant aspects in which ethics can be brought into finance. The first of these is “From Risk to Responsibilities,” which deals with the subjects of governance and decisions, virtue, regulation, and ethical codes to examine how we can reduce risks and responsibilities in the financial area in different domains and countries. The second part, “Ethics in Financial Products and Services,” examines those products that have been termed (and catalogued) as ethical, or which at least have an ethical perspective, including microfinancing, socially responsible investment, Islamic banking, ethical perspectives of digitalization and fintech, as well as aspects related to sustainable development goals. The next part, “The Crisis in the Governance of Financial Institutions,” sets out the ethical aspects related to insolvency creditors and bankruptcy proceedings, project managers, and banks and seeks to outline what form they should take

Preface

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and how they should act in the future. The final part, “The Influence of (Social and Ethical) Accounting in Ethics in Finance,” addresses social aspects, a new and transcendentally important area of finance, and a disruptive and centralizing axis in it. Here, a range of international authors set out their innovative ideas on social accounting, auditing, and artificial intelligence. This book, which first began with a Delphi analysis of a group of experts to detect disruptive themes for study in the area of financial ethics, offers four perspectives on the way in which this area can be improved in the future – a future which will undoubtedly be more inclusive, responsible, and collaborative. March 2021

Leire San-Jose José Luis Retolaza Luc van Liedekerke Editors

Contents

Part I

Ethics in Finance : From Risk to Responsibilities . . . . . . . . . .

1

Financial Institutions and Codes of Ethics . . . . . . . . . . . . . . . . . . . . . . . Christopher J. Cowton

3

...

17

Ethical Orientation in Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Laura Viganò

31

Ethics as a Solution to Fraud in Commercial Banks in Uganda . . . . . . Wilson Muyinda Mande

57

A Virtue Ethics Approach in Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . Ignacio Ferrero, Andrea Roncella, and Marta Rocchi

77

Regulation of Financial Conduct in Russia . . . . . . . . . . . . . . . . . . . . . . Irina Grekova and Maxim Storchevoy

97

Professional Ethics and the Financial “Professions” . . . . . . . . . . . . . . . Jim Baxter

117

Digital Financial Inclusion of Women: An Ethical Appraisal . . . . . . . . Paul Kofman and Clare Payne

133

Part II

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Ethics in Finance as the Result of a Strong Systemic Commitment Mauricio Humberto Baquero-Herrera

Ethics in Financial Products and Services . . . . . . . . . . . . . .

Microfinance Services and Women’s Empowerment . . . . . . . . . . . . . . . Nina Hansen, Marloes A. Huis, and Robert Lensink

161

Socially Responsible Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Silvana Signori

183

Ethics and Digital Innovation in Finance . . . . . . . . . . . . . . . . . . . . . . . . Antonio Argandoña

207

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Contents

Ethics for Automated Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . Ricky Cooper, Michael Davis, Andrew Kumiega, and Ben Van Vliet

229

Ethics in Education for Sustainable Finance . . . . . . . . . . . . . . . . . . . . . Jutaro Kaneko

247

Readiness to the FinTech Industry in Developing Countries . . . . . . . . . Chemseddine Tidjani

269

Ethics in Islamic Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ivan Ureta

301

Investment Inspired by the Principles of Catholic Social Teaching (CST) as a Contribution to the Social Development Goals (SDG): A Case Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . José-Luis Fernández-Fernández and Diego Blázquez Bernaldo de Quirós

317

Ethics of FinTech and Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Damian Crowe

337

Moral Education for Sustainable Financial Services . . . . . . . . . . . . . . . Jutaro Kaneko

373

Poverty Alleviation Through Financial Practices: The Importance of Microfinance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Osmar Arandia and Saskia Hepp

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Part III

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The Crisis in the Governance of Financial Institutions

...

Corporate Government as a Structure for Control and Promotion of Ethics in Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mariem Ghares and Eric Lamarque

425

Ethics of Bankruptcy Creditor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unai Olabarrieta, Andrés Araujo, and Leire San-Jose

441

Social Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paul Gower

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Applying Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Aloy Soppe and Koos Wagensveld

477

Ethical Responsibility of Financiers . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yolanda Angelina Altamirano Sánchez and Fernando Macedo Chagolla

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Part IV The Influence of (Social and Ethical) Accounting in Ethics in Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Many Merits and Some Limits of Social Accounting . . . . . . . . . . . Adrian Zicari

539 541

Contents

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559

Ethical Considerations About the Implications of Artificial Intelligence in Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Raphael Max, Alexander Kriebitz, and Christian Von Websky

577

Stakeholder Accounting for Sustainability Applied to Nonfinancial Information in Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Jose Luis Retolaza and Leire San-Jose

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Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

615

Ethics in the Independent Audits of Financial Statements Greg Shailer

About the Series Editors

Luc van Liedekerke is professor of business ethics at the University Antwerp and the KULeuven. He currently holds the BNP Paribas Fortis Chair in Ethics and Finance at the University of Antwerp. He was director of the Center for Economics and Ethics at the KULeuven and for many years president of the European Business Ethics Network, the largest academic network in business ethics. He publishes extensively on business ethics, CSR, and financial ethics. Professor Liedekerke is board member of several academic and non-academic organizations in Belgium and abroad that are active in the field of SRI and sustainable business. Christoph Lütge is full professor of business ethics and director of the Institute for Ethics in Artificial Intelligence at Technical University of Munich (TUM). He has a background in business informatics and philosophy, having completed his Ph.D. at the Technical University of Braunschweig in 1999 and his habilitation at the University of Munich (LMU) in 2005. Professor Lütge was awarded a Heisenberg Fellowship in 2007. His most recent books are: The Ethics of Competition (Elgar, 2019) and Ethik in KI und Robotik (Hanser, 2020, with coauthors). Professor Lütge has held visiting positions at universities of Harvard, Pittsburgh, California (San Diego), Taipei, Kyoto, and Venice. He is a member of the Scientific Board of the European AI Ethics initiative AI4People as well as of the German Ethics Commission on Automated and Connected Driving. He has also done consulting work for the Singapore Economic Development Board and the Canadian Transport Commission. xiii

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About the Series Editors

Alejo José G. Sison, Ph.D., is professor at the University of Navarra, where he teaches in the School of Economics and Business, and in the Institute for Enterprise and Humanism. He was president of the European Business Ethics Network (EBEN) between 2009 and 2012. He began his teaching career at the University of Asia and the Pacific (Manila). In 1997, he was appointed Fulbright senior research fellow and visiting scholar at Harvard University. Since then, he has received fellowships from the 21st Century Trust Foundation (London); the Academic Council on the United Nations System (Yale University), the American Society of International Law (Washington, DC); the Salzburg Seminar, Bentley University (Waltham, MA); the Policy and Leadership Studies Department at the National Institute of Education, Nanyang Technological University (Singapore); and the Institute of Education of the University of London. He became editor of the Philosophical Foundations section of the Journal of Business Ethics in 2009 and joined the editorial board of Business Ethics Quarterly in 2011. His research deals with the issues at the juncture of ethics with economics and politics, such as the virtues and the common good. His book, The Moral Capital of Leaders: Why Virtue Matters (Edward Elgar, 2003), has been translated into Spanish and Chinese. In 2008, Professor Sison published Corporate Governance and Ethics: An Aristotelian Perspective (Edward Elgar) with a foreword by Professor Jeffrey Pfeffer (Stanford University). His latest book Happiness and Virtue Ethics in Business: The Ultimate Value Proposition (Cambridge University Press, 2015) defends the critical role of the virtues in modern happiness studies.

About the Editors

Leire San-Jose is associate professor at the University of the Basque Country (UPV/EHU) in Bilbao (Spain), and she is also visiting research fellow at the University of Huddersfield (UK). She is leader of ECRI (Ethics in Finance & Social Value Research group). Leire was previously a visiting scholar at Loyola University Chicago under the supervision of Professor John Boatright and at Darden Business School under the supervision of Professor Edward Freeman. She has been at Fordham, Oxford, Heriot-Watt, and Bergamo as visiting professor, as well. Her most important publications are about ethics in payment to suppliers, social value and social efficiency, and stakeholder theory. Leire has published in impact journals such as the Journal of Business Ethics, Sustainability, European Management Journal, Corporate Social Responsibility and Environmental Management, and CIRIEC. She organized EBENSpain conference in 2010 and ISBEE in 2020 held in Bilbao. José Luis Retolaza is an associate professor at Deusto Business School and director of AURKILAN Institute for Business Ethics Research in Bilbao (Spain); he was also a visiting scholar at Darden Business School, USA, during the second term of 2015. Jose is the scientific director of Global Economic Accounting (GEAccounting) company, whose aim is to monetize the social value of organizations (social accounting) and integrate in the strategy of companies. The current research focuses on stakeholder theory, social value, and social efficiency in the financial entities. He is a member of ECRI (Ethics in Finance & Social Value) research group and HUME. Jose is author of several publications xv

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About the Editors

in national and international scientific journals, and he has participated in numerous national and international conferences. He acts as reviewer member of ranked journals (Business & Society, CIRIEC, INNOVAR, Society for Business Ethics, and Contemporary Economics). Luc van Liedekerke is professor of business ethics at the University Antwerp and the KULeuven. He currently holds the BNP Paribas Fortis Chair in Ethics and Finance at the University of Antwerp. He was director of the Center for Economics and Ethics at the KULeuven and for many years president of the European Business Ethics Network, the largest academic network in business ethics. He publishes extensively on business ethics, CSR, and financial ethics. Professor Liedekerke is board member of several academic and non-academic organizations in Belgium and abroad that are active in the field of SRI and sustainable business.

Contributors

Yolanda Angelina Altamirano Sánchez Facultad de Estudios Superiores Aragón, Universidad Nacional Autónoma de México, Mexico, USA Osmar Arandia Universidad de Monterrey, San Pedro Garza García, Nuevo León, Mexico Andrés Araujo Universidad del Pais Vasco UPV/EHU, Leioa, Spain Antonio Argandoña Department of Economics and Business Ethics, IESE Business School, University of Navarra, Barcelona, Spain Mauricio Humberto Baquero-Herrera Derecho, Universidad Alberto Hurtado, Santiago de Chile, Chile Jim Baxter Inter-Disciplinary Ethics Applied Centre, University of Leeds, Leeds, UK Ricky Cooper Stuart School of Business, Illinois Institute of Technology, Chicago, IL, USA Christopher J. Cowton Huddersfield Business School, University of Huddersfield, Huddersfield, UK Damian Crowe Obillex Limited; Collaborative Economic Systems Pty Ltd, Melbourne, VIC, Australia Michael Davis Center for the Study of Ethics in the Professions, Lewis College of Human Sciences, Illinois Institute of Technology, Chicago, IL, USA Diego Blázquez Bernaldo de Quirós DiverInvest, Madrid, Spain José-Luis Fernández-Fernández Pontifical University Comillas, Madrid, Spain Ignacio Ferrero Department of Business, School of Economics and Business, Universidad de Navarra, Pamplona, Navarra, Spain Mariem Ghares VALLOREM, IAE Tours, Tours University, Tours, France xvii

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Contributors

Paul Gower Warwick Manufacturing Group, University of Warwick, Coventry, UK Irina Grekova Moscow Exchange, Moscow, Russia Nina Hansen Department of Social Psychology, University of Groningen, Groningen, The Netherlands Saskia Hepp Universidad de Monterrey, San Pedro Garza García, Nuevo León, Mexico Marloes A. Huis Department of Social Psychology, University of Groningen, Groningen, The Netherlands Jutaro Kaneko Japan Center for International Finance, Tokyo, Japan Institute for International Trade and Investment, Tokyo, Japan Paul Kofman Faculty of Business and Economics, The University of Melbourne, Melbourne, VIC, Australia Alexander Kriebitz Peter Loescher Chair of Business Ethics, TUM School of Governance, Technical University of Munich, Munich, Germany Andrew Kumiega Stuart School of Business, Illinois Institute of Technology, Chicago, IL, USA Eric Lamarque Sorbonne Research in Management-IAE, Management and Governance of Financial Cooperatives, Paris 1 Pantheon-Sorbonne University, Paris, France Robert Lensink Department of Economics, Econometrics, and Finance, University of Groningen, Groningen, The Netherlands Development Economics Group, Wageningen University, Wageningen, The Netherlands Fernando Macedo Chagolla Facultad de Estudios Superiores Universidad Nacional Autónoma de México, Mexico, USA

Aragón,

Wilson Muyinda Mande Nkumba University, Entebbe, Uganda Raphael Max Peter Loescher Chair of Business Ethics, TUM School of Governance, Technical University of Munich, Munich, Germany Unai Olabarrieta Universidad del Pais Vasco UPV/EHU, Leioa, Spain Clare Payne The University of Melbourne and Vincent Fairfax Fellow for Ethical Leadership, North Sydney, NSW, Australia José Luis Retolaza University of Deusto, Bilbao, Spain Marta Rocchi DCU Business School, Irish Institute of Digital Business, Dublin City University, Dublin, Ireland

Contributors

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Andrea Roncella Department of Business, School of Economics and Business, Universidad de Navarra, Pamplona, Navarra, Spain Leire San-Jose Universidad del Pais Vasco, Leioa, Spain ECRI Ethics in Finance and Social Value Research Group, University of the Basque Country UPV/EHU, Bilbao, Spain Greg Shailer Australian National Centre for Audit and Assurance Research, and Research School of Accounting, The Australian National University, Canberra, ACT, Australia Silvana Signori Department of Management, Economics and Quantitative Methods, University of Bergamo, Bergamo, Italy Aloy Soppe Institute Financial Management, HAN University of Applied Sciences, Arnhem, The Netherlands Maxim Storchevoy St. Petersburg School of Economics and Management, HSE University, St. Petersburg, Russia Chemseddine Tidjani Division of Firms and Industrial Economics, Research Center in Applied Economics for Development (CREAD), Algiers, Algeria Ivan Ureta Economics and Management, SUPSI, Manno, Switzerland Ben Van Vliet Center for Strategic Finance, Stuart School of Business, Illinois Institute of Technology, Chicago, IL, USA Laura Viganò Department of Management, Economics and Quantitative Methods, Università degli Studi di Bergamo, Bergamo, Italy Christian Von Websky Research Group on Sustainable Finance, University of Hamburg, Hamburg, Germany Koos Wagensveld Institute Financial Management, HAN University of Applied Sciences, Arnhem, The Netherlands Adrian Zicari Accounting and Management Control Department, ESSEC Business School, Paris, France

Part I Ethics in Finance : From Risk to Responsibilities

Financial Institutions and Codes of Ethics Christopher J. Cowton

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate Codes of Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Code Content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Communication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Assessment of Corporate Codes of Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beyond Financial Institutions: Other Codes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 5 5 6 8 9 9 10 10 13 14 15

Abstract

Corporate codes are one of the most conspicuous tools in the business ethics armory. They have their vocal critics, but this chapter argues that they can make a positive contribution if they are well designed and embedded in the organization. A financial institution that seeks to take ethics seriously should ensure that the contents of its code are appropriate and current and that the code is effectively communicated, well supported, and diligently enforced. The codes of two UKbased banks are used to illustrate the points made. A final section recognizes that some employees will also be subject to professional codes of ethics and considers how this can support organizational ethics.

C. J. Cowton (*) Huddersfield Business School, University of Huddersfield, Huddersfield, UK e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_1

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C. J. Cowton

Keywords

Financial institutions · Banks · Codes of ethics · Codes of conduct · Professional bodies · Professional ethics

Introduction In the past, business ethicists paid comparatively little attention to finance, perhaps because it was thought to be ethically unimportant or uncontroversial, technically too challenging, or just plain uninteresting. Likewise, finance academics have paid little attention to ethics, especially since the field was intellectually captured by financial economics (Whitley 1986). However, the global financial crisis (GFC) prompted much greater consideration of the ethics of financial markets and financial institutions, not only by academics but also by regulators, the public, and even financial institutions themselves. Because of the financialization of society, this matters even more now than it did under the banking crises of the past, of which there have been many. Much has been written about the causes of the GFC and the role of the banks. While a lack of ethics is not the only explanation for what happened, it certainly features in many accounts. Moreover, it does not seem unreasonable to believe that better ethics would have led to less harm being caused, if not avoided altogether. Even if other causes are thought to have been more important, a lack of ethics has a part to play regarding those factors. For example, if it is thought that incompetence was a major factor, an underlying issue might have been a failure to recognize the moral duty to develop competence and to act only within one’s competence. Analyses of the GFC often lead to recommendations that particular tools of management or extended regulations be introduced or changed (e.g., reform remuneration systems to reduce reckless risk-taking; increase capital requirements). Although lack of ethics has been a factor identified in explanations of the GFC, one tool, the code of ethics, has not been a major feature of such discussions. Perhaps that reflects a lack of awareness of such codes or, more likely, a belief that they are of little or no value – a belief perhaps bolstered by the thought that many banks already had codes of ethics in the early part of the current century, before the GFC. A negative view of codes of ethics is far from unknown; although corporate codes of ethics have become one of the most conspicuous features of business practice associated with business ethics over the past three decades or so, not everyone is convinced of their value. However, this chapter will argue that not all codes are created equal. It matters what they contain, how they are developed and implemented, and the context in which this takes place. They can make a useful contribution, but they cannot be expected to achieve much on their own; and while they might never prevent something like the GFC, they might nevertheless be a very useful tool during less turbulent times. Professional bodies’ codes of ethics, which display certain parallels, and how they might support financial institutions’ own codes, will also be considered.

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The particular context envisaged in the chapter is commercial banks. However, many of the issues apply to other financial institutions too, especially those that are consumer-facing, e.g., insurance companies, savings and loans institutions/building societies, and large credit unions. At various points in the chapter, illustrations from the codes of two large, UK-based banks – Barclays and Lloyds – are provided. The remainder of the chapter is structured as follows. First, the nature of corporate codes of ethics and what is needed for them to be effective are discussed. A further section then assesses their value. The next section considers professional codes of ethics and the contribution that they might be able to make. Finally, the Conclusion summarizes the argument and key points of the chapter.

Corporate Codes of Ethics Introduction Most large companies in developed countries, including banks, now have a code of ethics (Kaptein 2017), following their initial popularity in the USA. Kaptein and Schwartz define a code as: a distinct and formal document containing a set of prescriptions developed by and for a company to guide present and future behavior on multiple issues of at least its managers and employees toward one another, the company, external stakeholders and/or society in general. (Kaptein and Schwartz 2008, p. 113)

Even though they have become common, there is a debate about whether codes are effective, i.e., a code makes some sort of difference to the behavior of the company. The issue of effectiveness will be returned to later, but one of the things that makes a general answer to the question difficult is that codes vary. It is not so much that they go by a variety of names (e.g., “code of ethics,” “code of conduct,” or a proprietary name, such as The Barclays Way and Lloyds’ Our Values in Action), but that they vary in what they contain and how they are used. To draw a parallel: does marketing work? Sometimes it does, but sometimes it does not. A well-designed and competently implemented marketing campaign can work wonders for sales. However, done badly, it is just a waste of money. Things are no different for codes; just as there are successful cases, there are less impressive examples – though, as will be discussed later, there is the additional possibility that implementation “failure” occurs principally because the substance of the code was not taken seriously by the firm concerned. Thus the content of a code of ethics matters, but so do several other factors associated with its implementation. The remainder of this section will consider, first, what the content of an effective code of ethics will likely look like and how it might be developed. Next, three facets of implementation will be examined: communication, support, and enforcement. Finally, some comments will be made about the importance of reviewing the code.

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Code Content Codes of ethics vary greatly in nature and scope. A company might review existing codes to provide helpful stimulus and guidance, but a code of ethics cannot – or at least should not – be taken “off the shelf.” It is important that a code reflects the company’s particular context, especially the sector in which it operates. This attention to context means that the code should not be full of general abstractions or vague exhortations. If it were, it would be neither useful nor convincing. Thus, even if it contains general statements that might be found in any reasonable corporate code, a bank’s code should differ from, say, that of a retailer, a manufacturer, or a mining company. The code should be oriented toward the particular ethical issues and risks that arise in its line of business. This implies that a code is likely also to vary in its details according to the type of bank, its market position, the sorts of customers it has, and the geographical contexts in which it operates. Even banks which appear externally to have very similar competitive positions in a particular market often possess, internally, rather different organizational cultures and ethical values, and it would be expected that this would be reflected in their codes in some way. This might all be summed up as a matter of ensuring an appropriate fit between code and company. There is also a question of how ambitious the code is. This is a further reason for variations between different codes. Should it simply try to distill the bank’s current practice, seeking to iron out inconsistencies and prevent particularly poor behavior from occurring? Or should the code aim to leverage practice above previous generally accepted standards by seeking to institutionalize the company’s current best practice – or even higher? This second approach is much more challenging because, rather than expressing existing corporate norms, the code is, to some degree, pitched against them. Without considerable supporting effort, such a code is likely to fail. Perhaps one way forward is to express aspirations in general terms but also to make it clear what sort of behavior is required as a minimum – a floor below which it is not permitted to go. The challenge is to make the aspirational “real and relevant,” perhaps by highlighting exemplars for commendation. A crucial aspect to drawing up a code is to get a good balance between the general and the particular. Without claiming to be exhaustive, a code should identify major issues likely to be pertinent to the particular business. It should give practical help to employees in doing their jobs, especially in relation to key ethical risks. However, there are dangers in focusing exclusively on detailed rules. For example, it runs the risk of “legalism,” where those who are so inclined to do so look for loopholes (“where did it say I can’t do that?”) or of a kind of moral “dumbing down,” where people stop thinking and simply try to follow the (necessarily inadequate) rulebook. It is instructive that the Chairman of Lloyds Banking Group refers to Our Values in Action as a “compass.” The Barclays Way refers to the Values of Respect, Integrity, Service, Excellence, and Stewardship (their capitalization) as forming “a centre of gravity, guiding us to behave in the right way and holding us to account” (p. 3). Codes are best anchored in general statements of values, which are probably already expressed in a mission statement or the like. Principles (even if they are

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not called that) can then be expressed. For example, The Barclays Way (p. 9) states the following: 1. 2. 3. 4. 5.

Act with integrity Act with due skill, care and diligence Be open and co-operative with the regulators Treat customers fairly Observe proper standards of market behaviour

Of course, such statements needed to be unpacked and applied operationally, but they serve to provide breadth of coverage and to indicate aspirations. Detailed guidance can then be seen as the most pertinent outworking of those principles, not the last word or an attempt to cover all possibilities. The code should probably not be a long document; excessive detail should be avoided, while reference may be made to detailed policies elsewhere. However, codes need to say something of substance, so a single side of A4 is unlikely to suffice, particularly for a large, complex organization. It is also important that the code is kept as simple and comprehensible as possible, bearing in mind the wide range of people who are expected to understand and apply it. Both the Lloyds and Barclays documents are clearly expressed in plain English. They are not the place for the technical jargon of finance. So far, no mention has been made of who should be responsible for developing the content of the code. Creating a code is almost certainly going to be a central initiative, but there are different approaches to determining its content. Drawing on existing policies and other statements, and based on knowledge of, and aspirations for, their bank, it would not be difficult for the senior management, with the backing of the board of directors, to draw up a highly plausible code. Indeed, some organizations take an essentially top-down approach. However, many commentators would recommend involving a wide range of employees. For example, Webley and Werner (2008) advise that who is involved in the development of the code and how they participate is important. Employees might at least be consulted in some way once a good draft has been developed, but it might be better – for both substantive and symbolic reasons – if some representative employees could contribute their own concerns and experiences at an earlier stage. Employees from different levels of the bank and its specialist functions are likely to have insights that would not necessarily occur to senior central staff, thus improving the quality of the content as well as avoiding the feeling that it has simply been imposed from on high. Employee participation in the creation of the code is likely to increase its acceptability to them, not only because it should be substantively better but also because of the process undertaken. A participative process is more likely to help establish legitimacy and generate commitment to the code when it is introduced. At the end of the development process, a code should display a good balance between the general (ethical values and principles) and particular (rules and illustrations), covering the key issues faced by the bank and reflecting its aspirations. Nevertheless, while appropriate content is necessary, it is not sufficient.

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The code also needs to be “embedded” in the organization in order for it to “live” (Kaptein 2017). The remainder of this section focuses on implementation, on turning a good code into good behavior.

Communication A code is not supposed to be just filed away. To be effective, it has to be communicated properly to the various parties whose behavior is intended to be shaped by it. It is notable that Lloyds’ Our Values in Action and The Barclays Way are both attractively produced booklets found easily in PDF format on the Internet. The audience will chiefly be employees, but it could also include third parties such as contractors that are undertaking business for the organization, or suppliers in certain cases – although they might be bound by a different policy document. For example, a bank will probably want to include an IT company to which it outsources work or workers who are employed through an agency. Other parties not bound by the code but which have a legitimate interest in it, e.g., customers or regulators, will also need to have the code communicated to them or at least easily available should they seek it. The Barclays Way states that it applies to all employees and all colleagues in subsidiaries in which Barclays has a controlling interest. Where Barclays has only a minority interest and is involved in a joint venture or other entities or individuals are working on its behalf, they are “encouraged proactively to adopt an equivalent approach” (p. 5). Codes are usually also made publicly visible, e. g., on the company’s website, so customers and other external stakeholders have some idea of what they should be able to expect – and can react accordingly if they do not experience it. If a code has been developed in a participative manner, its adoption should not come as a surprise to employees; thus the process of development itself can ensure a degree of communication. Moreover, when a code is introduced, there is likely to be a flurry of activity via internal corporate communication channels. However, telling people once is insufficient. They need to be reminded about it periodically, with references and links to the code included in company documentation, intranet pages, manuals, and the like. This is especially important once the company has had a code for some time. The code also needs to feature in training (both Lloyds and Barclays refer to annual training), which provides an opportunity not only to refresh staff’s knowledge of it but also – if done well – to focus on and explore the issues and implications most relevant to them. It should also be included in staff induction – and not just something to be mentioned and signed off on, but something that is shown to be important. The code, or aspects of the company’s business that would require reference to it, should also be included in regular activities such as “away days” or staff meetings that are not purely operational. Communication can take many forms. It is often said that “actions speak louder than words,” so it is important that top management sets an example and demonstrates its commitment to the code. After all, they are employees too. This is often

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referred to as tone at (or from) the top, but it applies to anyone with leadership responsibilities within the organization – though top managers’ words and behavior are particularly important. Do they “walk the talk”? Indeed, do they even mention the code once it has been in place for a while? If top management is not seen to be serious about the code, why would it be taken seriously by other employees?

Support A good code that has been well communicated is likely to be acceptable to, or even positively endorsed by, the vast majority of staff – not least because they do not want to be working with unethical colleagues. However, a positive attitude toward a code does not, in itself, make it easy to follow in all circumstances. Support is therefore important. Lloyds’ Our Values in Action (pp. 16–17) is not unusual in having a section on “How to raise a concern.” There can be two sorts of problems. First is the issue of interpretation, of coming to an appropriate judgment. As already explained, no code of reasonable length can be expected to deal conclusively with every possible issue and situation that might arise. Banks and other financial institutions tend to be large, complex, and dynamic. Judgment based on ethical values, principles, and cognate situations will be needed on the part of those bound by the code. However, sometimes an employee might not be sure about the appropriate course of action. In such a situation, it is useful to get a second opinion. In many cases the employee’s line manager will be the first person to approach, but for times when they are incapable of resolving the issue (or perhaps even part of the problem), a company should consider having in place other forms of support, such as local ethics “champions” or “ambassadors” (who also hold a normal organizational role, whether line or staff) or an ethics “hotline” to a central support function. Simply talking things through can be helpful, but advice from someone who is more highly trained and experienced in applying the code can be especially useful. The second issue is the challenge of forming and carrying through an intention to act based on the judgment, whether that judgment was relatively straightforward to come to or more complex. Acting in a particular way might place demands upon an employee and even require courage. The line of least resistance is often the most attractive, and temptation does not go away even when it is clear what the right thing to do is. Again, the example and attitudes of colleagues are important.

Enforcement The provision of support indicates that a code is being taken seriously, but enforcement mechanisms appear to be a crucial additional element. Some contraventions of a code will be discovered fortuitously or reported on an ad hoc basis, but companies taking the implementation of their code seriously will also wish to monitor compliance on a more systematic basis. Many companies have in place internal whistleblowing or “speak-up” mechanisms, through which concerns can be raised and

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alleged contraventions of the code reported safely. This does not mean that all staff who witness a possible breach will report it, but it increases the probability that they will do so, especially if they trust the process. Sanctions can be serious, up to and including dismissal. Staff soon get to hear of such instances, and, indeed, the organization might well publicize cases, even if only internally. It is worth noting that the disciplining of behavior that falls short of what a code requires is, up to a certain point, a “good thing.” It demonstrates to both insiders and outsiders that the code is taken seriously. It provides a message for employees that they need to take it seriously and, for those who are not committed to it for its own sake, disciplinary procedures provide a degree of deterrent. Thus a code does not necessarily prevent all unethical behavior, but it helps to identify it and so enable appropriate action to be taken – and in doing so, it probably reduces future unethical behavior. Lloyds’ Our Values in Action (p. 8) not only encourages colleagues to live up to the code but also refers to the possible consequences of failing to do so.

Review However much effort is put into developing a code, it would be unwise to assume its content and presentation could never be improved upon. It makes sense to review the code from time, establishing a process in which employees can be involved and drawing on experience of its operation, such as requests for advice and infractions of the code. It is notable that a brief piece of text on the final page (p. 32) of Lloyds’ Our Values in Action invites queries or comments to be sent, apparently by post, to the Group Chief Executive’s Office. Employees should again be involved. Furthermore, businesses and their circumstances change over time, with new ethical risks arising or existing ones becoming more or less serious. To amend a code too often can be confusing and undermine its credibility, but, even if no significant problems have arisen, it probably makes sense to undertake a regular review; every 3 years or so might be reasonable. The review and its outcome provide a further opportunity to communicate about the code.

Assessment of Corporate Codes of Ethics Having set out many of the issues that arise in the development and implementation of codes of ethics, it is important to address the question of whether they are effective. They have certainly attracted criticism. Some of the criticisms of codes are rather general in nature. For example, some authors criticize them for being about the control of employees. However, authors such as Webley and Werner (2008) take it for granted that codes are there to affect employee behavior. After all, if codes were not there to do that, codes would then become susceptible to the criticism of not attempting to make a difference to the behavior of companies. It is employees who are supposed to be acting in certain,

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ostensibly good ways. Perhaps two assumptions implicit in the criticism need to be addressed. First, it is not necessarily the case that employees are a homogeneous group; in practice, most employees are likely to be keen that their less ethically reliable colleagues abide by the code or are dealt with if they do not. Second, some critics seem to see codes as being about the control of employees by management. At one level this is true, but advocates for codes usually make it clear that the code should apply to all members of staff, including top managers. It is notable that The Barclays Way makes strong reference to “we” rather than “you” and the Lloyds document is “Our” Values in Action. This is consistent with the notion that the code’s credibility is enhanced by top managers “walking the talk.” Many codes state this explicitly, and some make specific mention of board directors too. Another criticism is that codes do not address certain issues or behavior toward certain stakeholders. They are criticized for what they omit. However, some of these concerns might be addressed in separate policies, for example, regarding CSR or the supply chain. Furthermore, many internal policies also carry ethical import. For example, in the HR area, there are likely to be many policies that deal with issues of ethical significance, such as discrimination or bullying and harassment. Indeed, both of these issues are explicitly addressed in The Barclays Way (p. 13), although they are presumably covered in greater depth in the actual HR policies. In the case of Lloyds, Our Values in Action refers to “extra resources” (p. 9): the Group Ethics and Responsibility Policy; the Colleague Conduct Policy; and the Code of Supplier Responsibility. To sum up, a code of ethics is rarely intended to cover all the ethical issues facing an organization, but that does not mean that they are not dealt with by the company. That they are not part of a so-called code of ethics seems less a substantive criticism than a matter of definitional nicety, at least without further knowledge about the context. Thus it should be recognized that, in practice, the scope of codes of ethics is not as wide as some academic commentators might want it to be. Perhaps that means a code of ethics should not be called that; but many are not, in any case – as the Barclays and Lloyds examples show. Given what codes of ethics do cover, though, the important question is whether they are effective. Some scholars are skeptical. For example, Warren (1993) describes codes as “superficial and distracting answers to the question of how to promote ethical behaviour in corporate life” (Warren 1993, p. 186). However, even supporters would not disagree with the proposition that some codes are useless or even misused. Webley and Werner (2008) wisely counsel that a code on its own is never sufficient, though it might be regarded as necessary (or useful, at least). Kaptein (2017) sums up his position in the following “formula” to ensure that a code “lives”: Effectiveness ¼ Content  Embedding Embedding can be viewed as having two levels. At the first level are the processes around the code, such as how it is developed, communicated, supported, enforced, and reviewed, to use the categories employed earlier. At the second level is the broader context. Webley and Werner (2008) conclude that a code not only needs to

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be well designed but also requires sustained ethical leadership and incorporation of ethics in organizational processes and strategy, as part of an ethical culture at all levels of the organization. The IBE, for which Webley has worked for many years, has a business ethics framework, which sees ethical values as embedded in a code of ethics, which is supported by communication and engagement; training and reinforcement; leadership, a supportive environment and “speak up”; and risk assessment, monitoring, and accountability (Institute of Business Ethics 2016). Thus, a code can make a contribution, but it will accomplish little or nothing on its own, even if looks to be a good one on paper. Molander (1987, p. 631) provides a fair summary: A well written ethical code, reliably and fairly enforced, can eliminate unethical practices, relieve ethical dilemmas and throughout the process demonstrate a firm’s or industry’s commitment to ethical conduct. If poorly designed and implemented, the code will not only be ineffectual but could further reduce business’s credibility with the general public and important opinion-forming institutions in the society.

The variety in the content of codes, how they are implemented, and the context in which they are situated make the empirical assessment of their effectiveness challenging. Contrary to the implications of the rather general comments of some critics, it is not sufficient simply to take a dummy variable indicating the presence or absence of a code and seek to relate this to some outcome(s). Building up a sound evidence base is a more complex endeavor. Much of the research on codes, especially in the early years, focused on their content, but in the most recent of a series of reviews of empirical research on codes of ethics, Babri et al. (2019) note that more studies have tried to answer the “golden question” of whether codes are effective. The overall view emerging in recent years, according to Babri et al., is that a majority of studies show somewhat positive effects, even when outcomes are measured in various ways. This does not show that all codes are effective; but the earlier discussion in this chapter gave no grounds for supposing that they would be. However, the results do suggest that codes can make a difference, which then shifts the question to what makes them effective. The complexity of the variables involved poses a challenge to finding clear answers, but the insights that have emerged appear to be consistent with the points made earlier about the formal and informal factors that are needed to make a well-constructed code work. None of this means that companies with codes will never do unethical things. In some cases, top management does not take the code seriously. The classic example would be Enron, which had all the trappings in place, but underneath was something very different. Such cases add to the skepticism, not to say cynicism, voiced by critics of codes. That is understandable, but it does not mean all codes are a smoke screen. Indeed, there is an unfortunate incentive structure here: the more that some companies use codes in a genuine way to improve their behavior, the greater incentive there is for a less virtuous company to institute a sham code of ethics. However, even a “good,” well-implemented code will not eradicate all bad behavior. One reasonable defense of codes is that they might reduce rather than eliminate bad behavior; perfection is no more to be expected in this aspect

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of organizational life than any other. Moreover, consider an example from the law. A law (with associated punishments) might reduce theft, but it will not eradicate it; but it does something else too – it helps to define and thus identify certain behavior as wrong and therefore liable to punishment. So it is with codes of ethics: they help to show what is right or wrong, both before and after the event. A conclusion of significance can be drawn at this point. Contra the arch skeptics, although codes are not always effective (and certainly are not perfect), they can be useful. Not all codes are the same, and some are operationalized better than others. It is therefore unwise to lump them all together when judging them – or to expect too much of them. Furthermore, some of the debate in the academic literature seems to imply that the key question is whether or not companies should have codes. However, most large companies, including many financial institutions, already have codes. The more important question then is how those codes can be of value, which is what the preceding discussion has focused on.

Beyond Financial Institutions: Other Codes The codes of individual financial institutions might be the most conspicuous, but they are not the only codes of ethical relevance to finance. Two particular types of code stand out. First, there are sector codes or “industry codes,” usually developed and promulgated by a trade organization. Such codes are present in many sectors, often developed as a result of public criticism or government pressure and designed to head off further criticism or regulation. An example is the “Code of Bank’s Commitment to Customers,” a voluntary code developed and promulgated by the Banking Codes and Standards Board of India (BCSBI), which is an independent industry watchdog that aims to protect consumers of banking services. The second type of code is the professional code. Professions have special obligations that go beyond ordinary morality and the law. A code of ethics is one means by which they are supposed to serve the public interest. It should be acknowledged that there are mixed views about the overall benefits – or otherwise – of professions, but the current author has argued elsewhere (Cowton 2009, 2019) that this should be empirically assessed, not just presumed. Moreover, while professions exist, it makes sense to advocate for them to fulfill their societal potential. This is similar to my earlier general argument about company codes of ethics, and many of the issues related to the effective implementation of a professional body’s code of ethics are similar to those that apply to a bank’s corporate code, albeit in a contextualized manner. For example, whereas a bank will need to ensure that new members of staff cover ethics in their induction process, a professional body is able to include ethical issues in the qualification process. It will also need to keep existing members’ knowledge refreshed and updated if the code is amended, through communication and continuing professional development. It should also provide guidance and support (e.g., through an ethics advice line) to members who are encountering ethical challenges. Finally, there should be a disciplinary process for those who do not abide by the code.

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There are three ways in which professionals (as a category), with their codes of ethics, interact with financial institutions. (See Cowton (2019) for a more extended discussion.) First, there are professionals that are external to financial institutions but provide services to them. This is the classic position of a professional; an independent expert, singly or in a professional firm, providing services to a client. Auditors and major law firms are clear examples. They do not always get things right (e.g., see Coffee’s (2006) analysis of the failures of the auditors (Arthur Andersen) and other external “gatekeepers” in the notorious case of Enron), but if they follow a good code of professional ethics diligently and with sound judgment, it is likely to be to the benefit of financial institutions and their stakeholders. Second, many members of professional bodies (e.g., accountants) are not independent practitioners but are employed by financial institutions. These may be referred to as “embedded professionals,” who bring their professional skills and attitudes to the financial institution on an extended, exclusive basis while subject to an external ethical code. To the extent that an embedded professional feels pressured to act in ways that are incompatible with their code of professional ethics, they experience organizational-professional conflict. When they choose to follow their professional ethics, it can be said that a code has made a positive ethical impact. This (conflict and possible resolution) is more likely to occur if the organization itself does not have a good corporate code or has one that it does not take seriously. Finally, there is a further type of employee who might be subject to a code of professional ethics, which I term the “sector professional.” The finance sector involves many relevant professional bodies (e.g., the CFA Institute, the Chartered Insurance Institute, and the Chartered Banker Institute). Members of such bodies would be expected to be strong upholders of a corporate code of ethics and, indeed, to go beyond it when appropriate. Financial institutions have not always been strong supporters of sector professional bodies in the past, but it is to be hoped that they will do more in the future. There are some encouraging signs at present. In conclusion, some of the biggest critics of the banking sector might be among the most skeptical of professions and their codes (and of codes of ethics in general, probably), but a more nuanced view of professions opens up the possibility of recognizing that well-functioning professional bodies with real influence might offer some measure of what the critics of ethics in the finance sector are seeking.

Conclusion Whatever the detail regarding causes, the global financial crisis (GFC) and other “scandals” confirmed that the ethics of banks and the finance sector more generally probably needed to be improved. One of the most prominent business ethics tool is the code of ethics, by whatever name it is known. Although – or perhaps because – codes of ethics are now very common, especially among large corporations, there is a degree of skepticism toward them. A healthy degree of skepticism might be in order, but it is the contention of this chapter that codes can be a useful tool for

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improving financial institutions’ behavior. Certainly, they can be misused – especially as window dressing – and they are insufficient on their own. However, if taken seriously and implemented well as part of an institution’s approach to managing ethics, they have much to offer. This does not mean that all employees’ behavior will live up to the code. However, a code helps to define and thus identify behavior that falls short of required standards and thus provides an opportunity for an appropriate reaction. There are no easy solutions to ensuring ethical behavior, but a code of ethics is too valuable a weapon not to have in the armory of a financial institution that is serious about engaging in the ethics battle. It is to be hoped that financial institutions will engage well with codes in the future, including the professional codes of ethics to which some of their staff (and hopefully an increasing number) are subject.

References Babri M, Davidson B, Helin S (2019) An updated inquiry into the study of corporate codes of ethics: 2005–2016. J Bus Ethics. https://doi.org/10.1007/s10551-019-04192-x Barclays, The Barclays Way, https://home.barclays/content/dam/home-barclays/documents/citizen ship/the-way-we-do-business/The-Barclays-Way-Campaign-2018-Online.pdf Coffee JC Jr (2006) Gatekeepers: the professions and corporate governance. Oxford University Press, Oxford Cowton CJ (2009) Accounting and the ethics challenge: re-membering the professional body. Account Bus Res 39(3):177–189 Cowton C (2019) Professional responsibility and the banks. In: Cowton C, Dempsey J, Sorell T (eds) Business ethics after the global financial crisis: lessons from the crash. Routledge, New York, pp 106–126 Institute of Business Ethics (2016) Enhancing the effectiveness of the ethics function (IBE business ethics briefing, issue 54). https://www.ibe.org.uk/userassets/briefings/b54_ethicsfunction.pdf Kaptein M (2017) The living code: embedding ethics into the corporate DNA. Routledge, Abingdon Kaptein M, Schwartz M (2008) The effectiveness of business codes: a critical examination of existing studies and the development of an integrated research model. J Bus Ethics 77(2):111–127 Lloyds Banking Group, Our values in action, https://www.lloydsbankinggroup.com/globalassets/ our-group/responsible-business/download-centre/helping-britain-prosper-2017/lbg_pro sperupdate2017_2017codeofresponsibility_pdf.pdf Molander EA (1987) A paradigm for design, promulgation and enforcement of ethical codes. J Bus Ethics 6(8):619–631 Warren RC (1993) Codes of ethics: bricks without straw. Bus Ethics: Eur Rev 2(4):185–191 Webley S, Werner A (2008) Corporate codes of ethics: necessary but not sufficient. Bus Ethics: Eur Rev 17(4):405–415 Whitley R (1986) The transformation of business finance into financial economics: the roles of academic expansion and changes in U.S. capital markets. Acc Organ Soc 11(2):171–192

Ethics in Finance as the Result of a Strong Systemic Commitment Auribus Teneo Lupum Mauricio Humberto Baquero-Herrera

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Some Features of the Financial Markets That Make Them Unique . . . . . . . . . . . . . . . . . . . . . . . . . . . . . How to Control Conduct in the Financial World? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Is There Such a Thing as Ethics in Finance? The View of Financial Regulators, Supervisors, and Central Bankers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary and Final Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

The financial world is pragmatic, eager to gain profits, and has a core purpose: increasing wealth, not for everyone but for specific groups of people. Equally, finance relies on other people’s money to obtain positive economic outcomes. The financial business has also become more transactional than relational and has always been prone to market failures. On top of that, the natural risks that are proper in financial activities are transferred in the markets by moving liability from hand to hand until it turns out to be too late. Bearing in mind these unique features, is there such a thing as ethics in finance? Can we talk about ethical financial institutions? If there is and we can, is this a subject matter that can be dealt with by establishing general standards of behavior aimed at being applied to all people and institutions involved? Establishing rules of conduct has been the role of regulators. Moreover, subjecting public and private institutions to monitoring and sanctioning noncompliance with such rules has been the role of states. Then, what is the purpose of financial ethics? The complex decisions people and institutions must make every day while managing other people’s money and financial assets need an approach compatible with the purpose of such businesses. Thus, it appears that relying on traditional ethics in the financial markets to correct improper behavior seems to be a dreamer’s desire rather than a real M. H. Baquero-Herrera (*) Derecho, Universidad Alberto Hurtado, Santiago de Chile, Chile © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_2

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solution. Therefore, this chapter proposes some ideas that could contribute to the construction of an adequate ethical approach to the provision of financial services in a globalized financial world. Keywords

Ethics in finance · Responsibility of financiers · Financial services ethical practices · Ethical standards in the financial world · Governance of financial institutions · Ethics of risk management · Financial scandals · Capital requirements to gain ethical behavior · Ethics in finance and regulation · Prudential regulation and ethics

Introduction The financial world has unique features, some of which are pointed out in the first section of this document. Taking into consideration these characteristics, is there such a thing as ethics in finance? Can we talk about ethical financial institutions? Can we get access to ethic financial services? What do these questions mean for a financial institution aimed at maximizing profits? What do they imply for the board of directors of such companies? For their employees that are hired to generate outstanding economic outcomes? All in all, what is the purpose of financial ethics? This chapter will not provide the answers to these fundamental questions. It contains reflections from a lawyer that has witnessed and studied financial crises and financial scandals for more than 25 years. The complex decisions people and institutions must make every day while managing other people’s money and financial assets needs an ethical approach compatible with the purpose of such businesses. That is why this chapter does not rely on ethics experts, but by reflecting on the words of the main executives at central banks, financial regulators, and supervisors, when speaking about financial ethics. After decades of establishing a comprehensive set of standards aimed at avoiding financial crises, massive financial turmoil occurred in 2008. At the time of this paper, more than 10 years have passed, and the world still resents the economic consequences of these grim events. On top of that, the SARS-CoV-2 pandemic has hit the world, and with it, has shown the true colors of financial entities with relation to troubled debtors. Certainly, regulation has been an important instrument for impeding reckless and improper behavior in the financial markets. However, it has not clearly been enough to stop greediness and selfishness. If gaining profits is the incentive that guides everyday behavior for people and institutions involved in the financial markets, losing all of them should be the consequence of profiting through improper conducts. Requiring more capital from shareholders and provisioning losses related to bad behavior should be the subsequent step. If the financial industry starts adopting these criteria when there is a breach of ethical behavior, this strong systemic commitment will lead to auribus teneo lupum.

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Some Features of the Financial Markets That Make Them Unique There are different financial services provided in the financial system. In general, adopting a broad definition of financial services, the financial services industry is composed of commercial banking, investment banking, insurance, and in some cases, asset management (Group of Ten 2001). There are specific institutions that provide these services such as depositary institutions (banks), securities firms, and insurance companies. Along with these activities and institutions, there is financial market infrastructure that facilitates the provision of financial services within the financial markets, whether local or international. Payment systems, central securities depositories, securities settlement systems, central counterparties, and trade repositories are examples (CPSS 2012). At the same time, during the past decades, the provision of financial services is conducted through multinational or domestic financial conglomerates (JF 2012). A key issue to consider is that financial services are produced by and offered to people. At the same time, in the real world, financial institutions are created, run, and developed by people. From the legal perspective, this subject could be argued. A corporation is usually considered a legal person. Some legislation even suppose that, in some cases, corporations even have, will, or could be criminally prosecuted as legal persons. However, this representation of a corporation as a legal person at the end will need a human or a group of human beings able to make decisions within the company, to represent it to third parties, and more importantly, a person or group of people that are registered as its owners. Equally, financial institutions cannot think by themselves. Financial institutions as corporations depend on their charters and on the regulation applicable. They do not have a free will. They cannot make decisions. The conduct of a financial institution depends on the people that own, manage, or represent it. This human element is at the core of our reflections on ethics in the financial world, and it supposes a paradox. It is so, since financial institutions depend on human beings. But, at the same time, human beings related to those institutions, whether owning them, managing, or working for them, must follow the corporation’s charter and comply with decisions made by its owners and the applicable regulations. Thus, this document argues that when considering ethics within financial institutions, one has to bear in mind that such entities do not have the capacity to think, to make decisions, or to carry out actions on their own. There must always be a group of human beings agreeing upon, instructing, and implementing such conduct. Similarly, such groups of human beings have different duties that will depend on the role they play within the institution. But nevertheless, all interested groups involved must comply with private (charter) and public regulations (i.e., corporate law, banking, and financial and insurance regulation, as appropriate). Furthermore, the owners could provide an outline of distinct behavior within the institution by providing in its charter, specific ethic commitments for the board of directors and all people involved in the company. Quite often, they do not do it.

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As a consequence, an ethical financial institution per se does not exist. The ethics of the institution will depend on the people involved within. Simultaneously, the conduct of people that, for instance, manage the financial institution will be shaped by the type of business the company must run according to its charter and by the interests that every person and group working in the financial institution has (Stingler 1980; for a different approach, Thaler and Sunstein (2009)). In this sense, the ethics of a financial institution is a complex issue. First, it is the result of the relationship between people’s duties and their own interests within the company. Second, it is the consequence of the purpose and activities determined by its shareholders in the company’s charter. Third, it is the result of compliance with the state’s regulations. It is a worldwide lament that financial systems are overregulated or are the subject of an inadequate regulation (Stiglitz 2001). Therefore, conduct of business shaped by regulations may be susceptible to loopholes and gaps that may allow room for misconduct that, in some cases, could be considered lawful but not ethical. Fourth, people do not behave in a vacuum. There is a culture that shapes the conduct of every human being in his country, city, neighborhood, and profession, as well as his home (Awrey et al. 2013). The financial world is pragmatic, is eager to gain profits, and has a core purpose: increasing wealth, not for everyone but for specific groups of people. Shareholders are usually the focus of this analysis. Shareholders, as the main providers of capital for the company, are entitled to make decisions regarding the financial institution according to its charter and the corporative law applicable. From its creation, it is expected that a financial institution, as a corporation, must produce profit. And, this output belongs to the shareholders not the financial institution. That is the purpose of its creation since they provide capital as well as all different means that enables it to undertake business and be profitable. Furthermore, governments do not allow the establishment or the existence of a financial institution if it does not succeed in the industry by creating revenue. However, financial institutions are not lucrative only due to having adequate capital. Such legal entities are composed by groups of diverse people that perform various activities that, in the end, make it gainful. And they do so in a highly competitive industry. The use of incentives such as employee compensation is a strategy that could yield economic benefits for the financial institution as well as for the directors and employees involved. Nevertheless, it may create negative effects for the company’s reputation and its financial health as it may end up rewarding sales volume and short-term profits (Mminele 2014). Sales managers, marketing executives, and more importantly, the members of the board of directors could be negatively influenced in their conduct of business due to such incentives. Therefore, along with the establishment of said incentives, there must be a culture of malpractices control. Another important feature of financial institutions is that they depend on other people’s money to obtain positive economic outcomes. This is the main component of commercial banking. The origin of banking businesses is based on the transformation of deposits into credits. Banks do not perform loans only with their own

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capital, but mainly with their client’s money. Equally, in the stock markets, companies issue securities with the aim of getting access to third parties’ capital. At the same time, asset management relies on money of third parties as well. All financial companies need to perform their business on economies of scale (Stigler 1958). Thus, people managing and working for such institutions are in contact, on a daily basis, with enormous amounts of money and assets that belong to third parties. In addition, the changing nature of financial business has transformed them into much more transactional rather than relational operators (Carney 2014). As there are more intermediaries, the link between the original service provider and the end-consumer starts to erode (Mminele 2014). As a consequence, confidence between parties, which is at the origin of every financial transaction, starts to fade. At the same time, there are important market failures in financial business (Stiglitz 1989): Asymmetries of information are present in almost all financial transactions. This might mean reaching unfair agreements for parties involved in a financial transaction. However, it could hopefully be resolved by trust, transparency, and professionalism. But, sometimes, it is not. Financial markets are also prone to monopolistic and oligopolistic structures. These features may create competition problems as well as abuse of the financial consumer. More importantly, financial markets could give rise to negative externalities able to crush the overall economy. Financial crises are the more radical example of them. And such crises expose the moral hazard issue in the commercial banking sector: Banks enjoy an implicit guarantee of government bailout. In other words, banking business might mean, for shareholders and the institution management, the privatization of profit and socialization of losses (Subbarao 2009). Another central aspect of financial institutions is that the natural risks that are proper of their activities are transferred in the markets moving liability from hand to hand until it is too late for the final bearer (JF 2013). All financial assets and financial operations carry financial risks that should be recognized by all parties involved. When those risks are not clearly identified and disclosed, by mistake or on purpose, legal and ethical issues start to arise. These special characteristics of the financial institutions – using customer’s money to gain profits, being built on economies of scale, becoming more transactional rather than relational, being prone to market failures and moving risk exposure – are the basis for a crucial type of regulation called prudential regulation. It is aimed at creating behavioral incentives for managers, employees, and shareholders by imposing capital requirements when risks associated with the financial institutions’ activities are not properly controlled. If the company is undertaking important risks, it will require more capital from its shareholders (Walter 2010; see also Basel Committee 2020; IOSCO 2017; IAIS 2003). Therefore, people within the organizations must behave with prudence, otherwise their conduct will increase the cost of doing business for the financial institutions and their owners. This strategy has been at the center of the work of regulators and supervisors all over the world over the past few decades (Baquero Herrera 2007). And it seems to work, as will be discussed in the following section.

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How to Control Conduct in the Financial World? Past and recent financial crises always emphasized that the financial world continuously needs special legal and supervisory rules (Kindleberger 2012). State intervention through the introduction of different types of regulation, establishes minimum standards of behavior for people and institutions involved in the provision of financial services (Bailey 2013). Therefore, instituting rules of conduct has been the role of regulators. Moreover, setting up institutions public and private for monitoring and sanctioning not compliant with such rules has been the role of states (Crockett 2003). Certainly, the protection of financial stability has become a global public good. The strategy for guarding global financial stability was set up at international level in the second half of the twentieth century. Due to several financial crises that had occurred in emerging economies with the capacity to affect financial markets all over the world, the G-10 group at the 1996 Lyon summit discussed the issue. As a result, global leaders imposed different international institutions the duty of issuing global standards of regulation and supervision of financial institutions (BIS/IMF 1997). During the last few decades, such work has been performed by standard setters specialized in the regulation and supervision of specific financial markets. For commercial banks, the Basel Committee on Banking Supervision focused on issuing a comprehensive set of regulatory and supervisory standards related to that market (BCBS 2006a, b, 2020). For securities, the International Organization of Securities Commissions addressed financial activities (IOSCO 2003), whereas the International Association of Insurance Supervisors did the same for the insurance industry (IAIS 2003). At the same time, the committee on payments and market infrastructures started to make recommendations about the safety and efficiency of payment, clearing, settlement, and related arrangements (CPSS 2012). While all these standard setters regulated financial institutions and set up the minimum requirements for their adequate regulation and supervision, other international institutions focused on the core aspects of financial activities. Among them, financial consumer protection (OECD 2011); pension funds (IOPS 2006); corporate governance (OECD 2015); effective deposit insurance systems (FSF 2011); effective resolution regimes for financial institutions (FSB 2014); insolvency and creditor rights (WB 2015); and measures to combat money laundering and terrorist financing, as well as the financing of proliferation of weapons of mass destruction (FATF Recommendations 2019). Notwithstanding such efforts, the global subprime crisis occurred (Dudley 2009). It spelled out again that the complexity of financial markets makes them exposed not only to their inherent risks, but to human behavior, exacerbated by greediness and selfishness (Mahapatra (2012). However, the reaction to the financial crisis did not change the strategy already in place. It focused on making it stronger (Restoy 2017). A new powerful standard setter was established by the G-20: The Financial Stability Board (FSB) was entrusted with the task of promoting global financial stability. The regulation of financial conglomerates was also strengthened (JF 2012), and the Basel Committee on Banking Supervision clung on to capital adequacy regulation (BCBS

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2020). At the same time, governments made sure that moral hazard was tamed by limiting bailouts of troubled financial institutions (Carstens 2019). Why, after the recent financial crises, the focus of the main regulation in place, aimed at avoiding systemic risk, is still the same? Because it seems that the approach is going in the right direction. Regulation usually promotes certain behavior on people. It can be done by prohibiting and sanctioning bad conduct and malpractice. This has been the traditional practice. But also, it can be achieved by creating incentives that entice people to perform in the way regulators want. This is the case of prudential regulation. During the past decades, it has been issued with a strong emphasis on creating the right incentives (Bailey 2016). If financial institutions are eager to gain profits, introducing regulation able to reduce them when senior managers do not perform in the way prudential regulation requires has proved to be an efficient incentive to get administrators to behave. At the same time, requesting more capital from shareholders when financial activities grow riskier has become the core prudential rule in the financial world. In both cases, senior managers that are accountable to the shareholders must explain to them why profits are lower, and they must provide more capital due to poor management decisions. Then, the prudent conduction of business is not the consequence of introducing prohibitions or criminal prosecution. It is not due to a strong ethical commitment of senior managers. Regulators have understood the importance of aligning the purpose of regulation with the nature of the financial industry. This document proposes that ethics in finance should follow suit.

Is There Such a Thing as Ethics in Finance? The View of Financial Regulators, Supervisors, and Central Bankers Everyone seems to accept that, apart from an enabling environment, proper infrastructure, skills, and knowledge, a responsible and ethical behavior of the participants is a prerequisite for efficient and well-functioning markets (Anwar 2012). Therefore, it is important for the financial system “(. . .) to cultivate a situational environment and broader system that encourage genuine professionalism and integrity of the people in the system” (Ghaffour 2017). Rule books are often imposed by regulators to introduce ethics on financial activities (Joshi 2013). Adopting a code of conduct, a code of ethics, or the like within the financial institutions is a usual step that reflects a corporate effort on ethics that might only exist on paper (Dombret 2015). There is sometimes a gap between what banks claim and what they do (Carse 1999). Creating a corporate culture able to influence the behavior of each individual employee is desirable (Baxter 2019). But, as Menon states, culture and conduct practices are uneven in the industry as some financial institutions “(. . .) are only starting to develop tools and indicators to obtain a holistic, cross-functional view of the culture within their organization” (Menon 2019). It might take years with few results if such culture is not aligned with the nature and main purposes of the financial institutions.

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Such organizations are created to gain profits by selling financial products. More profits usually mean higher bonuses for employees. As Khan describes it, “(. . .) individuals in the financial markets are usually specialized in science and technology who might tend to self-interest and greed,” which might lead them to mis-sell products to unsophisticated investors/borrowers. Thus, he proposes that all those who join finance professions “(. . .) must be required to have gone through valuebased education and socially relevant experiences during their college days” (Khan 2012). In a word, educational institutions must provide to the financial markets a work force with individual morality and social ethics aimed at responsible financial behavior (Ferguson 2004). Will this dream come true some day? What do we do meanwhile? Others in the same direction propose that the foundations of ethical behavior in financial institutions “(. . .) go well beyond corporate culture and policies. These are rooted in one’s moral training, lessons parents and school teachers have taught from early childhood on which affect not just individual behaviour the competitive business environment and indeed society as a whole” (Joshi 2013). In this sense, educators must have helped them to develop “(. . .) the ethical compass and the moral fortitude to adhere to doing things the right way” (Tetangco 2009). What happens if such requirements have not been fulfilled by parents and school teachers? Some regulators’ approaches understand ethical behavior as to “(. . .) set a good example and be a role model” Narube (2009). In this sense, it is expected that when people see something wrong they say something. As Dudley proposes, “cultures do not change simply by exhortation.” Therefore, financial institutions must “(. . .) encourage a culture that spots issues and raises concerns early.” To do so, “managers have to lead by example” and employees “(. . .) who speak up should be recognized” (Dudley 2017; See also Desario 1997). Stiroh, in an interesting speech, relates ethical behavior with corporate governance. He claims that misconduct in the financial sector is not just the product of a few individuals or bad processes, “(. . .) but rather the result of wider organizational breakdowns, enabled by a firm’s culture.” To tackle this problem, he focuses on cultural capital. In his own words, it is “(. . .) a type of asset that impacts what a firm produces and how it operates.” So, “(. . .) in an organization with a high level of cultural capital, misconduct risk is low and observed structures, processes, formal incentives, and desired business outcomes are consistent with the firm’s stated values.” Therefore, supervisors must increase their focus “(. . .) on firms’ decisionmaking practices and behaviors as a core aspect of good governance” in order to “(. . .) understand how a firm manages misconduct risk and to improve resiliency and reduce the potential for unwanted disruptions to financial intermediation” (Stiroh 2017). On the other hand, when analyzing the subprime crisis, Bini considers that the appeal to ethics and individual morality is an important starting point to correct the distortions that he found in his studies of such financial crisis. But to him, it is not enough. It is so, because “(. . .) unethical practices make it possible to obtain higher returns, those who do not follow them are likely to be penalised. In other words, those who comply with the dictates of ethics may not perform economically so well

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as those who do not, and so may find themselves out of the market” (Bini Smaghi 2010). Another important factor that contributes to making it difficult to attain ethical behavior within financial institutions has been pointed out by Chan: the short termism of shareholders that laid pressure on bank management: “(. . .) board directors and senior management were, and still are, under constant pressure to pursue higher RoEs. It is not difficult to see why capital raising, which improves the resilience of banks, is often rejected or delayed as it is negative for share prices in the short term. The result? Banks have no choice but to leverage up and take bigger risk in order to meet the targets that the shareholders demand” (Chan 2015). So, as Gjedrem Sijbrand states, focusing on “managing for value” only, banks lost track by preferring both short-term and instrumental thinking. “Clients became instruments to extract money from in order to maximize profits and thus increase shareholder value. Employees were hired on the basis of their capacity to make as much money as possible and as fast as possible, rather than for their capacity to make a sustainable contribution to the bank” (Sijbrand 2013). At the end, as Mahapatra recognizes, “(. . .) the malaise that we have seen in the financial sector might in fact be a result of degradation of value systems in the society as a whole” (Mahapatra 2012). Is there then, a solution? Would it be possible to move forward from “ethical drift” to “ethical lift” in the financial markets? (Shafik 2016; Carney 2017). Perhaps, as certain supervisors understand it, behaving ethically “(. . .) is not only the right thing for banks to do, it also makes sound business sense” (Carse 1999). Thus, not only ethics should be integrated into business strategy, but it also must be considered within the nature of financial institutions and their businesses (Dudley 2014). Following Villeroy de Galhau, “Good performances can neither excuse nor compensate for questionable ethical behaviour. Results obtained at the expense of ethical standards should not be rewarded. On the contrary, they should be penalised in order to send the right message with regards to expected behaviour, including from the managers of the employees concerned” (Villeroy de Galhau 2018). How to achieve this? The following section proposes some ideas that could contribute to the construction of an adequate ethical approach to the provision of financial services in a globalized financial world.

Summary and Final Remarks The last section “Is There Such a Thing as Ethics in Finance? The View of Financial Regulators, Supervisors, and Central Bankers” summarized the views of supervisors, regulators, and central bankers from different parts of the world. They were from speeches delivered in core events related to the financial industry. However, the approach to ethics from those authorities seems to be traditional, insufficient, and in some cases, naïve; as ethics is concerned with the norms of human social behavior, regulation, and supervision too. Although ethics and laws are different, in the end, both are aimed at creating certain human behavior.

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Financial activities are considered a public interest. That is why the provision of financial services, being a private and legal activity, is always authorized by states all over the world. It is strongly regulated and duly intervened by supervisory authorities, which have the power to require compliance. In these markets, regulation and ethics are very close in the aim of requiring the performance of a certain desired conduct, from the ethical point of view because they are socially important, from the state because they are related to the public good. As stated in section “How to Control Conduct in the Financial World?” Supra, financial markets are severely regulated by states. Even though the provision of financial services is a private activity, governments soon realized that such business involves negative externalities that affect the whole economic system. Avoiding financial crises has become a priority for regulators, supervisors, and central banks, all over the world. Different strategies were adopted. None of them have been successful. Financial crises will inevitably arise. However, the approach, of establishing regulatory incentives that induce shareholders, senior officials, and employees to use prudential conduct when providing financial services, has proved to yield significant outcomes. In this sense, this type of regulation has made an important finding: In order to be successful at achieving certain expected behavior from people involved in the financial world, incentives must be related to profits and capital. By taking into consideration the purpose and structure of financial institutions as corporations, as well as the nature of their operations, slowly but surely, prudential regulation has been able to create a culture of adequate management of financial risks. And it has been done not by establishing codes of conduct, urging to require good values, safe backgrounds, and meaningful education to their employees, or via self-regulation or criminal law, but with a regulatory tool that is strong enough to make sure that everyone within the financial institution will try not to affect shareholders’ revenue or capital. The complex decisions people and institutions must make every day while managing money and financial assets need an approach compatible with the purpose of such business. It seems that relying on traditional ethics in financial markets to correct improper behavior is a dreamer’s desire rather than a real solution. It is so because financial institutions as profit maximizers do have a clear purpose that will not change. Gaining profits is the incentive that guides everyday behavior for people and institutions involved in financial markets. It is the real ethos of these private activities. There is nothing wrong with it, if we all understand it and therefore start controlling such purposes from a practical perspective. Governments have placed their focus on financial stability issues. It is acceptable as financial crises create poverty and greatly affect people’s lives and assets. However, they are important issues that must be properly dealt with. For instance, abuses of consumers in financial services, improper handling of customers’ assets, misselling of financial products, and lack of transparency in the establishment of interest rates related to the provision of credit. If financial institutions have gained revenue from such conduct and their employees have also pocketed bonus from it, losing all of this should be the consequence of profiting through improper conduct. Requiring

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more capital from shareholders and provisioning losses related to bad behavior should be the subsequent step. In a word, it is time that regulators and financial institutions via self-regulation consider introducing reputational risk within the framework of capital adequacy requirements as well as within the accounting rules that require more provisions, when management makes risky decisions or when reputational events occur. Reputational risk is not a financial risk. However, operational risk, being a nonfinancial risk, has already been introduced into the capital adequacy framework. If the financial industry and governments start adopting these criteria when there is a breach of ethical behavior, this strong systemic commitment will lead us to auribus teneo lupum.

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fsb.org/multimedia/imf-panel-discussion-on-the-future-of-finance-ethics-and-finance/. Accessed 18 Jan 2020 Carney M (2017) Worthy of trust? Law, ethics and culture in banking. Available at https://www.bis. org/review/r170322d.pdf. Accessed 23 May 2019 Carse D (1999) The importance of ethics in banking. Speech given by the Deputy Chief Executive of the Hong Kong Monetary Authority, at the Banking conference on business ethics in Hong Kong, 15 Sept 1999. Available at https://www.bis.org/review/r990922c.pdf. Accessed 28 July 2019 Carstens A (2019) Post-crisis bank resolution: what are the main challenges now? Concluding remarks by the General Manager, Bank for International Settlements The 8th FSI-IADI conference on “Bank resolution, crisis management and deposit insurance,” Basel, 2 Feb 2018. Available at https://www.bis.org/speeches/sp180208a.pdf. Accessed 1 Aug 2019 Chan NTL (2015) How can the banking industry regain the moral and ethical high ground it once enjoyed before the Global Financial Crisis Speech by the Chief Executive of the Hong Kong Monetary Authority, at the Asian Banker Summit, Hong Kong, 15 April 2015. Available at https://www.bis.org/review/r150416d.pdf. Accessed 13 Aug 2019 CPSS (Committee on Payment and Settlement Systems) (2012) Principles for financial market infrastructures, 2012. Available at https://www.bis.org/cpmi/publ/d101a.pdf. Accessed 13 Aug 2019 Crockett A (2003) International standard setting in financial supervision. Lecture by the General Manager of the BIS and Chairman of the Financial Stability Forum, at the Cass Business School, City University, London, 5 Feb 2003. Available at https://www.bis.org/speeches/sp030205.htm. Accessed 3 Mar 2019 Desario V (1997) The financial system and the non-profit sector with respect to ethics and solidarity in finance. Available at https://www.bis.org/review/r970529c.pdf. Accessed 8 June 2019 Dombret A (2015) Why focus on culture? Statement by a Member of the Executive Board of the Deutsche Bundesbank, at the Institute of Law and Finance conference “Towards a new age of responsibility in banking and finance: getting the culture and the ethics right,” Goethe University, Frankfurt am Main, 23 Nov 2015. Available at https://www.bis.org/review/r151126c.pdf. Accessed 24 July 2019 Dudley WC (2009) Lessons learned from the financial crisis. Remarks by the President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Eighth annual BIS conference, Basel, 3 July 20 2009. Available at https://www.bis.org/review/r090708a.pdf. Accessed 4 Oct 2019 Dudley W (2014) Enhancing financial stability by improving culture in the financial services Industry, 20 Oct 2014. Available at https://www.newyorkfed.org/newsevents/speeches/2014/ dud141020a.html. Accessed 5 June 2019 Dudley W (2017) Worthy of trust? Law, ethics and culture in banking. Available at https://www.bis. org/review/r170328g.pdf. Accessed 10 Feb 2019 FATF (Financial Action Task Force) (2019) International standards on combating money laundering and the financing of terrorism and proliferation. Available at http://www.fatf-gafi.org/publica tions/fatfrecommendations/?hf¼10&b¼0&s¼desc(fatf_releasedate). Accessed 5 Mar 2020 Ferguson R Jr (2004) Economics and ethical behaviors. Available at https://www.federalreserve. gov/boarddocs/speeches/2004/20040522/default.htm. Accessed 22 Apr 2019 FSB (Financial Stability Board) (2014) Key attributes of effective resolution regimes for financial institutions, 2014. Available at https://www.fsb.org/wp-content/uploads/r_141015.pdf. Accessed 24 July 2019 FSF (Financial Stability Forum) (2011) Guidance for developing effective deposit insurance systems, Sept 2001. Available at http://www.fdic.gov/deposit/deposits/international/guidance/ guidance/finalreport.pdf. Accessed 5 Mar 2020 G20/OECD (Organization for Economic Co-operation and Development) (2015) Principles of corporate governance, 2015. Available at https://www.oecd-ilibrary.org/docserver/

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Shafik M (2016) From “ethical drift” to “ethical lift”: reversing the tide of misconduct in global financial markets. Available at https://www.bankofengland.co.uk/-/media/boe/files/speech/ 2016/from-ethical-drift-to-ethical-lift-reversing-the-tide-of.pdf?la¼en&hash¼C120FF0F F7E00FB7DE07858D2CD7DE95CC1BA695. Accessed 2 Feb 2019 Sijbrand J (2013) Ethic and the crisis in the financial sector. Available at https://www.dnb.nl/en/ binaries/Ethics%20and%20the%20crisis%20in%20the%20financial%20sector_tcm47-296151. pdf?2020021923. Accessed 12 Jan–June 2020 Stigler GJ (1958) The economies of scale. J Law Econ 1:54–57. Available at https://www.journals. uchicago.edu/doi/abs/10.1086/466541?journalCode¼jle. Accessed 29 Sept 2019 Stiglitz JE (1989) Markets, market failures, and development. Am Econ Rev 79(2):197–203. Papers and proceedings of the hundred and first annual meeting of the American Economic Association. Available at https://www.jstor.org/stable/1827756?seq¼1. Accessed 5 Mar 2020 Stiglitz JE (2001) Principles of financial regulation: a dynamic portfolio approach. Available at https://core.ac.uk/download/pdf/161443627.pdf. Accessed 28 July 2019 Stingler G (1980) Economics or ethics? The Tanner lectures on human values, Harvard University. Available at https://tannerlectures.utah.edu/_documents/a-to-z/s/stigler81.pdf. Accessed 4 Oct 2019 Stiroh K (2017) Misconduct risk, culture and supervision. Available at https://www.bis.org/review/ r171229d.pdf. Accessed 28 July 2019 Subbarao D (2009) Ethics and the world of finance. Available at https://www.bis.org/review/ r090828c.pdf. Accessed 15 Mar 2019 Tetangco A Jr (2009) Nurturing successful & ethical finance professionals. Available at https:// www.bis.org/review/r090206d.pdf. Accessed 21 June 2019 Thaler RH, Sunstein CR (2009) Nudge: improving decisions about health, wealth, and happiness. Penguin Books, New York. ISBN: 978-01-431-1526-7 Villeroy de Galhau F (2018) Ethics and trust in finance. Available at https://www.bis.org/review/ r180131a.pdf. Accessed 9 Nov 2019 Walter S (2010) Basel III and financial stability. Speech by the Secretary General, Basel Committee on Banking Supervision, at the 5th Biennial Conference on Risk Management and Supervision, Financial Stability Institute, Bank for International Settlements, Basel, 3–4 Nov 2010. Available at https://www.bis.org/speeches/sp101109a.htm. Accessed 5 Apr 2019; 4 Oct 2019 WB (The World Bank) (2015) Principles for effective insolvency and creditor/debtor regimes, 2015. Available at http://pubdocs.worldbank.org/en/919511468425523509/ICR-Principles-Insol vency-Creditor-Debtor-Regimes-2016.pdf. Accessed 24 July 2019

Ethical Orientation in Banks Original Roots in Bank Governance and Current Challenges Laura Viganò

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics in Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stereotypes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Holistic View of Ethics in Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics and Cooperative Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics and Alternative Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Critical Perspectives on the Role of Ethics in Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

Over the past 30 years, the banking sector has been characterized by increasing attention to ethics, which intensified as a consequence of the global financial crisis. Banks have the privilege and responsibility of directly interacting with a wide and diversified clientele and are supposed to base their long-lasting relationship with this clientele on trust, transparency, and proper behavior. Special types of banks, “alternative” to traditional banks in what they consider ethical behavior, have been increasingly present in the market. While alternative banks still cover a limited market share in terms of intermediated funds, awareness on their values and operational choices has been spreading throughout the financial community. The concept of social impact finance, currently permeating the financial sector, is a product of such a process. One interesting question, therefore, emerges: are these banks truly special and clearly distinguished from traditional banking? A second concern focuses on the role that these banks may L. Viganò (*) Department of Management, Economics and Quantitative Methods, Università degli Studi di Bergamo, Bergamo, Italy e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_3

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play in the financial system due to a more intense ethical orientation. To answer these questions, it is necessary to outline a suitable analytical framework. Differently from the common approach, which is purely based on banks’ investment choices, this contribution draws from some cornerstone work on ethical business and is enriched by the original view of a classical author of the Italian business economics academic community. The resulting holistic approach bases banks’ ethical orientation on the institutional nature of financial intermediaries, their ultimate strategic goals, and their role in the economy and in society. To make the analysis more concrete, the suggested theoretical framework is used to study two types of banks that are commonly considered particularly ethically oriented: cooperative and alternative banks. It emerges that a small size may be critical in facilitating the achievement of a high degree of ethical orientation. The conclusions drawn based on these cases are used to offer some critical perspectives on the role of ethics in the current overall banking system. Keywords

Ethical banks · Alternative banks · Cooperative banks · Ethical financial products · Transparency · Social impact · Marginal clientele

Introduction Over the past 30 years, the banking sector has been characterized by increasing attention to ethics, which intensified during and after the global financial crisis. The tremendous increase in nonperforming loans in the USA, the worldwide diffusion of the credit risk embedded in US banks’ loan portfolios through securitization, and the consequences on financial systems and real economies led the international community to attribute to the banks’ lack of professional deontology the role of trigger of the whole devastating process. In fact, other financial intermediaries as well as other nonfinancial actors (e.g., political, institutional, or private operators) played a significant role. However, banks, especially retail banks, still retain the privilege and responsibility of directly interacting with a wide and diversified clientele and base their long-lasting relationship with this clientele on trust, transparency, and proper behavior. These aspects have indeed been examined with reference to the largest banks in the world. On a different scale, special types of banks, which are self-defined as ethical or alternative to traditional banks in response to what is considered pervasive unethical bank behavior, have been increasingly present in the market. Initially, in the 1990s, these intermediaries sparked skepticism in the traditional banking system. On the one hand, bankers felt that the incidence of alternative banks was going to be minimal, and on the other hand, some bankers objected that the presence of banks self-defined as “ethical” questioned the idea that traditional banks could also be ethical. The adjective "alternative" may induce a perception of marginality. It is difficult to estimate the actual market share of these banks given that attributing

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banks to the “alternative” category is not straightforward. The FEBEA – European Federation of Ethical and Alternative Banks and Financiers – includes some cooperative banks but does not include some large, alternative, banks. The FEBEA’s total assets amount to 30.5 billion Euros (http://www.febea.org – last access July 12, 2020). Triodos Bank alone reports an amount of total assets of 12.1 billion Euros as of December 31, 2019 (http://www.triodos.com). Taking the example of Italy, Banca Popolare Etica, with its 2.1 billion Euros in total assets as of December 31, 2019, represents about 0.07% of the Italian banking system (http://www.bancaetica.it; http://www.bancaditalia.it – web sites accessed on July 12, 2020). As a matter of fact, these banks are still characterized by limited size, but awareness on the values and the operational choices they promote has been spreading throughout the financial community. The adjective “alternative” is used as these banks are actually “special” in their positioning and operations when compared to traditional banks, while their “ethical” quality is more difficult to assess, as will be explained in this chapter. The concept of social impact finance, currently permeating the financial sector, is a product of a cultural debate that originated much earlier than the global financial crisis and is now inspiring the strategies of banks and other intermediaries of various size and geographic coverage around the world. One interesting question, therefore, emerges: are alternative banks truly special and clearly distinguished from traditional banking? A second concern focuses on the role that these alternative banks may play in the financial system, both in terms of the financial transactions performed and as a benchmark for traditional banks in their aspiration to adopt a more intense ethical orientation. To answer these questions, it is necessary to outline a suitable analytical framework. Specialness may concern the ethical nature of the banks or the way they choose and approach their market and offer their products. It is easier to assess specialness based on market strategies and products offered. However, this perspective limits the assessment to the surface of the problem. A study on the ethical nature of banks, instead, is particularly challenging, as it considers the fundamentals of ethical behaviors and their effects on banks’ governance. The heterogeneous ways in which to express an ethical orientation make it difficult to set a dividing line between “good” and “bad” banks’ actions. The nature of the problem is much deeper: it requires clarification of the inherent meaning of the adjective “ethic” from the institutional point of view. A preliminary issue to be clarified is the relationship between the attributes “ethical” and “social” as they are often considered overlapping. Even Friedman (1970), in his liberal conception of the firm, weakens his position on wealth maximization by exploring the need for entrepreneurs to conform with the basic rules of a society, which are regulated by laws and ethical values. The corporate social responsibility (CSR) approach corroborates this view when it portrays the attributes “ethic” and “social” as interchangeable (see, e.g., Pava and Krausz 1996): actions and investment choices with positive social effects are considered ethical. However, these are different concepts, and an ethical nature is not necessarily determined by social relevance. This causal effect leads to denying the existence of ethical content in actions that are not socially important (Rusconi 1997). This

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contribution, shows that a wider view of ethics in finance, linked to the roots of the institutional nature of firms, may allow to understand the possible links between ethics and social impact. This chapter is organized as follows. In the next section, a brief review of the concept of business ethics, which is applicable to the subsequent analysis, is based on some cornerstone contributions and is enriched by the original view of a classical author of the Italian business economics academic community. The resulting conception of ethics in business is then applied to the banking case. To make the analysis more concrete, the suggested theoretical framework is used to study two types of banks that are commonly considered particularly ethically oriented. The conclusions drawn based on these cases are used to offer some critical perspectives on the role of ethics in the current overall banking system. The literature used draws from different fields, but this contribution is mainly based on a managerial approach to ethics in banking.

Ethics in Banking Stereotypes The envisaged link between ethical banking and social actions is a consequence of the fact that, in practice, several initiatives of ethical finance concentrate on their social utility: financing socially worthy projects (e.g., those supporting the preservation of life, peace, or the environment); actions connected to the facilitation of access to financial services by operators traditionally considered unbankable (i.e., because they are characterized by features such as a small size or the absence of sufficient collateral); the promotion of nonprofit organizations; and the exclusion of investments in non-socially worthy sectors (for a comprehensive review of these criteria, see Renneboog et al. 2008; Viganò 2001). As a consequence, the so-called ethical products offered by banks (the adjective “ethical” is here used for simplicity, without implying the expression of a judgment on the real products’ ethical quality, which depends on the bank’s overall ethical orientation; see section “A Holistic View of Ethics in Banks”) often concern forms of savings that foresee the relinquishment of all or part of the interest earnings and the assignment of the corresponding amount to socially worthy initiatives. Funds can be offered as grants or loans or capital participations; the depositors may not only give up some interest earnings but also directly invest their own capital in such ventures. Stanwick and Stanwick (1998) agree on the limitations of this approach. The ethical orientation of a firm goes beyond its CSR, and evaluating the sectors of intervention is insufficient. With specific reference to banking, judging ethical orientation based on investment choices related to social responsibility, such as promoting actions in favor of and opposing actions against specific social or moral values, relies on the value system of the proponent. As an example, interest on loans is a practice that is not accepted in Sharia-compliant finance but is applied elsewhere and practical actions may differ

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according to degrees of tolerance (on Islamic ethics and ethical attitudes of Islamic bank managers, see Rice 1999 and Quttainah and Almutairi 2017). Islamic experts stress that the simple respect of Sharia law does not ensure ethical behavior and, according to INCEIF, the Global University of Islamic Finance, considering Islamic finance automatically immune from unethical practices is a misconception (https://www.inceif.org/misconceptions/ - Accessed on June 7, 2019). Over the years, several studies have analyzed the implications of such choices on the performance of financial intermediaries (and firms in general), and there are no unanimous findings on whether ethical behaviors, measured according to this reductive approach or exclusively based on CSR or on specific moral values, positively or negatively affect performance. Rudd (1981) says that institutional investors’ choices based on exclusion criteria imply higher transaction costs, higher labor costs, and higher risks. Some authors even foresee the possibility that the spreading of news on social responsibility would be detrimental to the firm if it induces to perceive that the company is making extra profits (Boyle et al. 1997). Other studies state that socially responsible firms perform as well as or better than other companies. Stanwick and Stanwick (1998) stress that profitability may act as a stimulus for a socially responsible action. Pava and Krausz (1996) affirm that CSR may indeed increase financial performance, but they also contemplate the self-promotion effect on companies due to CSR actions, the case of measurement errors, or the possibility of reverse causation, where only highly profitable companies may afford CSR actions. An extensive analysis by Renneboog et al. (2008) of different international studies highlights the diversified results and the complexity of the approach. In the specific banking case, Simpson and Kohers (2002) report a positive relationship between corporate social and financial performance, while Soana (2011) does not find any significant statistical link. Hillman and Keim (2001) suggest that the effects of CSR on performance depend on the intended meaning of CSR. If CSR means better relationships with stakeholders, there should be an improvement in the firm’s value. In contrast, a reductive view that only selects some sectors to be avoided may decrease the value of the firm. The contrasting results may come from the difficulty of defining and measuring social and ethical values, the lack of a theoretical framework, the lack of data and information, the risk that ethical choices are simply ostensible (Rusconi 1997; Paulet et al. 2015 explicitly refer to window-dressing attitudes), or different perceptions of ethics given individuals’ backgrounds or changes in life phases (Loe et al. 2000; Lewis and Unerman 1999). Therefore, an approach to ethical finance and ethical banking based on only specific investment choices appears limited. Nevertheless, with the aim of obtaining objective indicators of ethical orientation or of elaborating performance indices of socially responsible companies, this approach was extensively followed. One of the pioneering indices in this respect was the Domini 400 Social Index. This index was created in 1990 and subsequently became the MSCI KLD 400 Social Index. The index highlights companies with high Environmental, Social and Governance (ESG) ratings and excludes companies selling products with negative social or environmental impacts (https://www.msci.com/msci-kld-400-social-index Accessed on June 7, 2019).

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A Holistic View of Ethics in Banks Objectivity in ethical judgment may be complex, but denying the possibility of setting an evaluation frame would mean acknowledging ethical relativism. While, in banking, an analysis of single actions without verifying coherence with the more general ethical principles often prevails and is typical of the reductive view, a holistic approach to a firm’s ethics offers a wider perspective. The holistic approach remains focused on general plans, without entering into concrete situations in which ethical dilemmas would need to be faced (Rusconi 1997). The holistic approach to banks’ ethics presented in this chapter bases the analysis of banks’ ethical orientation on the institutional nature of financial intermediaries, their ultimate strategic goals, their role in the economy and in society, and their effects on governance. The distinction between ethical and unethical actions is less neat than it is under the reductive view, as this approach does not propose directly measurable criteria. Rather, this approach questions these apparently objective criteria and proposes a frame through which to evaluate the ethics and social value of a firm (bank) as a whole. A widespread conceptual framework aligned with this approach is stakeholder theory (see, among others, the illustrative work of Freeman and Reed 1983), in which groups other than shareholders (i.e., workers, customers) express their expectations regarding the firm’s actions. Firms must aim at balancing the satisfaction of the economic interests of all entities, even when they conflict with each other. Some original work on the importance of reconciling the expectations of different actors surrounding the company originates from the earlier Italian classical school of business economics. For the purpose of this analysis, reference is made to the Italian business economist Carlo Masini (1974), whose view of the nature of the firm can be adapted to the banking case. As extensively explained in Viganò (2001), on which the following description is mainly based (unless differently indicated), Masini’s approach differentiates from stakeholder theory as he overcomes the conflicts between the objective of the firm and those of the actors within and surrounding the company. Masini defines the company as a socioeconomic institute, a complex of elements and factors, of energies and personal and material resources. The company is a long-lasting, dynamic institution that appears as a unity, where elements and factors complement each other to achieve the common good. The enterprise is autonomous but must take into account connections with other components of human society. Therefore, the goals of the enterprise must coincide with the goals of the people for whom it is created and managed: these persons inject energy and personality into the company. This aspiration to achieve the well-being of people accounts for the ethical character of a company. Masini goes further by distinguishing between “economic interests” and “interests of other kinds,” which represent the conditions necessary for the company to be respected and enhance the value of economic interests. Institutional economic interests must merge; through the firm, different interests pertaining to different persons pursue the goals of the firm’s socioeconomic community, allowing the achievement of a level of common good that, otherwise, could not be reached. The complementarity of expectations is essential.

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In Masini’s view, the “economic constituency” of a firm is the whole group of persons in whose interest the institution is established; this constituency goes beyond stakeholders and is not limited in its composition: shareholders, directors, sponsors, clients, the state, or other entities may at times belong to it. The importance of constituents depends on the contextual role they have in the institution. Since the final overall goals of the constituency are aligned into a single goal, it is necessary to reconcile all these interests in proportion to their contribution to goal formation. In contrast to theoretical positions in which profit maximization is the final goal, in this view, profit is not a goal but a part of the value system of the firm that ensures its durability. Profit is a condition of firm existence. Friedman (1970) acknowledges that shareholders should not be damaged by the socially responsible actions of a firm. Stakeholder theory, in turn, accepts that social costs are spread over different entities interested in the destiny of a company, including shareholders. The Etzioni paradigm (Etzioni 1988) explains firms’ ethical aspirations through the observation that individuals’ preferences allow them to reach higher levels of satisfaction if their action increases the well-being of the community. This result may lead individuals to reward choices that apparently are in conflict with their wealth maximization. Masini (1974) advances the view that the ethical nature of entrepreneurship can be achieved when the firm: • Puts the person at the center of its interests and institutional goals for the common good. • Is oriented by a constituency that expresses the institutional objectives and, at the same time, considers the expectations of other actors who are external to the company but are directly or indirectly affected by the bank’s actions, integrating the firm’s strategy. • As a consequence, sets its targets by considering profit a binding condition for the survival of the company rather than a goal. The firm’s ethical goal is the satisfaction of human needs to achieve the common good. This approach is necessarily generic regarding the definition of common good and does not offer an action evaluation grid based on the firm’s daily choices. Rather, this approach offers background criteria for concrete choices based on the social nature of a firm and its continuous aspiration to improve society. In this way, the dichotomy between ethics and social action is overcome. Applying these concepts to banking implies abandoning the widespread reductive approach of a strict relationship between investment choices and ethical orientation: an investment strategy focused on minorities, on the needy, and on the environment entrenches the risk that unethical behavior is masked by apparent ethical investment strategies, with little impact on an authentic social responsibility toward the stakeholders and the world. For example, investing in a green fund can represent a way to feel or appear good rather than an expression of a deep involvement in the environmental problem. Based on the preceding discussion, instead, the socio-ethical nature of the bank is justified by the efforts to make the intermediation process excellent to satisfy the goals not only of shareholders and workers but also of investors and

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borrowers and, eventually, of the community. This ethical mission coincides with the bank’s final institutional and entrepreneurial goal. In the case of banking, while profit and wealth maximization are normally considered institutional goals, banks may have a different governance (Becht et al. 2011) and different goals. Sometimes, goals depend on the conflicting interests of workers, clients, and shareholders. However, if the definition of constituency given by Masini (1974) is considered, conflicts between the goals of the constituency and those of the institution reveal that the constituents are not correctly identified. The constituency must include all the possible entities interacting with the bank; the agency problem deriving from the separation between ownership and control is overcome through corporate governance rules that align the expectations of all constituents. The balance of the contrasting forces relies on tools such as contractual and incentive strategies favoring the intended behaviors. This contractual view attributes an important role to explicit and implicit prices in giving the suitable signals to satisfy the expectations of the constituency (Mottura 1998). When price conditions are not suitable, the bank loses its signalling role. An example can be found in lending: if the bank follows an adequate evaluation process, loan pricing is a signal to entrepreneurs regarding the quality of their projects, which may also induce a potential borrower to give up the intended project if the price shows that the project is likely to fail. A market orientation, tuning, and a prompt answer to the demand, then, become efficient ways to express ethical intention, when they are finalized to promote consensus among all the components of the constituency with regard to the achievement of institutional objectives. Therefore, a suitable bank-customer relationship is a signal of ethical orientation. Profitability and a consistent stock value reveal positive responses from different client segments and must be interpreted as signals of appreciation by these actors not only for the price conditions but also for a higher utility level achieved in the bank-customer relationship. More generally, an ideal ethical bank is expected to: • Effectively satisfy borrowers, with the aim of making the evaluation process excellent and guaranteeing the satisfaction of these customers • Effectively satisfy investors by offering risk/returns options suitable to their desire to develop their savings/consumption choices over time according to their preferences • Preserve profitability, which allows the bank to operate over the long run and to continue offering effective services, to contribute to the stability of the financial system, and to respect the interests of all actors linked to the bank Figure 1 summarizes this view. As is indicated, there is no conflict between the goals of the constituency and those of the institution since the persons who express these goals are all strictly linked to the institution itself. Noninstitutional goals, instead, are external and represent the conditions for the bank to successfully operate in society (Masini 1974). In the figure, while acknowledging the importance of internal signals of

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INSTITUTIONAL INTERESTS Profitability Suitable governance Attention to external actors’ interests Social responsibility

WORKERS DEPOSITORS BORROWERS SUPPLIERS

INSTITUTIONAL GOAL

SHAREHOLDERS

EXPRESSION OF WILL

COMMON GOOD Internal and market positive responses prices of services customer retention market share stock values

OTHERS

Fig. 1 Driving forces of the ethical orientation in banks. (Source: Elaborated on a figure in Viganò 2001)

success (analyzed later in this chapter), the focus of the examples is on market signals to emphasize the importance of always aiming at being aligned with the market. Specific indicators of success may differ in different types of banks. However, all banks must ensure that the market is expressing appreciation by positively responding to the conditions proposed for products and services. Some studies claim that ethical banks should achieve social and economic profitability at the same time (see the discussion proposed by San-Jose et al. 2011). In our view, long-term financial sustainability is a consequence of the capacity of these banks to conform with the stakeholders’ utility functions, which eventually determines the terms negotiated and the bank’s operational conditions. In this respect, while Bollen (2007) supports the view of investors sensitive to investment attributes different from risk return, Renneboog et al. (2008), in a study on socially responsible investment with an extensive literature review, find hints of this sensitivity but not an unequivocal demonstration of it. The following analysis explains that investors’ and other stakeholders’ sensitivity to banks’ efforts to pursue social objectives becomes a key factor in banks’ financial and overall success. The framework of Fig. 1 ideally applies to any bank, from the very small and local to the large multinational and multiproduct corporations, as it offers an ideal picture, though this picture may be far from realistic. Banks’ positioning in the real world is the outcome of different driving forces, which are inherent in the company or are external factors. A genuine internal conviction regarding the positive effects of an ethical orientation in some banks may be contrasted by other banks’ skepticism if they are attracted only by the marketing power of the “ethical” product. Some banks may believe that their behavior is ethical by definition, while others may be struggling to pursue a higher level of ethical or social standards. Banks’ varying

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attitudes toward ethics in banking can be represented in a matrix with two dimensions, i.e., the level of awareness of ethical orientation and the declared introduction of the so-called ethical products (this classification was elaborated in a research conducted on Italian banks with the Bocconi-Newfin research center, as detailed in Viganò 2001). The following four combinations are envisaged (Fig. 2): Quadrant A includes banks that innovate by fostering their ethical standards due to an increased awareness of ethical orientation. The pursuit of ethical behavior is, for these banks, strategic and an integral part of their objectives. Quadrant B refers to banks that declare they are aware of and constantly monitoring the ethical content of their own behavior and of the products they offer. Consistent with this approach, such banks do not believe they need specific actions to increase their ethical intensity (in this way, they may approach the ideal model). Quadrant C includes banks that, despite offering products commonly classified as ethical, do not declare that they perceive a culture of ethical behaviors. The positioning of these banks, therefore, corresponds to a marketing strategy aimed at satisfying the segments sensitive to the ethical-social content of the products offered. Quadrant D includes banks that are neither sensitive to a particular ethical tension nor interested in ethical products. To refine the analysis, it is necessary to clarify the meaning of so-called ethical products. Savings collection products that relinquish remuneration for allocation as charity can be correlated with the banks of quadrant C. These products are easy to pack and offer: investors’ only limitation is that they give up part of their remuneration. Thus, these products may be promotional instruments that target segments that are aware of their link with the world of social responsibility and do not involve high risk on the part of the intermediary. A different case is the savings product aimed at direct investments in ethical sectors of high social value. These products are typical of banks in quadrant A, which are willing to eventually take on greater risk to implement their ethical aspirations. The banks of quadrant B, on the other hand, do not develop ad hoc products. Instead, within the ambit of their activity, these banks identify market segments worthy of attention. The difference between the banks of quadrant B and those of quadrant A is in the need, for the latter, to change their governance and organizational models in order to innovate their approach and offer products that, according to their view, show a higher ethical intensity. Relating specific banks to each quadrant is problematic. First, banks may change their attitude over time; second, the intentions behind the positioning cannot be DECLARED OFFER OF ETHICAL PRODUCTS

AWARENESS OF ETHICAL ORIENTATION

HIGH

LOW

HIGH

A Banks strongly involved in ethical innovation

B Banks satisfied with their own ethical orientation

LOW

C Banks looking at the phenomenon from a marketing viewpoint

D Banks not interested in the phenomenon

Fig. 2 Banks’ offer of ethical products, awareness and positioning. (Source: Elaborated on a figure in Viganò 2001)

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assessed by simply looking at the public information. It is even difficult to identify a correspondence between the quadrants and bank categories with regard to their size, location, or legal status. While it may seem easy to link banks in quadrants A or B with smaller, local banks, it would be superficial to say that large, international, bank corporations cannot show a genuine interest in higher ethical intensity, although this goal might be harder to achieve in practice, as will be explained later in this chapter. However, there are banks that, due to their institutional setting, to their choices in terms of the type of clientele served, or to their special link with the community, are more likely to be assigned to quadrants A or B. For example, with regard to the market perspective, investments in the non-profit sector or in support of so-called marginal clientele (Viganò 2001) are considered ethically oriented. Marginal groups rarely obtain bank financing because the determination of the viability of their projects necessitates a study based on complementary criteria rather than pure profitability, often due to the (perceived) risks and the high costs of serving them. Consistent with the critiques expressed with regard to the reductive view, a focus on these sectors may mirror a restricted vision of ethical finance. However, such a focus can indeed be included in an ethical banking strategy according to the holistic view. The ethical content of these initiatives does not lie in the product itself but is contained in the effort to identify and understand potentially bankable situations, which cannot be demonstrated under traditional evaluation parameters. What matters in the holistic view is that banks spontaneously (not as a result of public incentives) choose to widen their market to include areas in which other banks are not able to operate. In doing so, these banks satisfy the expectations of entities (stakeholders) that otherwise would be excluded, which would cause an overall decrease in the common good. From a historical perspective, in periods of poverty, an ethical orientation focused on serving marginal sectors is more naturally pursued by banks. Cooperative banks, operating in several countries since the nineteenth century and now widespread in poor countries, are considered good examples of ethically oriented banks as they have a natural pool of marginal clientele. Serving marginal clientele becomes a strategy – although not the only or most relevant strategy, to increase the ethical orientation of such banks. Indeed, the cooperative banks’ ethical orientation aligning with the holistic view is the outcome of their governance model. Another case is represented by some alternative banks. The next section elaborates (mainly drawing from Viganò, 2001) on the cooperative bank model, while the subsequent section examines alternative banks, their innovative governance and product offerings, and their possible specialness in the banking system.

Ethics and Cooperative Banks One of the main institutional objectives of cooperative banks has been to promote the financial inclusion of marginal sectors, usually the poorest sectors, not only access to loans but also education, which fosters monetary savings. Mario Masini, in a background paper for the World Bank World Development Report of 1989 entitled

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“The Italian ‘Casse Rurali e Artigiane’ (1880–1920s),” considered organization and governance key elements allowing cooperative banks to operate in marginal segments. Indeed, these features make the cooperative banks model more ethically oriented than other bank models. In fact, members of cooperative banks form a complex body, acting at times also as depositors, borrowers or even workers in the bank. Therefore, the alignment of the interests of the different stakeholders portrayed by Masini (1974) is achieved almost automatically. Moreover, membership in such a bank is normally instigated by the shared principles of mutuality and democracy; the member base is, then, homogeneous in its interests and goals (Di Salvo and Schena 1998). The centrality of members is the dominating element that reflects the quality of the contractual relationships of the bank. In particular, the common denominator of being members alters the utility of the relationship among the member-managers/ workers, the member-depositors, and the member-borrowers. For member-depositors, the expectation of remuneration from savings may be mitigated by the sense of belonging and the possibility, as a member, of influencing the strategy of the bank (Guinnane 1997). Member-borrowers are probably less sensitive to loan costs given their expectations regarding bank profit sharing. These members care about the solvency of the bank while they ask the bank to share the risk of their project. As in the case of member-depositors, the sense of belonging to the cooperative and the quality of a long-lasting relationship reduce agency problems and contribute to smooth potential recovery processes. High-quality bank-customer relationships are actually costly, but peer monitoring among members may contribute to keeping these costs under control. A potential conflict between depositors and borrowers (highlighted by Smith et al. 1981) may arise due to the higher risk aversion of depositors, but in addition to other benefits of being members, the possibility for both parties to be, at times, depositors or borrowers (depending on their life cycle phase) makes this conflict unlikely. Indeed, the peculiar corporate governance of cooperative banks, centered on the members, makes it easier to implement the model of ethical orientation inspired by Masini (1974). The practical implementation represented by the attraction toward marginalized sectors is made possible by the specific relationships among the different stakeholders that are underpinned by the characteristics of being members of the bank. Another feature supporting the ethical orientation of cooperative banks is the dividend distribution strategy. Commonly, part of the annual profit is not distributed and is either capitalized or given to the community in the form of social investments or charity. Funds granted to the community may be considered social dividends. Members draw some utility from this activity, even if it is not financially profitable. However, the ethical orientation and the propensity for charity do not soften the profitability constraint. These banks may show higher interest margins (as described, e.g., by Kaushik and Lopez 1996) and higher operating costs than other types of banks. This dynamic is consistent with a member-clientele sensitive to the quality of the relationship and of the service received and ready to discount this qualitative advantage from the financial component of the contract they sign with the bank.

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When the financial sustainability constraint is respected, profit allows the social function to be exercised as a service to members and to the community in the long run and to satisfy the constituency of the bank, which comprises different stakeholders, due to the members’ common bond. Over time, in several countries, cooperative banks evolved through reorganization and the restructuring of ownership rules modifying the dynamics just presented: access to nonmembers or growth may have loosened the common bonds and increased agency problems. In recent periods, the specificity of cooperative banks has been discussed: Kotz and Schmidt (2017) stress the softer effects of the global crisis on German cooperative banks due to their business model, while the critical evolution of such banks during the global financial crisis in Cyprus is described in Kleanthous et al. (2019). Butzbach and von Mettenheim (2015) focus on the competitive advantage of several managerial aspects of “alternative” banks (among which they include the cooperative ones). D’Amato and Gallo (2017), in contrast, show governance deficiencies of Italian cooperative banks during the global crisis. In making the difference, size may be a strategic element. The case of alternative banks further confirms this point.

Ethics and Alternative Banks Alternative banks claim to be inspired by explicit ethical principles, with the main goals of contributing to the benefit of society as a whole and caring about social welfare, the environment, and, more generally, the progress of the world. On these principles, see, among others, FEBEA (http://www.febea.org). A significant case is Triodos Bank (http://www.triodos.com), founded in the Netherlands in 1980 and expanded in other European countries. Alternative Bank Schweiz (http://www.bas. ch) in Switzerland and Banca Popolare Etica in Italy (http://www.bancaetica.it) are other examples. The names of these banks reflect nuanced self-perceptions, ethical vs. alternative, as discussed above (Web sites accessed on June 7, 2019). A mainstream interpretation of these banks’ behavior relates to their ability to satisfy the expectations of a market niche sensitive to the social impact of financial transactions (social investors) by offering specialized products: their specialness indeed pertains to the values they claim to follow in defining their objectives, strategies, operations, and products. While it may appear obvious, defining the criteria on which to assess the ethics of the behavior of these banks is a subtle exercise, as explained earlier in this contribution. Alternative banks can be analyzed according to the reductive perspective focused on specific investment choices or according to a deep and robust holistic analysis of the ethical nature of banks. In following the holistic approach, the way this banking model meets stakeholders’ expectations on the banks’ ethical orientation has an impact on profitability; size may eventually limit specialness given the profitability constraint. The underlying hypothesis is that the larger these banks become, the harder it is to meet stakeholders’ expectations, which are mostly based on a direct relationship with the bank and on their control over transactions. Size emerges as a key element for preserving specialness and ethical orientation.

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Behavioral models for alternative banks are limited in number. San-Jose et al. (2011) investigate the differences between ethical and traditional banks and develop an index (RAI, Radical Affinity Index) for measuring specialness based on the most common characteristics of ethical banks: transparency and quality of information, placement of assets, alternative guarantees, and participation in governance. In what follows, transparency, information quality, and participation in governance are not only characteristics of ethical behavior but also necessary elements that allow alternative banks to achieve their social goals and be sustainable. Paulet et al. (2015) compare conventional and ethical banks with regard to strategic choices made as a consequence of the global financial crisis. By analyzing several cases, the authors highlight some of the operational aspects that differentiate alternative banks in practice and substantial differences in the business model, particularly the nonprofit maximization of alternative banks. The authors stress the local outreach of these banks. While agreeing on these well-known characteristics, this analysis shows that the main difference is caused by the governance model and the consequent size limit. Relano (2008), in a comparison with traditional banks, analyzes the effects of being an alternative bank on the structure of the balance sheet and shows that financial aggregates which originate form transactions with customers have a high weight with more emphasis on the original bank core business as compared to other banks. The focus, instead, is here on the structure of the income statement to explain how the optimal size choice is strategic if the aim is to ensure the quality of the relationship. Drawing from agency theory and delegated monitoring in banking, hereunder, size emerges as a key driver of success. Size is considered in Diamond (1996), who states that the demand for monitoring by bank investors depends on the monitoring costs. When the number of investors is sufficiently high enough to reap the benefits of diversification, delegated monitoring costs can be reduced by issuing deposits, that is, a form of unmonitored debt. Haubrich (1989) points out that in banks, a key role is played by long-term relationships that exist in the lending activity but less in bank-depositor relations. In the case of alternative banks, though, relationship lending is far more relevant than in small-business lending, and a relationshipbased approach is strategic on the deposits side as well. Jensen (2001) states that agency costs may increase under this approach, especially when the bank grows. This analysis will show that an optimal (limited) number of customers may allow the achievement of high-quality bank-stakeholder relationships and the achievement of breakeven and of the bank’s social goals. What follows elaborates on Viganò (2001) and Viganò and Castellani (2015); the formal approach followed in modeling the behavior of alternative banks is made here more descriptive (a formal representation of the findings is included in Box 1 in the Appendix). Alternative banks follow a differentiation strategy that is not based on price but on generating a social impact, a key factor to attract and retain their target clientele. While several variants occur in practice, the most common characteristics of a generic alternative bank are: • The active role of shareholders/members in defining the bank’s strategies and the bank’s preference for social investments.

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• The capacity of depositors to select the investment conditions, i.e., the destination of the fund, and the possible charitable uses of their interest revenues. • The sharing of the bank’s mission by personnel, which can influence wage setting policies. • The presence of borrowers with risk-return profiles that may not meet the requirements of traditional banks: relatively low income, small size, (perceived) high risk, and loans intended for social impact projects. Some of these borrowers, defined as marginal clientele, may be the typical customers of microfinance institutions or cooperative banks, at least in their earlier stages (Viganò 2001, 2004). Alternative banks enjoy economies of specialization with regard to evaluation and often set lending interest rates that are below-market rates. The target profit is not maximized but set at a level that allows the bank to be sustainable. However, if the bank can sufficiently control the key variables (cost of funding, overheads, and risks), then the profitability level could ideally align with that of traditional banks. The degree of control over these key variables depends on several factors: the preferences of clientele and expected remuneration of the (human and financial) resources that shareholders, depositors, and personnel make available to the bank. The analysis shows how the satisfaction of stakeholders’ preferences contributes to achieving both target profitability and a high level of specialness and ethical orientation. The leverages that alternative banks may operationalize to this end are discussed hereafter with respect to the different stakeholders: depositors, shareholders, borrowers, and the personnel. Depositors intentionally forgo part of their remuneration to subsidize interest rates on loans or to fund target sectors. Their bargaining power is higher than it would be in traditional banks: they can self-determine the interest rate earned on deposited funds (with a cap) as well as the sectors of investments to maximize their utility, which also depends on their social aspirations. To explain these dynamics, the following variables are defined: i: market interest rate on deposits Sad: degree of satisfaction of the social aspirations of depositors Dc. degree of control by depositors over the destination of deposited funds Xd: percentage points of interest rate that are forgone by depositors σpd: degree of perceived bank risk by depositors The depositor’s utility is a direct function of the net return (i–Xd) on the deposit, the depositor’s degree of control over the bank’s uses of funds (Dcd), and how far the bank meets the depositor’s expectations in terms of social returns (Sad). The depositor’s utility is negatively related to perceived risk (σpd). It follows that the bank has a special interest in showing its social impacts to keep the cost of deposited funds low. Depositors are given a remarkable amount of risk-free decision power regarding their funds’ destination, as they take neither the typical risks of direct lending to the target sectors nor the equity risk of shareholders. A greater Dcd increases depositors’

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utility and decreases their perceived risk, which increases Xd. However, a stronger Dcd increases the bank’s costs: direct information and communication costs and an indirect loss of freedom in investment decision making with a suboptimal allocation of funds. Xd is also affected by perceived risk, σpd, but not real risk because the former is included in the depositor’s utility function. The greater the depositor’s access to information is, the more the perceived and real risks converge. If the bank is fully transparent and effective in its communication, depositors may accept less direct control (Dcd). Transparency and depositors’ control can be considered improper substitutes. If only a marginal portion of the depositor’s wealth is invested, as suggested by MacKenzie and Lewis (1999), the elasticity of the interest forgone by depositors to the perceived risk may be lower. This result may induce the bank to avoid large deposits, as the owners can be more risk averse. In summary, the bank’s degree of control over Xd (i.e., the ability of the bank to decrease funding costs) mainly depends on the bank’s social returns, depositors’ ability to meddle with the bank’s allocation policies, and depositors’ perceived risk. In the case of pure shareholders, the utility function and the interpretation of its components are the same as those of pure depositors. By replacing the interest on deposits (i) with the dividend rate (d), Xs (the subscript s stands for shareholder) is the percentage of dividends the shareholder is willing to give up. The shareholder’s utility is a direct function of the net return (d –Xs) on the investment, the shareholder’s degree of control over the bank’s use of funds (Dcs), and how far the bank is able to meet shareholder expectations in terms of social impact (Sas); the shareholder’s utility is negatively related to the perceived risk (σps). However, while a depositor sets the net remuneration in advance, the shareholder accepts a reduced dividend, which is determined ex post. Shareholders’ control over the bank’s investments (Dcs) is not a special feature of alternative banks; furthermore, σps is also different from that of depositors since meddling with the bank’s investment strategies should be the natural role of equity holders. Therefore, the bank has less discretion in setting Xs and Sas is its main leverage, which confirms the importance of effective transparency and the pursuit of social impact. The case of the shareholder-depositor is similar to that of the pure shareholder, even though there may be a trade-off between claiming higher remuneration on deposits and equity. The case of a shareholder-borrower is unusual but occurs when membership is a condition for loan eligibility. Compared to pure shareholders, shareholder-borrowers may forgo part of their investment return (increasing Xs) to reduce the interest on the loans they receive. In fact, as shareholders, these borrowers have control of the investment, and they may be more tolerant of the risk regarding their loans. Opposite behaviors may also apply with possible offsetting effects on profitability. In the case of pure borrowers, the demand of loans is a function of the following: • The interest rate on loans (rc), which mostly depends on the borrower’s probability of default (pd) and may be aligned with the market rate (rm) or may be different (assuming zero bank fees). • The expected profitability of the borrower’s investment (ri).

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• The borrower’s satisfaction of social objectives (Sab) through their motivation to implement “ethical” projects. Borrowers often show unattractive combinations of risk returns, though they are coupled with high social value. The expected economic and social returns (ri and Sab) increase the demand of loans, while the loan cost (rc) decreases it. The borrower is interested in Xb, i.e., the discount on rm, to obtain the subsidized interest rate rc = (rm–Xb). Xb should be inversely proportional to the borrower’s economic (ri) and social (Sab) return on the project. Xb also decreases if pd is high because of the borrower’s risk. An increase in rc may occur if business development services (BDS) are offered for free or at favorable rates (Lämmerman and Ribbink 2011). Financial advice and monitoring are useful to strengthen the bank-customer relationship. If BDS increase both economic and social returns, then the borrower is more willing and able to pay a higher interest rate. The offer of BDS allows alternative banks to apply interest rates close to market rates, even though, at the same time, there are associated operational costs. However, lending risk should decrease. Since the shareholder-borrower combination is unusual in alternative banks, these banks do not enjoy the advantage of shareholder peer monitoring, which is common in cooperative banks. This gap can lead to greater BDS costs. A final remark related to lending concerns the control that depositors have over the loan allocation. This control puts a costly and risky constraint on the bank, which should increase rc. The common concern of both depositors and borrowers for social values, a unique feature of alternative banks, may eventually become an obstacle rather than an advantage in the pursuit of bank profitability. The personnel in alternative banks are often sensitive to the banks’ social impact and may accept below-market salaries. (i–Xw) (the variables used for depositors and shareholders are applied to workers with the subscript w) is positively related to workers’ degree of control over the bank’s investments (Dcw) and the bank’s ability to meet workers’ expectations in terms of social impact (Saw), while it is negatively related to perceived risk (σpw). Personnel have high control due to their easy access to information through a kind of “social insider trading.” This factor affects the perceived risk: personnel would ask for higher salaries (decreasing Xw) if the bank’s risk were higher than the market risk. Hybrid situations, where personnel are also depositors, shareholders, or borrowers, have effects on Xw, Xd, Xs, and Xb. Combinations of these variables may make personnel indifferent and achieve the same utility level. The effects on salaries (through Xw) seem the most important, but the directions of these effects are not completely straightforward. Lower wages can be compensated by higher returns on deposits for worker-depositors. However, personnel may prefer a combination of lower salaries and lower remuneration of deposits for greater social impact by the bank. Similar considerations can be made by shareholder-workers who consider the dividend one determinant of their income. As the bank is able to promote a positive image of itself, it can increase personnel commitment (Valentine and Godkin 2017), and motivated personnel will encourage the implementation of more socially oriented activities.

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The above-described special features of alternative banks reflect on operating costs. Depositors’ control over fund allocation requires a specific organizational and informational setting and the adaptation of allocation policies. Greater control increases costs, limits the bank’s decisional power and, to some extent, affects the probability of the default of loans (pd) and the overall portfolio risk if the depositors’ allocation preferences are not consistent with the optimal portfolio allocation. Serving borrowers whose evaluation and monitoring requires innovative information collection and treatment also leads to specific costs. Given this deeper bankcustomer relationship, regarding both funding and lending, operating costs cannot be reduced below a given level; if the alternative bank has a social goal of reducing contractual interest rates on loans (rc) to targeted borrowers while preserving profitability, the only effective measure is leveraging Xd and Xs on the funding side, Xb on the lending side, and Xw in relation to overhead costs. However, this strategy may entail other types of costs or the reduction of other sources of revenues. The main driving forces are summarized in Fig. 3 (where R stands for revenue, C for costs, and σ for loan portfolio risk; all other symbols as explained in the text). These leverages, as previously described, do not help control costs under all conditions. A study originally developed by Viganò (2001) and refined by Viganò and Castellani (2015) suggests that the specificity of the relationship with stakeholders supports the hypothesis of a direct link between the volume of transactions and the unitary costs of loans and deposits. In fact, an increase in the number of interactions (deposits, loans, or shareholders) may reduce the degree of control Dc of

Higher interest income

-C

+C

Better borrowers’ performance

More volatile procjects?

+R

-C

Fig. 3 Stakeholder drivers and their effects on profitability. (Source: Elaborated on a figure in Viganò and Castellani 2015)

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each category of stakeholder and increase their perceived risk (σp). Consequently, the share of returns that stakeholders are willing to forego, Xd, Xs, Xw, decreases if the bank does not implement adequate measures to re-establish stakeholders’ original degree of control, which increases operational costs. The costs related to a higher Dc are likely to suffer diseconomies of scale. In fact, when depositors substantially increase in number, they perceive a loss of control that depends, for example, on the limited ability of existing personnel to follow the investment directions of a large number of customers. Only an incremental increase in scale would allow the bank to keep up with an increased number of depositors. A substantial increase in borrowers reduces the ability of personnel to directly monitor lending risk unless specific measures are taken. Paulet et al. (2015) assert that alternative banks are decentralized. Decentralization is likely to remain effective when control systems are in place. This approach would require a process redesign, the adoption of different lending technologies, which increases costs. Information and control costs are therefore related to the number of actors (depositors and/or borrowers or shareholders): the gathering and monitoring of information and the pursuit of a high level of transparency may become less effective. Unexpected and large increases in scale (expansion is expected to occur with an increase in the number of small transactions rather than with an increase in their average size given the characteristics of alternative banks) would not allow the bank to adequately fulfil the expectations of its customers and meet the high transparency standards and, through this, operate according to the stated ethical orientation. Transparency does not mean only public disclosure but high-quality information flows and proximity to stakeholders, as depicted in the holistic approach to ethical banking. The bank’s social value is important per se and as a positive marketing message. If the bank fails to promote its potential social value, it may also fail to reach out to its target market segments willing to offer resources under preferential conditions. It is therefore in the specific interest of the bank to be loyal to its mission and to disclose its success in the pursuit of social impacts to the market with adequate signals. Dimension-related transparency, in addition to being a key factor of ethical orientation, is, therefore, connected with profitability. Jensen (2001) states that the reason why agency costs may be increased by socially oriented behavior is the loss of focus on performance measures. This contribution, on the contrary, shows the importance of performance measures as drivers of strategy because good performance allows banks to pursue the social objectives that, conversely, are a determinant of good performance. It also states that there is an optimal size that allows a bank to ensure the best quality and the lowest costs of control. On size, Schminke (2001) found that members of larger organizations display stronger ethical predispositions. The specific relationships among stakeholders explain the contrasting result depicted here for alternative banks. In support of the conclusion in this chapter, Mitchell et al. (1992) focus on small banks’ personnel emphasizing internal ethical issues. Climent (2018) compares an alternative and a commercial bank after the global financial crisis and finds lower financial performance but higher growth in volumes of loans and deposits in the former. However, Viganò and Castellani (2015) found confirmation of the size limit based on the trends over 18 years of the main

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financial aggregates of the alternative bank they analyzed. They also found lower personnel costs (aligned with the current analysis) and lower cost efficiency than a group of comparable cooperative banks. Regardless of how large the potential market is, size is both a limit and the key determinant of alternative banks’ specialness. Upper and lower bounds of bank size can be identified. Below the lower bound, the breakeven may not be achieved, and above the upper bound, a change in scale and organizational setting is necessary to serve a greater number of customers, likely entailing a loss of quality in the relationship with customers. An analytical representation of how to define these bounds is offered in the appendix, Box 1. With an increase in size, a more structured organization and a delegated monitoring system may increase complexity and reduce transparency. This result changes stakeholders’ perception of playing an active role in the bank’s activities and decision-making process and reduces the differences between alternative and traditional banks.

Critical Perspectives on the Role of Ethics in Banks From the previous analysis, it emerges that all banks have an embedded potential ethical orientation that is externalized when they are led by the desire to satisfy of the expectations of stakeholders to achieve the common good. The ideal, holistic model presented in section “A Holistic View of Ethics in Banks” depicts the different driving forces of this attitude. Alternative banks are an application, and not the only one, of this principle, which is eased by the specific nature of their stakeholders. It is not a conceptual revolution but a significant innovative attitude that allows the widening and completing of the market. In fact, alternative banks’ focus on the social sensitivity of a particular market niche and their consequent strategy of product differentiation allow them to be competitive in their target market against traditional banks. Alternative banks offer a whole range of sophisticated financial and nonfinancial services to depositors and borrowers, and they disclose the social impact of their activities. The question of how to measure social impact is a highly debated subject (see, for the case of microfinance, Hulme 2000); however, these non-price competitive strategies meet the expectations of their “alternative” customers and make the bank ethically oriented. The stronger efforts and higher innovation capacity that are required to address the target market mirror an ethical orientation. Another signal is represented by the pursuit of transparency, whose importance is increasingly stressed as a worldwide, cross-cultural value (Vaccaro and Sison 2011; Neves and Vaccaro 2013). San-Jose and Cuesta 2018 foresee transparency as first element in their RAI index; they also applied the index and focused on transparency with reference to Islamic banking; for an ethical identity disclosure index for Islamic banks, see also Rahman et al. 2016). The particular ethical orientation of alternative banks emerges from the previous analysis, but the relationship between traditional and alternative banks is a rather controversial issue. The radical position of some ethical finance supporters (especially in the past) is that there be a clear separation between the two to avoid

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contamination. Isolating alternative finance from the traditional sector, besides being impractical, is not desirable, as the ultimate objective of the promoters of ethical banking is to induce traditional banks to rethinking their choices in favor of new approaches to socially worthy actions. Reality shows that there is not a clear-cut distinction between alternative and traditional banks. As depicted in section “A Holistic View of Ethics in Banks,” while some banks are barely sensitive to ethical values, others offer only so-called ethical investment products and adopt social impact measures as a marketing strategy, but some traditional banks are effectively concerned with sharing ethical values and information with their stakeholders and aim to meet stakeholders’ expectations and have an impact on society by increasing social value. Even when these attitudes are stimulated by the search for a reputation to foster financial performance in the long run, the fact that development and marketing objectives act as stimuli for an ethical orientation cannot be criticized: it may be a first step toward a thorough response by banks to ethical issues. From this perspective, the boundary between traditional and alternative banks becomes blurred, and the phenomenon of alternative intermediaries can be seen as a moment of market completion, which may eventually lead to a process of progressive integration. Indeed, some traditional banks have an inherent ethical orientation and are the closest banks to the ideal model presented in this chapter. A certain degree of physiological discrepancy from the ideal model is intrinsic in the imperfect human nature and in the institutions created by human beings. Physiology may turn into pathology when the levers of good governance are out of the bank’s control. This result may happen for several reasons but is probably more likely to happen under specific conditions, particularly under certain size conditions. Ideal growth should take advantage of economies of scale and scope without losing control. With growth, effective delegation mechanisms must be established. Size is critical for alternative banks but is also a strategic element of success or failure in traditional banks in relation to developing an ethical orientation. In large banks, a more structured organization increases complexity and may reduce transparency and weaken the bank-customer relationship, which is considered a key factor in the success of banks (e.g., Linsley and Slack 2013, highlight the role of relationships in an ethic of care approach, which was lacking in the critical case of Northern Rock bank). In fact, formal procedures, the delegation of power and incentive systems, structured monitoring, and automatic data treatment require that the organization is perfectly aware of any single process in order to achieve a satisfactory bank’s performance and the aim of responding to stakeholders and to society about behaviors. The global financial crisis proved that in some banks internal organization and control systems were not sufficiently fine-tuned to avoid distortive behaviors that ultimately led to banks’ financial distresses and failures. The crisis has surely been the outcome of several contributing factors, including those that were external to the banks. An interesting work by Schoen (2017) offers a revision of the main phases of the crisis and suggests some perspectives through which to reflect on the ethical behaviors of various actors (among them, mortgage brokers and lenders or rating agencies and regulators). Overall, the sudden public discovery of an unbearable level

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of risk revealed that internal governance was weak. If banks had put in place effective governance systems that not only constantly monitored the overall risks taken but also detected eventual deontologically unacceptable behaviors, the distortive process that spread worldwide could have been limited. In a healthy organization, uncontrolled growth in credit granting with limited or no effective credit risk evaluation would not be tolerable. In contrast, the euphoric attitude toward innovative risk negotiations coupled with distortive incentives to managers was not monitored. Observers point out that this phenomenon was exacerbated by a period of weak regulation (Schoen 2017). Regulation may, in fact, contain critical behaviors and drive banks’ choices. However, when regulation substitutes for internal effective governance, the outcome may not be the intended one. In this respect, Kane (2018), in an original interpretation of the role of public interventions in large bank rescues, explains the limitations of regulation and suggests new moral standards interlocking the main players (in his case, the government and bank managers). Bank regulation is increasingly sensitive worldwide and sets standards in terms of governance with compulsory formal internal control processes for the various strategic functions. Many banks are also adopting internal ethics manuals or comply with regulations that encourage a higher ethical standard. Ethical codes may have some impact due to their communication effects (Valentine and Godkin 2017). However, if these standards are not actually embedded in the governance system, they remain just guidelines with limited effectiveness (see also Hurley et al. 2014). Kane (2018) refers to the Dunning-Kruger effect (related to failing to recognize personal limitations) and depicts the self-overestimation of banks’ (and regulators’) skills, making them unaware of the injustice perpetrated during the global financial crisis. Kane evokes as an effective measure the increased individual liability of bank managers (specifically, in too-big-to-fail banks), which would lead them to comply with Kantian ethical imperatives, particularly with regard to treating individuals as ends and not as means. Other works stress malpractice and distortive behaviors. An extensive book by Boatright (2010) analyzes the relationship between finance and ethics and offers different practical perspectives with respect to financial markets and financial services, highlighting critical aspects such as insider trading, the risks originating in the different operations or in governance. Some observers claim the need to regain basic values, such as integrity, trust, responsibility, professionalism, and the quality of services (Cowton 2010; Congleton 2014). While in the reductive approach based on investment choices, transparency is necessary at least for communication purposes, it is actually a prerequisite of a holistic ethical business attitude, where honesty drives the achievement of the common good. In turn, this self-regulation (i.e., governance oriented toward long-term financial and social sustainability) makes, in the holistic view, external regulation more effective and complementary. Implementing the ideal model in large entities requires that the governance, internal organization, processes, and control systems be perfectly aligned with the highest objectives of the bank. Organizations are made by humans, and innermost human behaviors are hard to monitor. However, banks must put in place incentives and controls that, on one side, keep the ethical awareness and the motivation of personnel aligned with the bank’s overall objectives and, on the other side, are

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effective in detecting distortions. The extreme diversification of intermediaries and contracts in recent decades (Rajan 2005) has inhibited a full understanding of the underlying management and decision processes. Banks are currently operating in economies with highly diversified and often highly volatile stages of development, and technology can make bank operations leaner but less personalized. In these complex organizations, establishing high-quality standards and alignment can increase costs that are likely to be compensated for by the long-term perspective, as portrayed in the ideal model. The alternative is that the banks face the highest risk of losing control over their operations, leading to unsustainability. The possible short-term profits created by such a practice would be largely offset by the very plausible negative consequences, which would occur in the medium-long run. The global financial crisis offers clear evidence: the maximization of short-term profit with limited investment in quality standards led to financial distress. This has also been a lesson learned by bank stakeholders who lost trust in their banks (especially in the large ones, as analyzed by Hurley et al. (2014)) and became aware of the need for increased ethical, long-term orientations in banking. The future will reveal whether this seemingly trivial but in fact very powerful intuition will be internalized by banks and their governance systems. Especially in this post-crisis period, when the hard consequences still need to be overcome by banks and when competition exists not only among banks but also between banks and nonfinancial operators that are increasingly entering the financial service market, differentiation strategies may matter. Showing an apparent ethical orientation as a diversification signal would be a temptation, but it is not resolutive. Such a solution may help in the short run to attract some customers, but what truly matters is an ethical orientation embedded in daily operations and the ability to show this strong commitment to the clientele. To redirect banks’ incidental or deliberate diversions from the ideal model, from physiological to pathological cases, no rules or contingent remedies can suffice; the long-term perspective is required. Changing an organization and its culture means working with subjective and complex relationships (Connel 2017). Laouisset (2009) suggests, in the case of UAE banks, a “balanced multi-dimensional virtuous scorecard (i.e., material, intellectual, emotional, volitional and spiritual).” Eventually, turnarounds are demanding and require generational change to be successful. Awareness is essential to this end. Experiences of alternative banking are case studies for traditional banks and act as one driver. Alternative banks’ small size may represent an advantage, as explained above, but their overall attitude can be a benchmark that can be adapted to larger banks. Another driver to increase awareness and innovative bank behavior is represented by a demand for financial services that are increasingly responsive to ethical issues. The pressure of a sensitive public opinion (and market) will probably be a very powerful element in the process of embedding an ethical orientation in banks. Recent positions taken by several crossgenerational movements in support of the environment are a good example of driving forces for a better world. Specific actions aimed at raising concern about banks’ ethics have been at the center of the alternative bank movement. What will make these actions more effective today is, on the one hand, a constructive dialogue

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rather than an unfavorable attitude with respect to traditional banking and, on the other hand, a larger audience that is already sensitive to the promotion of attitudes in favor of the future of mankind and the planet. A third driver that can also influence public opinion is the contribution of research and the dissemination of ideas. This chapter, with no pretension to being exhaustive, is meant to add to this process.

Appendix Box 1 From the Income Statement to the Optimal Dimension of the Alternative Bank

MAIN COMPONENTS OF THE INCOME STATEMENT: Interest rate earned on loans= loans outstanding × interest rate (net of discount) × probability of repayment (hp: no partial repayment or recovery after default) Lnl [(rm–Xb)× (1- pd)] Interest rate paid on funding = interest rated on deposit (net of depositors’ chosen discount) × outstanding deposits (i–Xd) ×Dnd Transaction costs = unit cost of transactions × number of transactions [(nl+nd) × Cld] Salaries = personnel cost (net of discount) associated with each transaction × n. of transactions [(nl+nd) × (w–Xw)] Net profit, all distributed as dividends = % dividend (discounted compared to the average market level) × total value of capital (d–Xs) × Cns

LEGEND nl: number of existing loans L: average amount of a loan nd: number of existing deposits D: average amount of a deposit Cld: average cost (excluding personnel costs) of a deposit or lending file w: personnel cost at market rate associated with each deposit or lending file i: market interest rate on deposits d: dividend in % of capital C: average value of capital shares ns: number of shareholders rm; pd; Xb, Xd, Xs, Xw: as defined in the text

INCOME STATEMENT FUNCTION (F): F = Lnl ×[(rm–Xb)*(1-pd)] – (i–Xd)×Dnd – [(nl+nd) ×Cld+(nl+nd) × (w–Xw)] – (d–Xs) × Cns = 0 Interests on loans

Interests on deposits

Operational Costs

Dividends

The change in F due to an increase in the number of loans is given by: δF/δnl = L[(rm–Xb)* (1-pd)] – (i–Xd)L – [Cld+(w–Xw)]

with δF/δnl > 0 if L[(rm–Xb)* (1-pd)] > (i–Xd)L + [Cld+(w–Xw)]

hp: ndD = nlL.

MAXIMIZATION AND DIMENSIONAL CONSTRAINTS If the only decisional variable affecting operational costs and scale is the number of loans (nl), the bank achieves its target of customers’ satisfaction by maximizing the value of the loan portfolio (nl*L), accounting for two constraints: - a minimum number of loans nl to make the average amount small and provided to the small target borrowers; - a profit greater than or equal to zero (break-even) with the condition that the increase in loan unitary costs due to the increase in size does not exceed a given level that endangers the long-term profitability. Max nl*L (maximization of loan portfolio value) s.t.: nl ≥ h (minimum number of loans) Lnl[(rm–Xb)*(1-pd)]> (i–Xd)Dnd – [(nl+nd)Cld+(nl+nd)(w–Xw)], i.e., (d–Xs)Cns≥0 (profit constraint) The first-order conditions would provide the optimal number of borrowers nl that can be achieved given the current scale and the profit constraint. A more complex maximization problem would allow for the optimal number of both depositors and shareholders (nd, ns) while considering the constrained scale on the deposits side. The analytical solution would be different, but the conclusions would offer similar insights. The optimal number of nl, nd, (and ns) would set the threshold for the level of specialness and ethical orientation of the alternative bank.

Source: Elaborated from Viganò and Castellani (2015)

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Ethics as a Solution to Fraud in Commercial Banks in Uganda Wilson Muyinda Mande

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Evolution of Banking Sector in Uganda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regulation and the Banking System in Uganda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial Banking in Uganda’s Economic Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liquidity and Market Status of Commercial Banks in Uganda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fraud Faced by Commercial Banks in Uganda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Causes of Bank Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effects of Fraud on the Banking Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics and Fraud in Commercial Banks in Uganda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Virtue Ethics as a Solution to Fraud in Commercial Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Implementation of the Ethics Policy in Commercial Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Virtue Ethics Role in Curbing Fraud in Commercial Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58 58 60 61 63 66 66 67 67 68 69 72 73 75 75

Abstract

Fraud has dogged commercial banking sector for some time and continues to do so. Laws and controls have been instituted in order to curb the vice of fraud. In spite of such efforts, fraud has continued with minimal abetting. So in that matter, the current study has advanced the view that adoption of ethics can help to solve

W. M. Mande (*) Nkumba University, Entebbe, Uganda e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_17

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the problem. The study is structured in such a way that, first, the nature and context of commercial banking is discussed. This is given in the following sections: the evolution of commercial banking is presented in three phases, 1906–1953, 1964–1984, and 1993–2019; the regulation and banking system in the country; commercial banking and Uganda’s economic context; and liquidity and market status of commercial banks. Second, the study explains the fraud as faced by the commercial banks. Third, ethics is broached as a plausible solution to fraud in commercial banking. The way of implementing ethics in commercial banks is outlined. Keywords

Ethics · Fraud · Commercial banking · Uganda · Regulation

Introduction The thesis of this chapter is that ethical values have a role to play in mitigating fraud that commercial banks face especially in developing economies like Uganda. For some two decades, the commercial bank sector in Uganda has been growing steadily. In spite of the apparent growth which was partly encouraged by the country’s liberalization policy, commercial banks have been dogged by fraud which is a case of risk. Some commercial banks have been taken over, while about ten others have been closed down in two decades (1993–2014). The state of the banking sector has been characterized by challenges from both within and outside of the banks (Tumusiime-Mutebile 2017). The fact that commercial banking in Uganda has been growing but at the same time at least one bank is closed every 2 years makes Uganda’s commercial bank business setting serious enough to warrant an analysis like this one. The challenge of fraud arises from lack of ethics especially virtues. This is illustrated by that fact that some commercial banks that had been voted the best bank on several occasions had to be closed within a short period of time (Mwesigye 2017). It was weak ethics which led to “bad corporate governance, high cost of operations, and low levels of financial inclusion” (Businge 2017). In view of the foregoing observations and comments, it is appropriate to analyze the link between ethics and fraud faced by commercial banks in Uganda.

The Evolution of Banking Sector in Uganda Commercial banking in Uganda began in 1906 with the establishment of the National Bank of India in Entebbe. In the period preceding 1906, there was no banking institution in the country. It was in November 1906 that the National Bank of India opened its first branch. It extended its services to Kampala 4 years later.

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On the heels of the National Bank of India was the Standard Bank of South Africa Limited which opened a branch in Kampala on September 19, 1912. Both of these banks were foreign in ownership. Other foreign banks which followed included Barclays in 1927. In 1954 three more banks arrived. These were Bank of Baroda, Bank of India, and the Nederlandsche Handel-Maatschappij N.V. (Netherlands Trading Society). These banks often favored foreign business merchants. It was therefore not surprising that by 1950, Ugandans had realized that there was need to provide them with credit. Unfortunately, the exotic commercial banks at the time would not extend credit to Ugandans. This was considered discriminative and therefore unethical. Bank managers, on their part, often gave the reason that Ugandans did not have acceptable and credible financial securities. This implied that risk management was noted at this point. Lending to clients who did not guarantee payback, that is, without collateral, was risky. To resolve the impasse, under Ordinance 20 of 1950, the Uganda Credit and Savings Bank (UCSB) was created purposely to extend credit facilities to Ugandans who sought to do business in agriculture, commercial buildings, and cooperative society on October 2, 1950. The UCSB began operations in Kampala, and by 1961 it had spread to towns of Arua, Fort Portal, Jinja, Soroti, Gulu, Masaka, and Mbale. UCSB took deposits of Ugandans only (Lubega 2015). This was a case of affirmative action where positive discrimination was practiced. Affirmative action is usually a case of remedial justice which is a principle within the ethics realm. Notwithstanding the operations of UCSB, it is plausible to infer that from 1906 to 1965, the commercial banking sector was dominated by foreign banks. After Uganda gaining political independence from the British in 1962, the Ugandan Parliament gave UCSB a new name of Uganda Commercial Bank in 1969 (Kamukama 2017). After the rebranding USCB as Uganda Commercial Bank, the need to regulate the activities of financial institutions became more apparent. For that reason, the Bank of Uganda was created in 1966. The creation of a central bank was in itself a risk management factor. This is because the cardinal role of a central bank is to regulate financial institutions like commercial banks. Having a commercial bank and a central bank in place seemed to satisfy the regular banking need. However, it was realized that in order to support development efforts in the country, a financial institution focused on development needed to be created. So, the Uganda Development Bank was established in 1972. This shows that efforts toward development preceded the emergence of Millennium Development Goals and Sustainable Development Goals of 2000 and 2015, respectively. The number of commercial banks in Uganda has been growing over the years. By the start of 2019, Uganda had about 25 licensed commercial banks. These licensed commercial banks were:

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1993–2019 1964–1984 1906–1953 Pre-independence

(1) Stanbic Bank (2) Standard Chartered (3) Barclays (ABSA) (4) Diamond Trust (5) Bank of Baroda

Prior to gaining national independence in 1962, the opening of commercial banks was moved by economic gains. Although some banks like Stanbic and ABSA have changed names following changes in shareholdings in the home countries, they initially moved to explore new financial markets.

Postindependence

1) DCFU 2) Housing Finance 3) Uganda Development Bank 4) Tropical Bank 5) Centenary Bank 6) Bank of Africa 7) Finance Trust Bank

After independence there was fervor for nationalization of economic enterprises. Politicians wanted Ugandans to be in the driving seats of the national economy. During this period, many local banks were established.

Post-SAPs phase

1) Orient Bank 2) Cairo International Bank 3) Citibank 4) KCB Bank 5) Equity Bank 6) GT Bank 7) United Bank of Africa 8) Eco Bank 9) ABC Bank 10) Exim Bank 11) NC Bank 12) Commercial Bank of Africa From the 1990s, the country adopted economic liberalization policy. This explains why the number of banks increased by more than 50%. However, most of these were foreign commercial banks. So what was set up were actually branches.

It is clear that commercial banks in Uganda have increased in number over the years. However, only 8% are local; the remaining 92% are foreign owned. So, they come with differing cultures. Some three factors influenced the establishment and growth of commercial banking sector in Uganda. The three factors were (i) foreign direct investment (FDI), (ii) struggle for economic independence, and (iii) government regulations and policies like liberalization. These factors though critical did not necessary shield the commercial banks from risks. There were other commercial banks like International Credit Bank, Teefe Bank, Nile Bank, Uganda Co-operative Bank, Greenland Bank, Crane Bank, and others that succumbed to the disastrous effects of risks and had to either be taken over or close shop completely. For that reason, establishment of a commercial had little to do with its survival in business.

Regulation and the Banking System in Uganda The commercial banking system in Uganda is regulated by the Central Bank of Uganda. The Central Bank regulates quality and standards. The financial institutions are classified as follows:

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Tier 1 Commercial Banks In this classification are financial institutions that are authorized to hold chequing, savings, and deposits of individuals and organizations. The financial institutions in this category are permitted to deal in the local and foreign currencies. The financial institutions are required to have a minimum capital requirement of banks up to 1,250,000 currency points or UGX25,000,000,000/=. Given the above roles, the commercial banks in Uganda fall in tier 1 classification. Besides the regulations by the Central Bank, commercial banks also have some limited amount of self-regulation. This is done through the Uganda Bankers Association which among other things has a code of ethics to be followed by all member banks. Tier 2 Credit Institutions In this class are financial institutions that are permitted to make collateral and non-collateralized loans. The minimum capital requirement for tier 2 institutions is 50,000 currency points or UGX1,000,000,000/=. They can serve non-savings customers. These institutions are barred from establishing checking accounts or deal in foreign exchange transactions. These institutions are known as credit institutions. Such tier 2 financial institutions in Uganda are Mercantile Credit Bank, Letshego, and Postbank. Tier 3 Microfinance Deposit-Taking Institutions (MDIs) The financial institutions that fall in this calcification are mainly microfinance. The minimum capital requirement for tier 3 institutions is 25,000 currency points or UGX500,000,000/=. Tier 4 Non-deposit-Taking Institutions like SACCOs and Microfinance Institutions In 1992 the Savings and Credit Cooperatives Organizations (SACCOs) emerged. It is estimated that there are about 112 SACCOs in the country. Most people with little income find it easier to use SACCOs for borrowing. In a SACCO, people save and borrow. In addition to SACCOs, there are mobile money services that people with little income use for financial transactions. All the above financial institutions have specific laws that regulate their activities. What is not given much attention is ethics. Laws and ethics are not necessarily the same. In some aspects, law and ethics meet. For instance, stealing bank funds is as unethical as it is illegal. In other aspects what is unethical may not be illegal. Take the case of usury (high interest rates) which is considered unethical but legally acceptable. For that matter, it means that ethics ought to be given due attention so that it can mitigate both unethical and illegal actions in the commercial banking sector.

Commercial Banking in Uganda’s Economic Context Beginning in the early 1990s, Uganda liberalized its economy. This brought in many investors. About 50% of the commercial banks operating in Uganda were established as a response to economic liberalization policy. With liberalization, there are not only banks but also many microfinance institutions, private money

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lenders, Savings and Credit Cooperative Organizations or SACCOs, and telecommunication companies that offer financial services to low- and medium-income members of society. They find it easier and convenient to transact financial matters with the above quasi-financial institutions instead of the commercial banks. In a bid to achieve the Sustainable Development Goals (SDGs), the government usually avails developing funds to people through institutions like SACCOs and not commercial banks for fear of higher interest rates 22–24% charged by commercial banks. The interest and the requirement for a borrower to have financially viable collateral make commercial banks unpopular among local people (Namara 2019). This heightens the market risk and the business risk for commercial banks. Faced with such challenges, commercial banks have panicked and tried several initiatives in order deal with the risk so as to remain in banking business. The initiatives have included giving loans to salaried people without collateral. Online banking using mobile phones was introduced in a bid to keep clients who were finding it convenient to use mobile money platforms. Since these were excellent initiatives, they increased the commercial banks’ liquidity and other related risks (Tumusiime-Mutebile 2017). Another significant matter in Uganda’s banking sector is that the sector seems to be sandwiched between context and national laws. This is well illustrated in Fig. 1. The above figure indicates that the context in which commercial banks operate in Uganda is one of (i) competition, (ii) information technology, (iii) sustainable development plans, and others. The competition arises from the fact that besides the commercial banks, there are mobile money operators, private money lenders, Microfinance Deposit taking Institutions (MDIs), microfinance institutions (MFIs), credit institutions, and Savings and Credit Cooperative Organizations (SACCOs). All these institutions try to get clients, hence the reference to cut-throat competitions for clients. In such competitions, fraud is possible. Fig. 1 Commercial banking sits between pressures of context and legal demands

Context 1)

• Competition • Information Technology • Sustainable development

2)

Commercial banking National laws

3)

• Central Bank role • Financial Institutions Act

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At the bottom are national laws. These include the role of the Central Bank and the various financial acts which were enacted at different points in time. So commercial banks are caught between two factors: context and national laws.

Liquidity and Market Status of Commercial Banks in Uganda Commercial banks’ main role is to trade money. So, finance is the main commodity of all commercial banks without exception. Other assets only have values if they can be turned into liquidity. For that reason, it is true to underline the view that liquidity is an indispensable factor for most if not all commercial banks. The liquidity position of a commercial bank underlines the strengths of a bank. Liquidity in terms of assets signifies the viability of a commercial bank. Sometimes liquidity is seen in terms of (a) asset accumulation, (b) lending, and (c) profitability. Assets accumulation also enables one to assess the liquidity risk. The liquidity of commercial banks in Uganda by 2017 is indicated in Table 1. Commercial banking in Uganda faces risks every day especially liquidity. This usually affects the overall performance of commercial banks. As shown in Table 1, all the commercial banks met the minimum capital requirement as stipulated by the law. According to the Financial Institutions Act 2004, section 26 (5), all commercial banks are required to have a minimum of 1,250,000 currency points or UGX25,000,000,000. As shown in Table 1, the commercial banks with the lowest capital had UGX34,000,000,000 which is almost UGX10,000,000,000 above the required minimum of the Bank of Uganda. In view of that fact, an international auditing firm, the PricewaterhouseCoopers, intimated in 2017 that overall the banking system in Uganda was doing well. With such levels of liquidity, commercial banks were in a good position to contribute to development in the country. In terms of performance, it is clear from Table 1 that Stanbic Bank with assets of UGX5.4 trillion was the leader in the commercial banking industry, followed by DFCU with UGX3.0 trillion. The first five commercial banks had assets of over 67%. The remaining 19 banks shared the 33%. All commercial banks have assets of UGX24,626 trillion. In commercial banks market is often associated with profitability. In Table 2, the commercial banks (Stanbic, Standard Chartered, DFCU, and Centenary) that had a big market share were also the leaders in profitability in 2016 and 2017. From bank number 5 to number 12, good profits were posted. Bank numbers 13 to 18 posted positive profits though low. It was bank numbers 19 to 24 that posted negative profits. Besides the first 12 banks, the rest of the commercial banks did not appear to have been recognizably profitable. This implied that half of commercial banks could be described as struggling. This was because for 2 successive years, they did not post significant positive profits. Their market share was small and so were the profits. This linear relationship implies that market risks affect the profitability of a commercial bank. Market risk arises from a decrease in the market value of a portfolio of financial instruments caused by an adverse move in market variables such as equity, bond and

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Table 1 Categories of banks according to liquidity strengths Total assets in UGX Percentage in terms of Commercial bank (billions) Branches assets 1 Stanbic Bank 5,400 93 21.9 2 DFCU Bank 3,030 67 12.3 3 Standard Chartered 2,944 14 11.9 Bank 4 Centenary Bank 2,706 64 11.0 5 Barclays (ABSA) 2,477 43 10.1 Bank 6 Bank of Baroda 1,500 16 6.1 7 Diamond Trust Bank 1,437 33 5.8 8 Equity Bank 1,000 39 4.0 The eight banks listed above were the only ones with trillions of Uganda shillings in form of liquidity. These were the strongest commercial banks in the country 9 Citibank, Uganda 951 1 3.8 10 Bank of Africa 689 34 2.8 11 Housing Finance Bank 680 20 2.7 12 Orient Bank 554 21 2.2 The four commercial banks listed above have assets of less than half a trillion shillings 13 Exim Bank 367 4 1.5 14 KCB Bank, Uganda 336 16 1.4 15 Uganda Development 298 1 1.2 bank 16 Tropical Bank 257 13 1.0 17 Finance Trust Bank 179 36 0.7 Uganda 18 Eco Bank Uganda 164 11 0.7 19 United Bank of Africa 153 9 0.6 20 Cairo International 117 8 0.5 Bank 21 GT Bank Uganda 112 8 0.4 The nine banks listed above have assets between 100 and 400 billion. These banks have few branches 22 Commercial Bank of 55 1 0.2 Africa 23 ABC Bank Uganda 50 1 0.2 24 NC Bank Uganda 34 1 0.1 The last group of commercial banks has assets of less than 100 billion. These have one branch each Total 24,626 554 100% Source: https://en.wikipedia.org/wiki/Asset_allocation_among_commercial_banks_in_Uganda

commodity prices, currency exchange rates, interest rates and credit spreads, and implied volatilities on all of the above. Market risk exposures as a result of trading activities are contained within the bank’s corporate and investment banking trading operations. The bank manages market risk through a range of market risk and capital

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Table 2 Market risk of the commercial banks

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Commercial bank Stanbic Bank Uganda DFCU Bank Centenary Bank Standard Chartered Bank Barclays or ABSA Bank Uganda Bank of Baroda Uganda Diamond Trust Bank Uganda Equity Bank Uganda Citibank Uganda Bank of Africa Uganda Housing Finance Bank KCB Bank Uganda Orient Bank Bank of India Finance Trust Bank Uganda Eco Bank Uganda United Bank of Africa NC Bank Uganda ABC Bank Uganda Cairo International Bank Commercial Bank of Africa GT Bank Uganda Tropical Bank Exim Bank Total

Market share 26.02 16.60 13.04 12.12

Remarks It is clear that these five banks with percentages ranging from 9.37% to 26.02% are the predominate ones as far as market share is concerned

9.37 6.42

These seven universities have market share between 1% and 7%

1.93 3.64 5.11 2.16 2.59 1.33 0.62 0.46 0.31

In this group are commercial banks with less than 1% of the market share. Although 1% is low, it is a positive market share

0.20 0.14 0.07 0.07 0.15

The negative market share implies that these banks are weak as far market share is concerned. Some of the banks that were closed had had less than 1% of the market share

0.17 0.25 0.72 078 100%

Source: https://en.wikipedia.org/wiki/Asset_allocation_among_commercial_banks_in_Uganda

risk limits. Banking-related market risk exposure principally involves the management of the potential adverse effect of interest rate movements on net interest income and the economic value of equity. This structural interest rate risk is caused by the differing repricing characteristics of banking assets and liabilities. The governance

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framework adopted for the management of structural interest rate risk mirrors that of liquidity risk management in terms of committee structures and the setting of standards, policies, and limits. This is also true for the monitoring process and internal controls. The financial market is one thing that a single commercial bank cannot control. A commercial bank is simply acted on. Even though financial market is outside the ethics sphere, the attendant problem which is fraud can be controlled.

Fraud Faced by Commercial Banks in Uganda Fraud The term fraud refers to wrongful deception or trickery intended to result in financial gain by a particular individual or individuals. In a banking sector, the purpose of fraud is almost always monetary gain. Given the above definition, fraud is therefore unethical because it runs contrary to the virtues of honesty and contentment. Honesty as a virtue refers to one being truthful, sincere, and therefore not lying or cheating. Contentment is the quality of feeling satisfied with one’s possessions, status, or situation. People who lack these two virtues easily commit misdemeanors or felonies. For that matter, fraud is an unethical predisposition that is common in the commercial banking sector. The motive behind fraud is to steal which results in deprivation of the bona fide owners of the funds. The banking system in Uganda faces high incidences of the fraud. There are many instances of fraud involving commercial banks in Uganda. It was reported that four Bulgarians tried to defraud the bank. There were detained and one deported (Nakabugo 2017). Cyber-related fraud was estimated to be worth $10 million (Techjaja 2017). Fraud in the commercial banking has been noted to take following forms: (a) Check fraud. These include counterfeit, forged, altered, and drawn-on closed account (UBA 2019). Fraud involving checks according to Deloitte survey of 2013 was as high as 50% in the country (Mugisa 2014). (b) Phishing is where fraudsters ask their prospective victims to give bank details electronically. Fraud is committed electronically (Stanbic 2019). (c) Automatic teller machine (ATM) fraud occurs when fraudsters access information of bank clients and use it to withdraw money from their bank accounts (Monitor 2018). (d) Fraudulent activities by banking staff. This includes transfer of small amounts of funds which are below daily reporting threshold to offshore accounts for a long period of time (Morawczynski 2015; Mugisa 2015). (e) Deposit slip scam which occurs when the customer’s agent suppresses the whole amount or part of the cash entrusted to him and forges a bank slip to show as evidence of cash deposited (BOU 2005).

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(f) Manipulation of bank’s database. This occurs where the information technology staff in a commercial bank add fictitious entries. The bank staff in connivance with outsiders install unapproved program on a bank’s Structured Query Language (SQL) server. With this clients’ accounts are tampered with and figures change to the advantage of the fraudsters (Mugisa 2014). (g) Accounting fraud is performed when a business uses manipulated bookkeeping to exaggerate or make their financial standing look impressive. With such tampered financial statements, they seek loans from the commercial banks. Four Ugandan commercial banks in 2017 had to write off UGX20 billion because they had come to conclusion that the funds would be recovered (Mabala 2018).

Causes of Bank Fraud There are several factors that explain why fraud occurs in the banking sector in Uganda. These include: (i) Financial pressure – some people want to live above their income (Nakabugo 2017). (ii) Greed and want of self-discipline lead to the propensity to try get rich quickly. (iii) Lack of ethics – especially when virtues are not inculcated. (iv) Manipulatable internal controls in the commercial banks. (v) Inadequate supervision and leadership in a bank (Clementina and Isu 2016). (vi) National laws that curd fraud being rather weak (Katimbo 2014). The causes of fraud in commercial banks have been classified (Ojo 2008) as (a) endogenous, that is, institutional like the inadequate supervision and weak controls, and (b) exogenous or environmental like greed and general moral decadence; weak legal processes that fail to effectively arrest, convict, and punish offenders are all external to the commercial banks. It is a combination of both endogenous and exogenous factors that makes fraud in the banking sector a serious problem.

Effects of Fraud on the Banking Sector (a) Financial loss – “In 2018 the Criminal Investigation Department 198 cases of electronic fraud resulting into loss of UGX610 million” (URN 2019). A survey carried out by Deloitte indicated that commercial banks in the East African region were losing $245 million or UGX367 billion annually to cyber fraud (The Citizen 2014, Mugisa 2014). (b) Mistrust in the banking system – there are instances where many people letting their bank accounts remain dormant (Oketch and Nakaweesi 2018). In some cases, many people closed their accounts on suspicion of a particular bank nearing closure (URN 2018).

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(c) Increased competition – there is increased competition among financial institutions in the country as MDIs, MFIs, SACCOs, and private money lenders come to provide financial services that commercial banks would have ordinarily provided. People believe it is easier to work with these institutions than commercial banks. (d) Dented institutional reputation – commercial banks’ reputation was dented especially at the time when some of them were being closed and others taken over. (e) Insolvency and liquidation – several banks were declared insolvent, taken over by the Bank of Uganda, and eventually liquidated. These included the Cooperative Bank, Greenland Bank, International Credit Bank, Teefe Bank, and Gold Trust Bank. (f) Court cases involving banks – there have been numerous suits in the anticorruption court on the problem of financial fraud involving commercial banks in the country (ULII – Kakooza vs Eco Bank suit 44 of 2014; Morawczynski 2015; Anyoli 2016; Kabahumuza and Amamukirori 2017; Newvision 2019). Such suits are expensive and time-consuming.

Ethics and Fraud in Commercial Banks in Uganda The lack of ethics was recognized in 2003. For that reason, there was mounting fraud in the banking sectors in Uganda (Panapress 2014). It was deemed necessary to have a code of best business practices and corporate governance principles to counter the menace. The Uganda Bankers Institute contended that the banking sector was rife with fraud because of the lack of code of ethics. Consequently, commercial banks had credit lines which ended up being dormant because both the lender and the borrower were suspicious of one another. Lenders (banks) overcharged the clients by imposing high interest rates, and borrowers presented fake security. It appeared each wanted to defraud the other. The Uganda Bankers Association put in place an ethics policy commonly referred to the code of good banking practice. The cardinal aim of this policy was to ensure that risks in the commercial banks are kept at bay by promoting and maintaining high standards of professional and moral behavior (Mutebile 2010). However, it emerged clearly that all the participating banks had had incidents of fraud among other factors. Bad ethics or failure to adhere to the ethical principles had had a disastrous effect on banks. A number of commercial banks in Uganda that failed due to unethical performance were many and suffered as indicated in Table 3: From Table 3, it can be noted that within 21 years ten commercial banks closed down. This meant that on average, at least one commercial bank closed in every 2 years. This phenomenon undermined the trust the populace had in the commercial banking industry. Furthermore, the failure of the above banks was ascribed to “unethical practices.” The situation could be referred to as one of poor and abusive management which exposed the bank to the seven described risks; consequently the bank had to be closed (Mwesigwa 2014). It was also observed that profitability of

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Table 3 Commercial banks that were closed in Uganda

1 2 3

4 5 6 7 8 9 10

Closed Teefe Bank Greenland Bank Uganda Commercial Bank Fina Bank National Bank of Commerce Nile Bank Global Trust Bank Cooperative Bank International Credit Bank Crane Bank

Year of closure 1993 1999 Taken over

Main causes of collapse of banks The closure and mergers or takeovers of these commercial banks were caused partly by unethical activities. The activities were linked to liquidity risks, insider lending, compliance risks, lack of virtues, credit risks, negligence of professional ethics, and operational risks

Taken over 2012 Taken over 2014 1999 1998 2014

Sources: Mugerwa 2018

commercial banks in the country had been declining, while nonperforming assets and loans had been on upward trend (Businge 2014). The collapse of banks shows a need for ethics in the sector.

Virtue Ethics as a Solution to Fraud in Commercial Banks Virtue theory is an old concept. It is an umbrella term referring to a number of theories. Socrates, as represented in Plato’s early dialogues, held that virtue is a sort of knowledge (the knowledge of good and evil) that is required to reach the ultimate good, or eudaimonia, which is what all human desires and actions aim to achieve. Plato claimed that the rational part of the soul or mind must govern the spirited, emotional, and appetitive parts in order to lead all desires and actions to eudaimonia, the principal constituent of which is virtue. Aristotle (384 BC–322 BC) was a Greek philosopher and a scientist. His book entitled Nicomachean Ethics describes virtue (arête) as a practice or habit – something that is learned through doing. He argued that the more one practiced the arête or virtues, the more virtuous one became. Being virtuous involves possessing the virtues and acting according to them. In this way we learn to be a good person, and by being a good person, we flourish (eudaimonia). In the twenty-first century, the concept of virtue refers to the quality that marks someone’s success as a person. To possess virtues is to be self-actualized, well

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adapted, and fully functioning and to be a good specimen of the humankind. A virtue is an acquired human quality the possession and exercise of which tends to enable us to achieve those goods which are internal to practices and the lack of which effectively prevents us from achieving any such goods. Proponents of virtue contend that what is most important in moral life is not consistent adherence to principles and rules, but reliable character, moral good sense, and emotional responsiveness. Principles and rules cannot fully encompass what occurs when a bank manager advises a pensioner to invest his money in the risk ventures. People’s feelings and concerns toward others and toward duties cannot be reduced to following principles and rules. Virtues are dispositions to behave properly, and they embody a person’s philosophy of life – this includes self-understanding and understanding the natural and social world around. Virtues determine one’s concerns, desires, emotions, and perceptions of virtually everything that is socially and morally valued. Those who work in the banking industry ought to uphold virtues in their duties and dealings. Virtues are many and those concerned with banking industry include: a) Accountability – the quality or state of being accountable, especially an obligation or willingness to accept responsibility or to account for one’s actions. Banking officials have to know about accountability since they deal in finances where activities like auditing are akin to accountability. It is imperative for all the people who handle funds to expect to be asked to give accountability. This should lead people to shun fraud. b) Commitment – the firm carrying out of purpose. The financial sector ought to have people who are dedicated to serve it well and not to defraud it. c) Contentment – this is the quality of feeling satisfied with one’s possessions, status, or situation. The people who engage in fraudulent activities in banks should be lacking the virtue of contentment. Otherwise, people who are not contented normally involve themselves in defrauding a commercial bank money or any other financial institution. d) Diligence – conscientiousness in paying proper attention to a task; giving the degree of care required in banking. Whenever the virtue of diligence is wanting, even the internal controls cannot work effectively. If staff are not diligent, then fraudsters find it possible to penetrate the system and commit actions of deprivation. It therefore follows that commercial banks need staff who are prepared to have sufficient about of determination to not only perform their duties but also look out for the any possible fraud. e) Discipline – the term discipline refers to the trait of being well behaved and under control. The best staff in the commercial banking sub-sector are those who are disciplined. They need to be well disciplined because short of that, they open their bank to fraudsters. f) Forbearance – this is not only about the restraint under provocation, patience, or good-natured tolerance of delay or incompetence; rather it involves bank management and staff to develop this virtue. Lack of it creates windows of susceptibility to fraud among other things.

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g) Frugality – prudence in avoiding waste. Being economical with resources. All resources including finances require one being frugal. Frugality is the opposite of extravagance. It does not preclude people from spending. Those who spend recklessly often want more money to spend. Consequently, when they run out of money, they resort to fraud in order to get more money. h) Honesty – the virtue of honesty is also described as truthful or sincerity. People who possess the virtue of honesty do not lie nor cheat. The banking clients want staff who will be honest. Similarly, the banking staff expect clients especially those who borrow banks’ money to be honest especially with the information they provide. i) Impartiality – this demands that people act fairly, that is, without undue preference of one party to the other. An inclination to weigh both views or opinions equally without bias. When approving loans or other services, it is expected that each concerned party would act fairly, that is, without deliberate intention to favor a side at the expense of another. For that matter the virtue of impartiality is useful in the banking sector. j) Industry – the virtue of industry is about one being hardworking. Since it is true that every human being normally would like to have money, one has to be industrious to the money. Those who get involved in fraudulent actions want money without first struggling for it. Fraudsters use trickery to access funds which they are not entitled to. This unethical propensity is rife in commercial banks because they are collection of finances. Those who engage in fraudulent activities lack the virtue of industry among others. k) Justice – this can be defined as that which people deserve or what they have a right to. It takes various forms; for instance, it may be in the form of receiving a particular treatment or certain goods or enjoying certain prerogatives or freedoms. All these can be required of individuals, groups, organizations, or society generally. What people deserve may be beneficial or harmful. So, justice can be interpreted as fair, equitable, and appropriate treatment in light of what is due or owed to persons. If fraud occurs, then justice is sacrificed in the sense that bank clients or the bank itself is denied what they deserved. l) Resourcefulness – the ability to act effectively or imaginatively, especially in regard to difficult situations and unusual problems. Commercial banking as a sector like other organizations needs the virtue of resourcefulness if it is to weather the fraud storms which frequently rock banks. m) Respect – the virtue of respect demands that one treats others with due dignity. Treating others in that way includes desisting from violating their rights to their funds. The act of defrauding implies failure to respect others. For that matter fraud is unethical because it negates the virtue of respect. n) Responsibility – those who possess the virtue of responsibility have control over events. That is to say, they make decisions and carry out actions for which they are accountable. As noted in commercial banking, staff have responsibility because they possess knowledge of the systems. However, they deliberately use that knowledge to disadvantage other people who deposit their monies with the banks. Almost all the money a bank holds is collection of depositors’ funds.

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It has been noted that there are very many instances whereby staff in the banks collude or connive with other fraudsters out the bank to fleece copious sums of money. Such people lack the virtue of responsibility. o) Trustworthiness – most people if not all deposit their money with commercial banks knowing that they are dealing with trusted financial institutions. In this case, bank clients seem to hold the view that a financial institution is a moral person. Commercial banks are trusted or considered reliable as far as keeping depositors’ monies is concerned. Everyone who deposits money with a commercial bank knows very well that the deposit will be securely kept until the depositor decides to spend it. The deposits ought to attract interest as long as it is kept on the commercial bank for more than a month. This expectation is based on the view that commercial banks use clients’ deposits to make more money. So, to be ethical, the clients ought to have a share in the form of interest. The virtue of trustworthiness is expected of the commercial bank as an institution. When fraud occurs, it wanes the trust depositors have in the financial institution.

Implementation of the Ethics Policy in Commercial Banks Having an ethics policy in place is one thing and implementing it is another thing. It is the implementation which makes an ethics policy effective. For the commercial banks, there are four main actions which are necessary for effective ethics policy implementation. These are: (1) Training Staff in Ethics For staff to know and apply ethics principles, they have to be trained in ethics. However, there is a view that teaching ethics is a debatable matter. In ancient Greece, philosopher Socrates struggled with the question whether ethics could be taught. Socrates intimated that if ethics is knowledge, then it could be taught. Regarding ethics, Socrates argued that since ethics was concerned with the knowledge of what ought to be, it was teachable. Similarly, Ayer (1986) and Ryan and Bisson (2011) stated that since ethics had knowledge, it could be taught. In traditional Ugandan societies, morals were taught through proverbs, stories, and role models. The teaching enabled people to cultivate virtues of industry, gratitude, honesty, generosity, and the like (Mande 1996). Given the fact that ethics can be taught, it is imperative for the Uganda Bankers Association (UBA) to go beyond formulation of an ethics policy and train the employees of commercial banks in ethics matters. This could be integrated in the profession of banking whereby every bank professional must have undergone ethics training. (2) Regular Communication of the Ethics Principles to Staff Good practice comes from knowing, and knowing comes from hearing and having a resolve to practice what has been learned. This implies that UBA and the individual commercial banks in Uganda ought to harp the ethical principles regularly. Different methods may be used in this particular activity of

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communicating information about ethical issues. For that reason, there must be staff who are responsible to ethics issues in the bank. (3) Creation of an Ethics Committee Within the Bank Good implementation of an ethics policy requires monitoring the compliance and provision of information to staff and top management of the commercial bank. The ethics committee ought to be composed of staff from the major department of the bank. Members can serve for 2 years and change. This allows as many staff as possible to have an opportunity to serve on this committee as fraud cases are frequent. (4) Creation of a Conducive Environment Conducive environment for the operationalization of the ethics policy requires each bank to formulate policies that promote ethical conduct of all workers. Such policies ought to be widely publicized on all using noticeboards, bank website, emails, blogs, embroidery, souvenirs, and fliers. The primary purpose is to have ethical principles engrained in the psyche of the staff and other deliberations. (5) Including Ethics in Staff Appraisal Commercial banks through their human resource management departments have a policy of appraising staff every year. The reasons for the utilization of performance appraisals are: (a) Performance improvement (b) Being a basis for employment decisions (c) To aid with communication (d) To establish personal objectives for training programs and for transmission of objective feedback for personal development (e) As a means of documentation to aid in keeping track of decisions and legal requirements (f) In wage and salary administration (g) To aid in the formulation of job criteria and selection of individuals who are best suited to perform the required organizational tasks (h) To be part of guiding and monitoring employee career development (i) To aid in work motivation through the use of reward systems It would be beneficial if ethics was made part and parcel of what the bank appraises. Only a few attributes like leadership acumen, teamwork, and innovativeness are sometimes incorporated. The inclusion of ethics in the appraisal system helps to entrench the ethics culture in the bank. Once ethics is incorporated, staff do not only know but also realize that good ethics practice contributes to their promotion, annual salary increment, and renewal of job contracts. In that way ethics will be streamlined in all the operations of the bank.

Virtue Ethics Role in Curbing Fraud in Commercial Banks Figure 1 illustrates the fact that the context or the environment in which commercial banks in Uganda were operating made it possible for fraudsters to fleece money from

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banks or from clients. The control measures especially the Central Bank or Bank of Uganda and the financial statutes perform a curative role. When fraud has already taken place, then the fraudsters would be hunted and, when found, indicted and penalized accordingly. It is important to consider ethics as a solution to fraud in commercial banks in Uganda’s setting. Ethics especially virtues give conviction to individuals to act ethically even in a situation where they would have acted otherwise. Ethics is more important because it comes from the inside unlike the laws and rules which are from the outside. Laws and rules have been used for some time but were not able to completely wipe away fraud. When ethics is embraced seriously, it is like religious conviction in the sense that those who have the conviction behave according to their conviction. For person who has ethical conviction, acting contrary would be an anathema. Figure 2 shows that the introduction of ethics can shield the commercial bank against the causes of fraud one of which being lack of ethics. It is presumed that inculcation of ethics can help to reduce the fraud cases in the commercial banks. The introduction of ethics in commercial banks can be done at two levels. First, the commercial banks themselves ought to formulate training in ethics for all the staff. This can also be supported by policies that emphasize ethics to all departments of the bank. Second, the Uganda Bankers Association (UBA), to which all commercial banks in the country belong, could be strengthened by instituting a monitoring role. When ethics is streamlined in the operations of the commercial banks, it is possible to curb the incidences of fraud.

Fig. 2 Ethics curbing the incursion of fraud into commercial banks

Context • Competition • Information Technology • Sustainable development

1)

2) 3)

Ethics • Context Commercial banking National laws

4) • Central Bank role • Financial Institutions Act

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Conclusion It has been proven that commercial banks in Uganda face a lot of instances of fraud. Fraud comes from both within and outside the banks. There are many causes of fraud one of which being lack of ethics. Given that perspective, it is noted that fraud brought about financial loss, mistrust, competition, dented reputation, insolvency, court cases, and closure of ten banks. In view of those effects, the chapter has proposed the adoption of virtue ethics. It is hoped that when ethics is enforced by each commercial bank and monitored by the UBA, fraud would be mitigated significantly.

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Mutebile ET (2010) Bankers’ Code of Conduct. Available at www.bis.org/review/r101206b.pdf/ Mwesigwa A (2014) BOU calls for claims from Global Trust Bank Creditors. https://www.observer.ug/ Mwesigye J (2017) Parliament probe into Bank of Uganda activities welcome. https://eagle.co.ug/ 2017/07/28/parliament-probe-bou-activities-welcome.html Nakabugo L (2017) Analysis of fraud in Uganda’s financial institutions. Makerere University Master’s Thesis. http://www.makir.mak.ac.ug Namara E (2019) Tired of corruption, Ugandans explore formal banking opportunities. https:// globalpressjournal.com/africa/uganda/tired-corruption-ugandans-explore-formal-bankingopportunities/ NewVision (2019) Company sues two banks over UGX5billion fraudulent transfer, withdrawal. In The New Vision, https://www.newvision. November 4th Ojo JA (2008) Effect of bank fraud on banking operations in Nigeria. Int J Invest Financ 1(1):103 Oketch ML, Nakaweesi D (2018) Why banks are faced with rising inactive accounts. Daily Monitor, October 16, https://www.monitor.co.ug Panapress (2014) Uganda bankers want code of conduct as fraud mounts. http://www.panapress. com Ryan TG, Bisson J (2011) Can Ethics be taught? In International Journal of Business and Social Science. 2(12). https://www.researchgate.net/publication/236935435 Stanbic Bank Annual Report for the year ended 2013 (2019) Risk management and control. https:// www.stanbicbank.co.ug/standimg/Uganda/fileDownloads/SBU%20Annual%20report%203277.pdf Techjaja (2017) Mobile money transactions are now half Uganda’s national GDP. https://www. techjaja.com Tumusiime-Mutebile (2017) Key challenges for Uganda’s Banking Industry. https://www.bis.org/ review/r170815g.pdf UBA (Uganda Bankers Association) (2019) Fraud Protection. https://ugandabankers.org/ ULII (Uganda Legal Information Institute) (2014) Kakooza v Eco Bank Uganda Ltd. Civil Suit No. 44 pg 2014. https://ulii.org URN (2018) Closed banks: BOU staff hid liquidation reports from governor. In Observer. https://www.observer.co.ug URN (2019) 3 dfcu officials grilled over theft of clients’ deposits. https://observer.ug/news/head lines/61396

A Virtue Ethics Approach in Finance Ignacio Ferrero, Andrea Roncella, and Marta Rocchi

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Strengths and Limitations of the Institutional Perspective on Finance . . . . . . . . . . . . . . . . . . . . . . . . . A Virtue Ethics Approach to Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Good Finance Is Virtuous Finance: An Aristotelian Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Purpose of Finance: A MacIntyrean Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finance and Solidarity: Insights from Catholic Social Teaching . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions and Further Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

The global financial crisis and the subsequent economic recession brought attention to bear on banking and financial activities. Although the financial crisis had several causes, financial and political economists have been largely concerned with the institutional side of the crisis, often marginalizing an ethical dimension as something that diverts attention from what they consider the real structural problems of a complex sector. This chapter (i) reviews existing literature on the ethics of finance from the perspective of virtue ethics and, based on that literature, (ii) offers an explanation of how the institutionalist perspective can be integrated with the ethical approach typical of virtue ethics, showing that finance can be an activity that enhances the good of those who practice it and similarly enhances the effectiveness of financial institutions to contribute to the good of society.

I. Ferrero (*) · A. Roncella Department of Business, School of Economics and Business, Universidad de Navarra, Pamplona, Navarra, Spain e-mail: [email protected]; [email protected] M. Rocchi DCU Business School, Irish Institute of Digital Business, Dublin City University, Dublin, Ireland e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_25

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Keywords

Finance · Virtue ethics · Aristotle · MacIntyre · Catholic Social Teaching

Introduction The aim of this chapter is twofold: (i) to review existing literature on the ethics of finance from the perspective of virtue ethics and, based on that literature, (ii) to offer an explanation of how finance can be an activity that enhances the good of those who practice it and similarly enhances the effectiveness of financial institutions to contribute to the good of society. The global financial crisis and the subsequent economic recession brought everyone’s attention to bear on banking and financial activities, emphasizing the need to distinguish “the wheat from the chaff.” Although the financial crisis had several causes, financial and political economists have been largely concerned with the institutional side of the crisis, often marginalizing an ethical dimension as something that diverts attention from what they consider to be the real structural problems of a complex sector. Consequently, they implicitly associate a good finance exclusively with having good and just financial institutions (Zingales 2015; Calomiris and Haber 2015). “Institutionalists” are right in affirming that one of the main features of a good finance is justice, which is to have just financial institutions (Herzog 2017). However, instead of exclusively attributing the main responsibilities of the financial sector to the behavior and performance of these institutions, it is also necessary to consider the decisions that humans took and which actually lead to the financial meltdown. This consideration leads to the inquiry of ethics in finance, including the study of the moral character of financial agents. Hence, this chapter reviews the literature in the vast domain of ethics in finance, taking both the individual dimension and the institutional and systemic dimensions into account. The contributions included in this critical review share a theoretical framework rooted in the virtue ethics tradition, and in particular, they belong to a school of thought that connects Aristotle, Aquinas, MacIntyre, and the Catholic Social Teaching (Sison et al. 2019). The chapter proceeds as follows: Section “Strengths and Limitations of the Institutional Perspective on Finance” shows strength and limitations of an approach to the ethics of finance that is solely concerned with the institutional side of the financial sector as a means to analyze its role and responsibilities. Once the limitations of this approach are unveiled, Section “AVirtue Ethics Approach to Finance” critically reviews existing literature on the ethics of finance, highlighting three streams of literature, each connected to a specific author or source in the virtue ethics tradition. Section “Good Finance Is Virtuous Finance: An Aristotelian Account” deals with Aristotle’s distinction between “economy proper” and “chrematistics” (Aristotle 1990) in order to discover what it means to be a virtuous financial agent; Section “The Purpose of Finance: A MacIntyrean Perspective” reports on the critical position toward finance of the Neo-Aristotelian

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philosopher Alasdair MacIntyre (2015, 2016) and what the purpose of the financial activity should be through an analysis of the academic thinking that stems from his work on the topic; Section “Finance and Solidarity: Insights from Catholic Social Teaching” illustrates how finance can contribute to a society which adopts solidarity as a core value, as is further espoused by the Catholic Social Teaching. Finally, the chapter concludes by providing avenues for future research.

Strengths and Limitations of the Institutional Perspective on Finance The 2008 financial crisis shed light on the fragility of the financial system. Soon after the crisis, several authors underlined the institutional problems behind its collapse. Acharya and Richardson (2009) analyzed an entire collection of white papers authored by different scholars with the aim of “thinking about what changes to the system can mitigate the damage and, it is hoped, make future storms less likely” (2009, p. xi). In this all-encompassing work, the authors looked into all the major problems concerning the financial system, including the securitization process, the rating agencies, the shadow banking system, derivatives and other financial innovations, the role of the government, and the compensation scheme, among other aspects. All these issues are considered from an institutional point of view, namely, what concerns the structures of processes, products, and strategies. Similarly, Calomiris and Haber (2015) published a book on the fragility of the banking system, arguing that the strengths and shortcomings of banks are ultimately “the predictable consequences of political bargains and that those bargains are structured by a society’s fundamental political institutions” (2015, p. x). By political institutions, these authors mean “the way a society structures the incentives of politicians, bankers, bank shareholders, depositors, etc.” (2015, p. 4). They further claim that when the citizens place the blame on the “moral failings of bankers or regulators, or on ‘market failures’ related to greed and fear, they miss the opportunity to see banks for what they really are: an institutional embodiment of the political system” (2015, p. x). Similarly, Shiller argues that “the magnitude of the collapse after the bubbles burst was largely due not to moral faults but to poorly understood and poorly managed interdependencies and inflexibilities” (2013, p. 404). From these examples, a prevailing focus on the institutional side of finance can be seen. The logical consequence is that in order to have a “good” or better finance, the concern should be firstly directed towards the adherence of the financial system to some institutional features. What then are these institutional features? According to Zingales a good finance is at once “competitive, democratic and inclusive” (2015, p. 1338). More specifically, a competitive finance “relies heavily on the prompts and unbiased enforcement of contracts,” and it is opposed to “a relationship-based finance where the financier secures her return on investment by retaining some kind of monopoly over the firm she finances” (2015, p. 1338). The goodness of finance should come therefore from some kind of institutional setup, such as an unbiased enforcement of contracts. Zingales is not alone in this

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institutional approach. Shiller (2009, 2013) defines a good finance as one that extends its benefits widespread to a number of people, and between different social classes, thereby reducing inequality. Even though these authors differ on the kind of institutional setup that might be deemed “good,” their approaches feature two common elements: (i) they overcome that reductive association for which Pareto-efficiency means good and which represents one of the main problems with financial economics research (Zingales 2015, p. 1340), and (ii) they are mostly focused on the structures of the financial system. Regarding the first point, the debate around a criterion that could integrate the “efficiency argument,” and eventually replace it, has also captured the attention of other disciplines. For example, Herzog (2017) claims that financial markets “have specific features that make them particularly interesting for those interested in justice” (2017, p. 4) and that financial markets should be considered not only from a perspective of efficiency but also from a justice perspective. However, even this broader approach to finance that takes justice into account is focused “mostly on institutions and the ways in which they coordinate and regulate behavior” (2017, p. 14, emphasis in the original). While this search of pragmatic solutions and policy designs is much needed, this chapter highlights that that alone is not sufficient to guarantee a “good finance.” When is it then possible to talk about a “good finance”? History provides a host of answers to the question about the relationship between the concept of “good” and money. These span the poverty of Saint Francis of Assisi on one end to the apology of Gordon Gekko’s “greed is good” (Stone 1987) at the other extreme. Each possible answer has a twofold connotation: it realizes a certain balance in the relationship between the parties involved, and it contains a certain distribution of available resources. Zingales’ proposal for a good finance (i.e., “competitive, democratic, inclusive”) is considered better than a relationshipbased finance that would lead to crony-capitalism. From a “justice perspective,” such a finance should realize a fairer balance between the parties and a more just distribution of resources. A “good finance” then is firstly a “just finance.” This would be coherent with a long tradition, which dates back to Aristotle and Aquinas, who found in the account of justice the key for a good relationship between finance and the society where finance operates. For Aristotle (Aristotle 1995, Nicomachean Ethics, henceforth) and Aquinas (Aquinas 2006, Summa Theologiae, henceforth S. Th., II-II, q.61), justice is understood as two different kinds of relationship. The first kind – commutative justice – is concerned with the relationships between parts. This kind of justice takes place mainly through the exchange of products or services (Aquinas 2006) between individuals or groups. The second kind, namely, that of distributive justice (Aristotle 1995), is described as the fair relationship between the community and the individual in the same way that the whole is related to its parts. This kind of justice concerns itself with the proper distribution of goods among members of the community. It is seen in trading, usufruct, money lending, deposits, or rent (Aristotle 1995), i.e., in actions that manifest exchange (Aristotle 1995). Aristotle refers to justice in exchange as a form of proportionality: “in associations for exchange this sort of justice does hold men together – reciprocity

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in accordance with a proportion and not on the basis of equality” (Aristotle 1995). The Greek philosopher emphasizes this kind of justice because it is what makes exchange possible which, according to him, is the foundation of human association (Aristotle 1995). However, justice also concerns the distribution of resources: where everyone is recognized for what they own, according to merit, dignity, or any other appropriate criterion. Accordingly, a good finance is pursued through (i) a proportion in the exchanges and (ii) a reasonable distribution of resources. It follows on from the former that a good finance does not turn into fraud and remains a vehicle for balanced exchanges, limiting the possibilities of information exploitation and power asymmetries between the parties. Similarly, the second point suggests that a good finance sets the conditions that contribute to a fair distribution of wealth, favoring an allocation of resources capable of contributing to the development of as many people as possible. Moreover, the second point underscores another issue that is central to our account of a good finance, namely, the fulfillment of the purpose of the financial activity. In more concrete terms, a good finance takes on an instrumental role in the development of the real economy by recognizing and giving priority to work. Conversely, a self-referential use of finance, disconnected from productive employment and job creation – the “money that creates money” – represents a threat to both human flourishing and thriving social structures. However, in both cases a good finance steers away from an approach that only emphasizes the particular utility of the individual, for it enhances its relational and social dimensions. If we agree then with the “institutionalists” about what a good finance is, the open question concerns whether – in order to achieve this kind of good – it is sufficient to have fair and just institutions. Some insights suggest that this is not the case. Even though a competitive finance is desirable to avoid crony-capitalism, it is not completely devoid of problems, first and foremost because such “unbiased finance” can easily fall into the anonymity trap, where human relationships are ignored in the name of the impersonality of markets (O’Hara 2016) and technological disintermediation, as we can currently notice in the algorithmic trading. This is a crucial aspect. As explained by Dembinski (2017, p. 68), “the expansion in financial transactions happened at the expense of personal relationships between parties to financial relations, namely intermediaries and their clients.” While this shift towards a “faceless finance” may be perceived by financial economists such as Zingales as a good institutional setting in order to avoid crony capitalism, Dembinski warned that “once relationships are concealed by an algorithm, ethics is on thin ice because in the absence of a human face, empathy – so effective in identifying ethical dilemmas – is unlikely to develop” (2017, p. 68). At the same time, it is a real concern that a bad relationship can actually lead to an unfair finance that assigns more importance to personal friendship between the parties than true competence and better projects of unknown entrepreneurs. This is a concrete dilemma in the resource allocation process that a faceless algorithm is not exempt from: Turner Lee (2018) showed the algorithmic biases against black people or other minorities that can actually characterize the lending of credits. Thus the need for a just finance does not disappear by merely avoiding human intermediaries. Conversely, the human

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dimension still retains a central role, for example, in the coding of the algorithms, and hence the moral character of the programmer cannot be discarded as unimportant (Rocchi 2019a; Roncella and Roncella 2019). Likewise, a plain “more democratic” finance aimed at increasing the number of people involved in the financial mechanisms could be a double-edge sword. An example of this is the 2008 mortgage-backed securities crisis, where a large number of people were allowed to borrow money in the hope that the securitization process could spread their risk beyond national borders. Behind the “American dream” sold by institutions providing mortgages, there was an entire system whose opacity grew as complexity increased. A more inclusive or democratic finance was not sufficient to guarantee neither a just finance nor a good one. These two examples point at a simple but not obvious idea: the moral character (specifically the virtue of justice) of the financial agents is not secondary to the institutional setting of a good organization, and it should therefore be at the center of the debate around a “good finance.” In the quest for a good (or virtuous) organization, Moore and Beadle (2006) identify three main features: (i) the presence of virtuous agents; (ii) a conducive mode of institutionalization, which distributes both decision-making authority and decision criteria within institutions; and (iii) a conducive environment. In accordance with the scheme developed by Moore and Beadle, this chapter highlights that institutional focus is a necessary but not a sufficient condition to have a good finance, given that the moral development of the financial agents who ultimately perform financial activities is not considered. Conversely, a first order condition to have a good finance is to have fair and virtuous financial agents who practice good finance. For this reason, the chapter now turns into a critical review of existing contributions to the ethics of finance as per the virtue ethics perspective.

A Virtue Ethics Approach to Finance The shift from an almost exclusively institutional perspective on finance to the consideration of the moral character of financial agents and the contribution of finance to the good of society needs an appropriate conceptual vehicle to frame the activities of the agents within the financial sector. Among the different schools of ethics developed within normative ethics, namely, deontological ethics, utilitarianism, and virtue ethics, this chapter suggests the latter as the most appropriate option to conduct an ethical analysis of business and finance, since it integrates the advantages of both deontological ethics and utilitarianism. As Sison, Beabout, and Ferrero explain, “virtue ethics, like deontology, subscribes to universal principles, and, like utilitarianism, it considers overall results. But unlike deontology, virtue ethics pays attention to the particulars of agents (motives, intentions, habits, character, relationships) and actions (circumstances, community), and unlike utilitarianism, it maintains that exceptionless prohibitions do exist” (Sison et al. 2017, p. viii). Virtue ethics establishes a link between the actions the human being performs and

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who he or she becomes, asking first what kind of person I become in performing this action or how to live a life worth living. Aristotle, and the authors in the tradition of virtue ethics, identified the supreme good of the human being as “eudaimonia,” which means happiness or flourishing (Nicomachean Ethics, henceforth Aristotle 1995). Flourishing involves “living well and doing well” (Aristotle 1995), and since “flourishing represents the definitive form of virtue or moral excellence, it is human nature in its perfect state” (Sison et al. 2018a, p. 6). Hence, virtues are necessary for and partially constitutive of flourishing. Virtues are “freely acquired habitual disposition or character traits that enables one to perceive, experience emotions, deliberate, decide, and act in a proper way; it is also the controlling factor for eudaimonia (human flourishing)” (Ferrero and Sison 2014, p. 386). This definition of virtue and its relation to flourishing are based on Aristotle, who is considered the father of the virtue ethics tradition. Virtue ethics has been widely used as an interpretive lens for human behavior in the context of business and finance, and the writings of Aristotle, the documents that describe Catholic Social Teaching, and the Neo-Aristotelian elaboration of Alasdair MacIntyre are considered the main sources for the inquiry of business phenomena in light of the ethics of virtue (Sison et al. 2018a). In the Middle Ages, Aquinas integrated Aristotelian teachings into the Christian worldview. More recently, MacIntyre revisited the Aristotelian-Thomistic tradition, highlighting the social and historical dimension of the virtues. His work After Virtue, published in 1981 (MacIntyre 2007), is among the philosophical contributions which sparked the beginning of the revival of virtue ethics, and his thoughts represent a consolidated trend in business ethics literature nowadays (Ferrero and Sison 2014). The authors and sources that are regarded as proponents of the virtue ethics tradition share a specific perspective on human actions, and their elaborations can be grouped under the label of “agent-centered” approaches to ethics. Annas (1993) discusses this categorization, summarizing the difference between approaches to ethics typical of the ancient philosophers, including Aristotle, and modern ethical theories. She describes the former as agent-centered, while the latter as act-centered. Indeed, regarding ancient ethical theories, she affirms that “the entry point for ethical reflection is not isolated problems in the abstract, but my life as a whole and how it is going” (Annas 1993, p. 124), while modern moral theories “often begin from questions about what we do and our intuitions as to how we ought to act” and have as one of their main tasks the identification of “our ways of coming to decisions” (p. 124). As Annas clarifies, this does not mean that ancient theories do not offer criteria for action or that modern theories do not look at the virtues of the agent at all. The difference lies in the emphasis and primacy that ancient and modern ethical theories attribute to the agents and to their actions. A similar classification is offered by Abbà (1996), an Italian philosopher who distinguishes ethical theories based on whether they take the approach of the acting person (“first-person” approach to ethics) or the perspective of an external spectator who is observing and judging the action (“third-person” approach). Explicit references to both Abbà and Annas are contained in the contributions to

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the ethics of finance according to a first-person or agent-centered approach to ethics, and these will form part of the critical review that follows, which also aims to identify the main features of a just finance by integrating the institutionalist view with a virtue ethics-oriented analysis. The following three sub-sections describe a manner in which the institutionalist perspective can be combined with the agent-centered virtue ethics tradition. They review existing contributions related to (i) what it means to be virtuous financial agents, adopting the perspective of Aristotle; (ii) what the purpose of the financial activity should be, considering the writings of MacIntyre and the abundant literature derived from them; and (iii) how finance can contribute to a society which adopts solidarity as a core value, as espoused by Catholic Social Teaching.

Good Finance Is Virtuous Finance: An Aristotelian Account To Aristotle, the ultimate goal for human beings is happiness or flourishing, which he considers to be equivalent (Aristotle 1995). The Greek Philosopher claims that the only way to attain happiness is to live a virtuous life. However, to achieve this kind of life, human beings need material goods (external and bodily goods) as a means to obtain the internal goods of the soul, excellences or virtues (Aristotle 1990, 1323b). In his schema, “politics” is the most important science, because its object is flourishing. Nevertheless, to achieve this goal, politics needs two sub-disciplines, one to take care of the material goods, which is referred to as economy (oikonomia), while the other takes care of the non-material ones, ethics (ethike). The former divides into two main activities: how to use and distribute wealth – the economy proper – and how to acquire and produce wealth, chrematistics (1990, 1253b). The production or acquisition of material goods is a means to the end, which is the usage of those goods. Therefore, Aristotle can distinguish between a natural way to produce material goods for a proper use and an unnatural way, when the purpose of that production is only accumulation (Aristotle 1990, 1257b, 35–40). When the provision of material goods becomes an end in itself, without any other purpose than to have more and more, the chrematistics becomes unnatural, and it represents a threat to happiness. From this perspective, finance can only be good or virtuous “insofar as money and financial resources are used to acquire, produce, or purchase other goods necessary for flourishing” (Ferrero and Sison 2017, p. 3). Finance falls into the realm of chrematistics, and hence it cannot be an end in itself; it has to be purpose oriented. This purpose should be to provide material resources as a means to produce non-material goods such as virtues, with a view to flourishing, the final end of human beings. If more is not always better, the production of material goods or wealth and, in the case of finance, the production of financial resources have to observe a limit. Consequently, the financial activity can be judged as “virtuous” or “vicious” depending on whether it keeps a “natural” limit. From an Aristotelian perspective, finance becomes a vicious activity, “not by reason of its object, but because of the

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agent’s intentions or motives. There is nothing wrong about making money as long as it doesn’t become an end in itself (. . .) It becomes a vice when the agent is overcome by an inordinate desire for wealth or greed, accumulating money for itself” (Sison et al. 2019, p. 996). The real question is how to determine this limit since no mathematical formula exists to determine how much is enough or what the natural limit might be. The only way is to judge every particular situation, weighing up the real intentions of the agent, the relevant circumstances, and the expected consequences of every decision. This is precisely the role of practical wisdom. Aristotle defines practical wisdom as prudence or phronesis as the ability to choose the appropriate means to achieve a moral good, ordering the means correctly in view of an end that is good for mankind (Aristotle 1995). Practical wisdom involves practical reasoning of that which ought to be done (Aquinas 2006) alongside a correct order of particular actions (Aquinas 2006). Practical wisdom is able to analyze complex situations (Roca 2008), aimed at doing the right thing given a set of particular circumstances (Melé 2010, 2012). Therefore, practical wisdom is the virtue of good judgment in practical situations (Tsoukas 2017) and governs our ability to decide what to do (Koehn 1995; Hartman 2008; Solomon 1992). Therefore, practical wisdom or prudence plays an essential role in establishing what is the right amount of financial resources that a society needs to serve the real economy. Moreover, this decision also needs to attend to the demands of the virtues of moderation, justice, and courage: it needs “the practice of self-control over wishes and desires, careful attention to duties toward the material welfare of others and one’s own, determination to overcome challenges and difficulties at work” (Sison et al. 2019, p. 998). In this way, financial agents have the opportunity to grow in the virtues in the context of a really “good finance.”

The Purpose of Finance: A MacIntyrean Perspective MacIntyrean scholarship has been quite influential in business ethics (Beadle 2017) and, as this chapter shows, also in the ethics of finance. This section critically organizes primary and secondary literature regarding MacIntyre’s perspective on finance, and it discusses how secondary literature in particular, despite MacIntyre’s own criticism of the structures of finance, helps in recovering the original purpose of finance and unlocks its potential to be a virtuous and purposeful human activity. MacIntyre’s perspective on the economy in general has always been particularly critical: the figure of the bureaucratic manager as one of the fruits of the culture of emotivism in After Virtue (MacIntyre 2007) is just one of the many famous examples of a set of references to business and finance as almost irredeemable human practices. For example, in an interview in Kinesis, MacIntyre discusses the impossibility for financial management to be listed as one of those activities which he calls “practices” (MacIntyre 1994), and this is a more precise reference to finance among a set of other contributions where his critique is more generally directed at business and the economy (e.g., MacIntyre 1979). The most extensive

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and interesting contribution which MacIntyre dedicates specifically to finance is The Irrelevance of Ethics (MacIntyre 2015). In this chapter from the edited volume Virtue and Economy (Bielskis and Knight 2015), MacIntyre states that educating someone according to the standard of the virtues will prevent this person from achieving a successful career in the financial sector. His reasoning goes in the line of detecting a set of incentives, proper to the financial system, which stimulates the cultivation of vicious behaviors instead of virtuous ones. He identifies four specific traits of moral character that those who work in financial trading are expected to have and which are directly opposed to four virtuous habits. Using financial traders as a proxy for the other roles in finance, MacIntyre describes (i) their need to be overconfident, instead of having a balanced self-awareness; (ii) their tendency to be reckless in risk-taking instead of virtuously courageous; (iii) their incentive to have an unbalanced attention toward the present instead of a more reasonable longterm perspective; and (iv) their tendency to benefit themselves and their clients first instead of casting a wider concern to the overall actors present in the market. This discussion is framed in the more general consideration about the fact that the vocabulary of the virtues and the way of understanding the role of money have been disconnected. In the 2016 Ethics in the Conflicts of Modernity (MacIntyre 2016), the reference to the financial sector is not as explicit as in The Irrelevance of Ethics, yet MacIntyre specifies by means of different concrete examples how the preferences that human beings need to maximize are not market preferences but the order of goods of human life. In this analysis, MacIntyre reconsiders the fact that money cannot be the end of an exchange but serves as a means to achieve different individual and common goods. In explaining Aquinas’ reception of Aristotle, he expounds how for this author “agents need to understand that the acquisition of money is no more than a means to the achievement of and the acquisition of goods and that such achievement and acquisition is to serve common goods” (MacIntyre 2016, p. 91). It is helpful to frame these positions of MacIntyre toward finance in the more general theoretical architecture of his thought, which heavily nourishes secondary literature on the ethics of finance inspired by MacIntyrean constructs. MacIntyre builds his definition of virtue on three pillars, which are three fundamental elements of his proposal for moral philosophy: the concept of practice, the understanding of individual lives as narrative unities, and the concept of tradition. MacIntyre describes a practice as “any coherent and complex form of socially established cooperative human activity through which goods internal to that form of activity are realized in the course of trying to achieve those standards of excellence which are appropriate to, and partially definitive of, that form of activity, with the result that human powers to achieve excellence, and human conceptions of the ends and goods involved, are systematically extended” (MacIntyre 2007, p. 187). This definition sums up different fundamental concepts: the existence of human activities that are at the same time coherent, complex, cooperative, and socially established and the possibility of achieving – by practicing these activities – both internal goods and standards of excellence typical of this kind of activities. Internal goods are goods which are not rival and not excludable: they synthetize the excellence of the activity itself and the

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excellence of the person who is practicing the activity (Moore 2017). They are the opposite of external goods, which are material, excludable goods, such as power, reputation, and status. Through the definition of practice, MacIntyre wants to highlight the existence of activities whose development not only allows the achievement of a material result but also helps the agents to perfect themselves while enhancing the standards of the activity itself and thereby improving the tradition. Practices are usually hosted by institutions, who put in place the structure for the practice to develop but who can also constitute a risk insofar as they can privilege the achievement of external goods over internal goods. And this is the case, usually, in finance. MacIntyre thinks that the financial sector is structured in such a way that the desire for material incentives is so high that it can crowd out any desire for a virtuous life that a financial agent has or at least that it can potentially nurture the tendency to give up virtuous behaviors for material rewards. Due to the presence of these institutionalized incentives, working in a financial institution prevents the agent from living a virtuous life and a life of integrity, where integrity is the virtue of showing the same moral character in different contexts (MacIntyre 2006). These are the specific points in which MacIntyre’s criticism takes action. However, as Rocchi (2019b) argues, MacIntyre’s criticism is not directed to finance qua finance but to the way finance is currently institutionalized. If the practice-institution relationship develops in a way that the institution actually protects the practice, agents can live a virtuous life more easily than in an environment where the logic of the institution prevails over the original spirit of the practice. For MacIntyre, it is essential to observe the development of the agents in the narrative unity of their individual lives. In finance, as in any other field, this means that agents need to be self-aware of the fact that, even if they can interchangeably assume different roles, they are still the same person. The integration of personal and professional roles can help the agents to develop their personality traits and to become the best version of themselves. The problem arises when different roles have different and contrasting priorities or conflicting requests. People working in the financial sector can be asked to carry out an activity in a way that they would prefer not to perform as requested if, for example, they were in the presence of their children. In these cases, it might be easier to opt for compartmentalization (MacIntyre 2006) and to show the requested moral character in different contexts instead of remaining coherent to one’s own moral character. Understanding life as a narrative unity means to interpret every role with the same attitude, being able to judge, case by case, the goodness of different situations and living out the virtue of integrity (MacIntyre 2006). The different lives of the many agents share the same context, which is a tradition: the way a community chooses to order its goods and evaluate its standards of excellence. Indeed, in order to fully characterize the dynamic of the virtues, MacIntyre emphasizes the enhancement of social traditions as a last essential passage. Traditions are the context of individual narratives, and they keep alive and improve the concept of excellence of a community over time. In some way, a financial activity can contribute to the achievement of the good of the community as

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a whole – only insofar as it is based on a virtuous practice-institution dynamic, which favors the virtuous integral development of financial agents. Accordingly, the standards of excellence of the different activities within finance are preserved and improved, and these standards of excellence align with a shared conception of the good within the context of the society where finance operates. All the abovementioned concepts are relevant for finance ethicists in their undertaking to build a more optimistic portrait of financial activity than the one suggested by MacIntyre. Many scholars have tried to apply MacIntyre’s concepts to different domains within finance. Given the complexity of the financial sector and the wide variety of roles, this endeavor has assessed whether different kinds of financial activities can be considered “practices,” as per MacIntyre’s definition. Robson (2014, 2015) enquires about banking; Wyma (2015) writes on investment advising; West (2016) extends the argument to accounting; Rocchi and Thunder (2019) offers a direct reply to The Irrelevance of Ethics, asking whether a good person can be a good financial trader; and Roncella and Ferrero (2018) discusses the collapse of a money market fund from a MacIntyrean perspective. And even more generally, different papers address the influence of MacIntyre on finance: Characterizing Virtues in Finance (Sison et al. 2019); Virtues and the Common Good in Finance (Sison et al. 2018b); and Aristotle and MacIntyre on the Virtues in Finance (Ferrero and Sison 2017). The article Can Finance Be a Virtuous Practice? A MacIntyrean Account (Rocchi et al. 2020), taking into account the primary and secondary literature described in this section, defends the thesis that finance can be considered a “domain-relative practice” (Beabout 2012), whose purpose is to create the material conditions for the development of projects creating common goods. All these contributions contain explicit and extended references to the application of MacIntyre’s thought to the financial sector. As the discussion on the future of finance is providing a growing body of academic literature devoted to the discussion of the rising financial technology (fintech) sector (Lynn et al. 2019), so finance ethicists begin to dedicate their efforts in highlighting the new ethical challenges that arise in the adoption of fintech. MacIntyrean influence is also felt in the emerging academic debate, in contributions such as Technomoral Financial Agent: Ethics in the Fintech Era (Rocchi 2019a), where the author argues for a return to ancient ethical theories to solve the new ethical dilemmas of twenty-first-century finance, suggesting that academic curricula in fintech should be integrated with an agent-centered ethics and nourished by the MacIntyrean proposal. So far, this literature review has shown the efforts to apply the perspective of an agent-centered ethics inspired by MacIntyre’s Neo-Aristotelianism, to rehabilitate finance as a meaningful human activity. Working in finance with a virtue ethics outlook can help financial agents become the best version of themselves, while they also contribute to the good of society. Yet, this description of the purpose of finance should not be idealistic and needs to be constantly contrasted with the reality of financial markets, the design of incentives in financial institutions, and the fragility of human nature. This is the reason why MacIntyre’s practice-institution schema is still a valid theoretical tool to analyze ethical challenges of present and future

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finance. Moreover, this section provides the theoretical tools to integrate the abovementioned institutionalist perspective with a virtue ethics approach to finance. On the one hand, it comprises the institutionalist aspiration for “perfect” institutions that can actually lead towards a good finance but which avoids dealing with agent misbehavior, while on the other hand, it highlights the positive role that the agents’ character can play both in resisting the pressure of merely material incentives and in determining the purpose of good institutions in the wider framework of society. The former is what MacIntyre refers to as the acquisitiveness and competitiveness of the institutions (MacIntyre 2007).

Finance and Solidarity: Insights from Catholic Social Teaching Both Aristotle and MacIntyre underlined the risk that financial agents are exposed to when they are concerned mostly (or firstly) with external rather than internal goods. This concern is shared among prominent financial scholars, even though each one might phrase it differently. Rajan, for example, claims: “But because their [financial agents] business typically offers few pillars to which they can anchor their morality, their primary compass becomes how much money they make” (2011, p. 126). If the financial sector lacks an internal criterion able to halt that sentiment of euphoria that triggers the typical mechanisms behind financial bubbles or herding behaviors, a need emerges to look for these criteria somewhere else. In this sense, an authoritative voice that stems from its age-old tradition is that of the Catholic Church and its Social Teaching. This term usually refers to the corpus of encyclicals, pastoral letters, conciliar, and other official documents with a social focus, whose beginning is generally traced back to the encyclical Rerum Novarum by Pope Leo XIII (1891). The relevance of finance for contemporary capitalism makes a dialogue with the Catholic Social Teaching (henceforth CST) urgent, even though the relationship between these two worlds has not been always straightforward. Probably due to its Aristotelian influences, the CST has been mostly focused on the harmful aspects of finance, condemning practices such as usury (Mews and Abraham 2007, pp. 3–5) or, more recently, a certain type of speculation (Guitián 2015a, Chap. 7). Nonetheless, Catholics have also been a source for important financial products that shaped economic institutions of the West such as the Montes Pietatis, i.e., low interest rate lending institutions founded by the Franciscans throughout Europe in the fifteenth century (Todeschini 2004, p. 172). Even nowadays, the Catholic Church continues to express its perspective on financial activity, both by underpinning its positive role in sustaining economic growth and through sounding its concerns about the social and ethical threats that financial products can trigger. In this vein, the Congregation for the Doctrine of the Faith (henceforth Congregation) jointly with the Dicastery for Promoting the Integral Human Development recently published a document entitled Oeconomicae et pecuniariae quaestiones: Considerations for an Ethical Discernment Regarding Some Aspects of the Present Economic-Financial

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System (Congregation 2018) that recalls the long-standing tension in the financial world between the systematic presence of distortive practices and the existence of a vocation of its own consisting in serving the real economy. If finance has a crucial role to play within the larger economic order, there should be a virtuous way to fulfill it. Pope Francis, who in some of his social writings did not spare words of harsh condemnation of a certain type of selfreferential finance (Francis 2013, #58; 2015, #109), also said “economy and finance are dimensions of human activity and can be occasions of encounter, of dialogue, of cooperation, of recognized rights and of services rendered, of dignity affirmed in work” (Francis 2014). In order to understand under which conditions finance contributes to the service of the economy, “a synthesis of technical knowledge and human wisdom is essential” (Congregation 2018, #1). Thus, the CST has proposed its own format to analyze financial instruments, which results in three phases of (1) seeing, (2) judging, and (3) acting (Pontifical Council of Justice and Peace, henceforth PCJP 2014; Paul VI 1971, #4; John XXIII 1961, #271). The first phase of “seeing” involves the analysis of financial products according to the main scientific results as a necessary step to avoid any shallow moralism. This approach is useful in noting how finance may arise as an attempt to improve the markets, but over time it risks becoming a self-focused practice detached from its original purpose (Gennaioli et al. 2012). The second phase expresses a moral judgment according to three pillars of the CST, specifically (1) human dignity (Compendium of the Social Doctrine of the Church (henceforth CSDC 2005), #105, #132), (2) subsidiarity (CSDC 2005, #186), and (3) solidarity (CSDC 2005, #192, #193). Insofar as financial agents operate in accordance with these principles, they contribute to the achievement of the fourth pillar of CST, that is, the common good (CSDC 2005, #164, #165). These principles, which form the permanent core of CST, are rooted in a complex network of social ideas that shape a comprehensive and transcendent vision of the socioeconomic life. Human dignity is the foundation of the entire CST (CSDC 2005, #107): “From this point forward it will be necessary to keep in mind that the main thread and, in a certain sense, the guiding principle of Pope Leo’s Encyclical [Rerum Novarum], and of all of the Church’s social doctrine, is a correct view of the human person and of his unique value, inasmuch as man is the only creature on earth which God willed for itself” (John Paul II 1991, #11). It is rooted in the fact that the human being has been created in the image of God and claims that he/she is at the center of all social institutions (Guitián 2015b, p. 63). Two main consequences may follow on from this assumption: (1) “the human being is always a value as an individual, and as such demands to be considered and treated as a person and never, on the contrary, considered and treated as an object to be used, or as a means, or as a thing” (John Paul II 1988, #37); and (2) each person has rights and duties, which together flow as a direct consequence from his nature. The respect for human dignity sheds light on another relevant dimension in the world of finance, namely, the priority of workers over capital, which entails that employers “consider the welfare of the workers before the

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increase of profits” (Congregation for the Doctrine of the Faith 1986, #87). It implies therefore a duty to maintain productive capital by investing to consolidate jobs and to create new ones (Sison et al. 2019). The principle of subsidiarity, which seeks to preserve human freedom, requires that “a community of a higher order should not interfere in the internal life of a community of a lower order depriving the latter of its functions, but rather should support it in case of need and help to coordinate its activity with the activities of the rest of society, always with a view to the common good” (John Paul 1991, #48). In the business and financial world, the subsidiarity principle upholds entrepreneurship as well as the need to undertake some risks. In fact, the assumption of risks is not perilous per se, but it becomes so in the case of excessive risk-taking or misunderstanding the risk (which eventually converts a particular investment into a form of gambling). Applying the principle of subsidiarity to finance would mean, first and foremost, to distinguish between risks we can or should bear ourselves, through informal reciprocity schemes, and those we should entrust to financial management. The intended result would be to achieve a demutualization brought about by finance and create new financial processes of mutualizing risks (Dembinski 2017, p. 68). The principle of solidarity reaffirms the social nature of human beings as that of a reality born in a social context as opposed to the individual as society’s atom, asserting the “obligation to contribute to the common good of society at all its levels” (Congregation for the Doctrine of the Faith 1986, #73). Solidarity makes human beings aware of the responsibility they have towards each other, not as an external rule imposed by some authorities but as a response to their own nature. If there is an economic sector that should urgently consider the social dimension as fundamental in its behavior, it is finance. This is largely due to the high risk of abstraction, depersonalization, and commodification that can be observed in its most structured domains (Rooney et al. 2013). Finally, the third phase of this methodology provides an analysis of “acting” without which the CST “would become simply inanimate words rather than a lived reality” (PCJP 2014, #62). Despite the fact that the CST does not propose any technical solutions or models, the Church reminds us that “there is no genuine solution of the ‘social question’ apart from the Gospel” (John Paul II 1991, #5). A crucial point in this proposal is the indispensable role played by the cardinal virtues – justice, temperance, courage, and prudence – and the theological ones, faith, hope, and charity. This framework that CST provides would be of great utility when assessing the activity of financial agents and institutions and their contribution to the common good. This chapter began with an analysis of the key strengths and limits of having only just institutions and integrated that approach with a focus on the agents and their virtues. The CST takes this conversation one step forward, claiming the necessity to surpass justice’s demands with those of charity. According to Benedict XVI: “On the one hand, charity demands justice: recognition and respect for the legitimate rights of individuals and peoples. It strives to build the earthly city according to law and justice. On the other hand, charity transcends justice and completes it in the logic of giving and forgiving” (2009, #6).

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This latter concept was introduced by Benedict XVI (2009, #34) who challenges some of the classical liberalism’s paradigms when he affirms that “economic, social and political development, if it is to be authentically human, needs to make room for the principle of gratuitousness as an expression of fraternity.” The first and second theorem of welfare economics – pillars of the contemporary Western economic model – have meant a sharp dichotomy between the function of the market, i.e., wealth creation, and that of politics, i.e., distribution (Grassl 2011, p. 110). Markets have been configured as ethically neutral or even justified in creating inequalities and injustices that policy would have remedied. In this regard, Benedict XVI recalls how “the Church’s social doctrine holds that authentically human social relationships of friendship, solidarity and reciprocity can be conducted within economic activity, and not only outside or ‘after’ it” (2009, #36) and that our great challenge consists of being able to immerse the logic of gift, as concrete expression of fraternity, into commercial relations and business activities. This is not simply due to a commandment concerning charity, but it represents an economic need. According to the World Investment Report, “total investment needs in developing countries in key Sustainable Development Goals’ (SDG) sectors are estimated at $3.3 to $4.5 trillion per year over the proposed SDG delivery period [2030]. Current public investment in these sectors is around $1.4 trillion, implying an annual investment gap of $1.9 and $3.1 trillion” (World Investment Report 2014, p. 140). If sustainable finance meets this challenge, two goals will be achieved: • First, the demonstration that the “subsidiarity is the most effective antidote against any form of all-encompassing welfare state” (Benedict XVI 2009, #57) and that, instead of waiting for redistributive policies by the state, civil society and the private world can help people in need by providing resources or including them in the production processes. The business world would therefore become the creator of new opportunities even for the weakest segments. • Second, the fact that venerable dimensions such as those of gratuitousness, reciprocity and solidarity, which have their origins in a civil society, can now also be applied to the market sphere, advancing the development of a “new way of understanding business enterprise” (Benedict XVI 2009, #40), as part of the wider project of a “new integral humanism” proposed by Pope Benedict XVI (2009, #78).

Conclusions and Further Research This chapter reviews existing literature on the ethics of finance from the perspective of virtue ethics and, on that basis, seeks to provide an integrated approach to characterizing what a good finance is, something which an institutionalist approach cannot accomplish on its own. While the “institutionalist” approach highlights the need for structural reforms when facing a financial crisis, the chapter considers such a focus as a necessary but not sufficient condition in order to restore a good finance. It suggests the integration of the institutional framework with agent-centered contributions in the virtue ethics tradition, as developed by Aristotle, MacIntyre, and the Catholic Social Teaching.

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The tradition that emerged from these three sources constitutes a philosophical corpus capable of understanding the dynamic of financial agents and financial institutions. Empirical research showed in fact that finance’s contribution to the development of society can be distorted to the point that it represents a threat to both the human flourishing of the financial agents and the stability of the institutions within which they operate (Gennaioli et al. 2012). The coherence between these authors with respect to their interpretation of economic phenomena is based on the fact that the Aristotelian distinction between a natural chrematistiké, respectful of its own limits and dictated by being a “servant” of the real economy, and an unnatural one, which is turned towards itself, is similar to the MacIntyre’s tension between “external” and “internal” goods. This balance, if correctly interpreted, would see the former serving the latter, but if reversed, it implies a gradual corruption of the “practice.” Finally, Catholic Social Teaching makes these concepts its own, emphasizing the priority of labor over capital, and leads them back to a respect of fundamental principles such as that of human dignity, solidarity, and subsidiarity, which contribute to the achievement of the common good of society (CSDC 2005, #164, #165). Insofar as the institutional system will allow, albeit with difficulty, financial agents exercise their freedom so that financial activity might be directed towards its goals. As recent crises have shown, it is not merely an exercise to strive for a better finance, but it also implores the best efforts of society as a whole, given the high level of risk that characterizes this sector. Conversely, if the state of things were such as to guarantee no possibility of seeking the good life, it would be more consistent to abandon naïve visions in which a virtuous life is possible in any professional environment linked to finance and rather to investigate how to create new “practices” whereby we might achieve our ultimate goal. Further research in this field should be guided by the need to model the interaction between virtue ethics-based constructs for finance and the institutionalist perspective, expressing the concepts developed by finance ethicists in a language that experts in finance could easily adopt. Moreover, a role-by-role analysis of the different activities in the financial sector should be conducted, with the purpose of highlighting which activities and roles are most in danger of being distorted by material incentives. Finally, a study of the history of finance, to retrace and underscore its original purpose, would be beneficial to keep finance on track in times when disruptive technological changes obviate human involvement in a number of financial activities. Virtue ethics will need to provide theoretical tools to investigate moral agency in an increasingly technological environment.

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Regulation of Financial Conduct in Russia Irina Grekova and Maxim Storchevoy

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Evolution of Regulation: 1989–2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FCSM in 1993–1999: FCSM and Harvard Consultants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002–2004: FCSM and Kostikov Reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004–2013: FSMS as Weak Regulator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008–2013: Course to Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Since 2013: CBR as Mega-Regulator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Self-Regulation of Conduct in Different Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer Bank Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Microfinance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Debt Collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cross-References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

The chapter is devoted to evolution of regulation in Russian financial sector. In the first part, we describe the general evolution of regulation starting from the late 1980s when the country started transition to market economy to current situation. The system of regulation came through two large stages: 1989–2013 was a period of coexistence of several different regulatory bodies, and 2013-nowadays when Bank of Russia started to serve as a mega-regulator and took the responsibility over all financial sector. We examine positive and negative side of this evolution.

I. Grekova Moscow Exchange, Moscow, Russia e-mail: [email protected] M. Storchevoy (*) St. Petersburg School of Economics and Management, HSE University, St. Petersburg, Russia e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_26

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In the second part, we describe several episodes of self-regulation of ethical behavior in several financial markets (banking, microfinance, and debt collection) and try to explain the factors of their success or failure. Keywords

Financial markets · Stock exchange · Ethics · Regulation · Self-regulation · Russia

Introduction The chapter is devoted to evolution of regulation in Russian financial sector. In the first part, we describe the general evolution of regulation starting from the late 1980s when the country started transition to market economy to current situation. The system of regulation came through two large stages: 1989–2013 was a period of coexistence of several different regulatory bodies and 2013-nowadays when Bank of Russia started to serve as a mega-regulator and took the responsibility over all financial sector. We examine positive and negative side of this evolution. In the second part, we describe several episodes of self-regulation of ethical behavior in several financial markets (banking, microfinance and debt collection) and try to explain the factors of their success or failure. There is little research devoted to evolution of regulation of financial sector in Russia. There is a book about financial regulation of emerging markets (Kawai and Prasad 2012), but Russia was not included. Another book covers just early years of development of financial markets in the Baltics and Russia (Knight et al. 1999). There also some papers about regulation of financial markets in Russia (Ezangina et al. 2016), problems of law enforcement (Pistor 2004), financial backwardness (Tompson 2000), but regulation of financial conduct is mostly not discussed. Some papers focus on particular aspects of ethical conduct like transparency (Farvaque et al. 2012).

Evolution of Regulation: 1989–2020 When Russia turned to the market economy in the 1990s, the country was hardly ready for this challenge. USSR financial sector was dominated by one bank since 1930s – Gosbank (the State Bank) of the USSR which served as a central bank and savings bank for people. Gosbank did not have a profit motive and served as instrument of government policy. It provided loan funds to favored individuals, groups, and industries as directed by the central government and did not care about creditworthiness, reserves, and other “capitalist” concepts. Insurance market was also dominated by one company – Gosstrakh (an integrated system of state insurance organizations in all Soviet republics). Gosstrakh provided compulsory and voluntary insurance and offered a range of products like life and property insurance for people

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to harvest insurance for collective farms or cargo insurance for trade enterprises. The problem of unethical behavior was not very relevant in these markets because the managers and directors of Gosstrakh and Gosbank did not have a profit motive which usually pushes their counterparts in the market economy to bend laws and moral norms. In 1985, the communists announced Perestroika as a process of moderate “reconstruction” of economic system. The main idea was to increase decentralization to increase managerial and economic autonomy of enterprises (i.e., decrease shirking and other unethical behavior of people in overcentralized administrative system). According to this strategy, in 1987, the Soviet Government divided Gosbank into six major banks – the State Bank (“bank of banks”), the Promstroibank (industry and construction bank), which was engaged in lending to industry, construction, transport, and communications; Agroprombank (agriculture and industry bank), which credited the agro-industrial sector; Zhilsotsbank (housing and social bank), whose task was lending and servicing housing and social services; Sberbank (saving bank), serving the population; and Vnesheconombank (foreign economic bank), serving foreign economic activity. In 1988, a revolutionary Law on Cooperation was adopted, which opened up opportunities for entrepreneurship in various fields including financial markets. People started to establish “cooperative banks” or “credit cooperatives” trying to fill a free niche in lending and raising funds. The first cooperative bank “Patent” was registered in Leningrad in August 1988, and then a whole wave of opening banks followed. By January 1, 1989, there were already 43 commercial banks, a year later – 224, and by the end of 1991 – 1357. The quality of these organizations was very heterogeneous. On the one hand, entrepreneurs in this area did not have experience, and on the other hand, many of them were adventurers or just scammers, so many of these banks soon went bankrupt and closed. It was obvious that banking activity required separate regulation, and at the end of 1990, two laws were adopted: the law “On the State Bank” and the law “On Banks and Banking Activities,” which determined the conditions for opening a bank, ways, and methods of control over them. However, the further peaceful evolution of the financial regulation was disrupted by a severe economic crisis. The economic problems accumulated during 1985–1991 (state budget problems, deficit in goods market) led to dissolution of the Soviet Union. After acquiring independency, Russia decided to implement a faster transition to free market. In reality, it turned to be a shock therapy which undermined the trust of population to the government for many years ahead. High inflation in 1991–1992 wiped people’s lifelong savings in Sberbank accounts; high unemployment destroyed people’s feeling of economy security. This created a landscape of general mistrust and fear. Government started to create institutional base for a new market economy, but for many years, it was not very effective. Therefore, in the 1990s, the actors in many financial markets had to solve problems with misconduct themselves. Sometimes they were pretty much successful, and later governments formalized these. Until 1993, there was only one regulator of financial markets – Central Bank of Russia (CBR) who inherited its staff and bureaucratic traditions from Gosbank.

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Initially it was a weak institutional player like the Ministry of Finance. The main purpose of CBR in the 1990s was control of money circulation and commercial banks, and it did not pay much influence to financial markets or problems of unethical conduct. In 1989 CBR with other participants of the market established the first currency exchange – Moscow Interbank Currency Exchange (MICEX) – to conduct currency auctions between banks. It turned to be a very active market, and its quotations were used by the Central Bank for a long time. In 1992, MICEX opened a trading floor for corporate securities and became the first stock exchange market. At this time, the vast majority of enterprise were still owned by state, so no significant stock market was possible. However, it was going to change very soon – between 1992 and 1994, mass privatization was conducted by State Property Committee led by Anatoly Chubais. The main instrument of privatization was voucher – specially issued privatization certificate which every Russian citizen could exchange for a number of shares in any privatized enterprise or to invest in a specially established investment fund. These certificates could be freely traded and exchanged, which immediately created a highly liquid and speculative voucher market. However, majority of Russian citizens did not know what to do with vouchers, and many of privatization dealings were fraudulent or manipulative. As a result, it created considerable obscurity in the Russian corporate sector which lost attractiveness for decades.

FCSM in 1993–1999: FCSM and Harvard Consultants In March 1993, the first regulator of securities market was established – Federal Commission on Securities Market (FCSM). The commission reported directly to president and was independent from CBR or government. In the beginning, FCSM followed advice of Harvard consultants and tried to build a version of an American market in Russia: a legal regulatory framework, clearing and settlement organizations, depositories, large investment banks, asset management companies, mutual funds, etc. Even the first name of FCSM (Securities and Exchange Commission) was borrowed from its American counterpart. Another important legal innovation recommended by Harvard consultants was the introduction of the concept of nominee holder into the Russian legislation. It was a bit unusual because Russian legal system was built on continental legal tradition, but the concept of nominee holder was borrowed from Anglo-Saxon tradition. This innovation had significant influence on the emerging Russian corporate culture. It made the stock market liquid because selling and buying shares became much easier and less expensive. In 1994, after accumulation of experience in voucher auctions, 15 most active brokers decided to create an organized market were the shares of newly privatized companies would be more effectively exchanged. An organized market would have many advantages – general rules, general informational system, common registrar, etc. As a result, Professional Association of Stock Market Participants (PAUFOR) was established. In the same year members of PAUFOR developed the first version

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of rules for the market which included the rules of making contracts, protection of fraud, etc. Victorov (2015) claims that PAUFOR was created by the initiative and guidance of FCSM, however, Alexey Savatyugin, a participant of this process, does not support this and suggests that PAUFOR appeared absolutely independently as self-regulation of market participants, and only later FCSM discovered that this new rules and regulations work good and decided to support them. However, soon it became obvious that PAUFOR should be reorganized. First, the law prohibited to one organization to be a trading platform and a membership-based self-regulatory association. Second, PAUFOR was an association of Moscow brokers, but there were also three other regional associations of brokers (St. Petersburg, Ekaterinburg, Novosibirsk) who developed in isolation with their own rules and informational systems and traded mostly the securities of local companies. It was a mutual desire of all four associations to merge and create one trading for securities. Therefore, in 1995, PAUFOR was reorganized. The Russian Trading System (RTS) was established as a trading platform. National Association of Stock Market Participants (NAUFOR) was created by members of associations a national self-regulating organization of stockbrokers. RTS had to organize a platform for over-the-counter securities market and decided copy the experience and even software of NASDAQ. The entire trading was founded on mutual trust between a narrow circle of brokers, and the trade took place mainly via telephone. Only large brokers participated in RTS (it was not available for small participants). The clients were foreign high-risk investment banks and hedge funds, and the settlements were done in offshore structures (partly due to tax consideration). The main purpose these investments was to purchase cheap Russian equity. The inflow of this money was highly nontransparent throughout the 1990s since it was not usually disclosed which particular investors acquired securities. These investors contributed much to the first stock bubble but were not interested in participation of management of enterprises. At the same time, in 1995, large banks and investment firms were also developing a project of establishing their own association for brokers who were active at the securities floor of MICEX. In January 1996, they created National Financial Association with support of Ministry of Finance and CBR. In March 1996, Russian Duma adopted Law on Security Market which formalized the rules which were developed spontaneously in the market. Following to American practice and Harvard consultants’ advice, FCSM tried to delegated considerable self-regulating functions to associations of brokers. Chapter 13 was devoted to self-regulating organization of professional participants of security market who were delegated with responsibility control professional standards and professional ethics in the market. In 1997, FCSM actually introduced an obligatory membership for all stockbrokers in NAUFOR. This was not accepted positively by the rest of Russian brokers because of dominance of the large brokers in NAUFOR, and it was cancelled in 2000. Therefore, in the 1990s, the Russian stock market operated through two main stock exchanges RTS and MICEX and two main self-regulating associations NAUFOR (brokers) and NFA (credit organizations).

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Unfortunately, the economic effect of stock market in the 1990s and in 2000s was quite limited. It remained a highly speculative environment. The first problem was general lack of trust to market mechanisms and to state protection of investments. There were unclear formal regulations, obscure privatization deals, corporate governance abuses, and especially informal networks of government officials and business leaders. As a result, the stock market was dominated for a long time by nonresident investors who were driven by short-term speculative motive. The main funds for stock market come from foreign high-risk capital, which was very sensitive to any political rumors or to oil prices. The second problem was insider trading which widely practiced in 2000s. There was no law against insider trading in Russia before 2011. The third problem was that Russian companies avoided using equity for financing because they were afraid of potential corporate raiders. If they had to use financial markets as a source of investments, they prefer to issue debt in the form of corporate bonds. That is why the corporate bond market in 2000s expanded significantly, but the stock market was not a major source of major investments for corporate sector. The first speculative bubble happened with government short-term bonds between 1995 and 1998. Oil prices were low, and the government had to borrow lots of money to fill the budget deficit. Investments into these bonds became the main source of financial gains, but the series of bond emissions eventually turned into a financial pyramid. The bubble ended with severe economic shock, depreciation of ruble, and political crisis. However, Russian government did not respond with any restructuring of financial markets for several years (Thießen 2004 and 2005).

2002–2004: FCSM and Kostikov Reforms After the crisis, the head of FCSM was replaced to Igor Kostikov (a director of a large brokerage firm AVK Securities) – the first and the last businessman appointed to this position. He tried to conduct several reforms, but, surprisingly, he was very independent from other informal circles, and his activity was not very comfortable for major players. In early 2000s, macroeconomic stability returned, and oil prices began to rise. A period of economic growth began which could mean development of a normal stock market. Surprisingly, RTS lost its position as the leading Russian equity market because it refused to introduce Internet trading. Liquidity as well as retail stockbrokers moved to the MICEX. RTS continued operations and was still under control of large brokerage houses which used this platform because of its informal network informal contacts and shared interests. In the same time, the MICEX actively developed Internet trade as well as corporate bond and repo markets. Internet trading gave birth to a new generation of discount brokers who could compete with the old RTS brokerage houses. As a result, corporate bond market expanded rapidly in 2000s as the main source of finance to Russian companies. However, the stock market grew very slowly. Mutual investment funds started to accumulate savings from the population, but it was mostly money of wealthy

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Russians, and no mass investors appeared in this decade. The stock market did not improve because of lack of trust and transparency in ownership and protection of stockholders’ interests. This is why in 2002, Kostikov introduced a Corporate Governance Code to increase protection of investors and the transparency of the largest Russian businesses. The leading Russian companies who were preparing for internationalization actively participated in the code development. However, activity of rather independent FCSM with Kostikov was a problem for Russian financial market. Victorov (2015) claims that Kostikov tried to play the role of independent and effective enforcement agency and major players (like largest brokers in RTS) had no influence of Kostikov, which was not usual and comfortable for them. Other experts say that the main reason was corruption in FCSM and the fact that Kostikov lobbied interests of his brokerage firm AVK Securities. Even the Bank of Russia was not very happy because Kostikov insisted on withdrawal of the CBR as the MICEX’s shareholder. When in 2004 the President decided to renew the cabinet of the government Kostikov lost his position.

2004–2013: FSMS as Weak Regulator After Kostikov’s dismissal, FCSM was transformed into FFMS (Federal Financial Markets Service). The scope of its activity was significantly enlarged and now included almost all financial sectors (microfinance, credit cooperative, commodity exchange, and since 2011 insurance) except banking and auditing. At the same time, it was a considerably downgrading of the authority. Initially FCSM reported directly to president, but FFMS became an agency in Russian government. It became a weaker organization unable to effectively supervise the financial markets. First, it was poorly financed and could not pay competitive wages to attract best professionals. Low pay forced the FFMS employees to practice dual-income sources and have second jobs in broker firms and depositories, which created conflict of interests. Different informal networks (large brokerage firms, oligarchic groups, and state corporations) de facto controlled the FFMS and manipulated the agency in their interests (Viktorov 2015). The brokers were not interested in the strong regulator because in this case their business would become less profitable. At the same time, they did not want to remove FSMS completely because it transfers of its functions to CBR as mega-regulator. In 2006–2008, the second speculative bubble grew in the financial markets. Partly, it was a consequence of global financial bubble (led by US mortgage markets). Russian banks abused access to cheap international capital and borrowed too much. The regulators (CBR and FFMS) failed to restrict risky speculative highleverage practices used by the leading investment banks. This factor contributed heavily to the collapse of the MISEX’s repo market, which triggered the 2008 financial crisis in Russia. During the crisis, leading private investment banks fell victim to their risky derivative operations. It ended with sharp drops in Russian stock indexes and equity prices. About one trillion of market valuation was wiped. The Great Recession had a major impact on the regulation of financial markets abroad (Inderst 2009; Friedman and Kraus 2011; Porter et al. 2011; Ferran et al.

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2012). However, the Great Recession was experienced not in Russia as severely as it was in the USA or in Europe, because Russia accumulated huge dollars reserves during several years of high oil prices, and now these money were used to cover crisis needs. Several large companies were saved from margin calls from western banks by Russian government loans. Experts say that this protection actually prevented a healthy process of market cleaning (similar to one which happened after crisis of 1998), and structural problems were conserved for the future crises.

2008–2013: Course to Integration In 2008, the new President Medvedev announced an ambitious program to make Moscow an international financial center. The huge dollar reserves created confidence that Russia is powerful enough to claim a strong position in the global financial landscape. The decentralized regulation of financial markets was understood as a problem in this course. Many saw the problem in the diversity or dualism of regulation structures. There were two leading stock exchanges (the MICEX and the RTS) and two regulators (the FFMS and the CBR). There were no central depository and central clearing. There were a number of self-regulatory organizations of brokers and dealers made the institutional matrix of the markets too complicated and fragmented. In 2011, under pressure of CBR, RTS merged with MICEX creating Moscow Exchange. The purpose was the reduction of the number of organizations with overlapping functions, the creation of a single platform for issuers, traders, and investors, and the reduction of transaction costs and easier trading. In 2011, the law against insider trading was introduced it last. The problem of insider trading was relevant since the early 2000s, but the law was being developed very slowly because there were many hidden opponents of this law which benefited from insider trading. One of them was the Ministry of Economic Development and Trade – the former minister was personally involved in insider trading on several occasions, and the market knew which broker served his interests (Viktorov 2015). In 2011, Federal Insurance Supervision Service was merged with FFMS. This made FFMS the regulator who is responsible for all nonbanking financial markets. In 2012, FFMS introduced the law requiring establishing the position of internal controller in every professional firm of securities market who is responsible for monitoring unethical conduct. All customers’ complaints are directed to a controller who has power to collect all necessary information, take actions, and report about this to the director of the firm. In 2012, the government continued the task of making regulation more effective. The main problem was that FFMS was not powerful enough. So the government considered three options: (1) add more financial resources to FFMS, (2) create a special agency of financial markets in CBR, and (3) transfer all function of FFMS to CBR (Mwenda 2006; Buklemishev and Danilov 2013). Eventually, they chose the third option. There were several cultural and institutional reasons for Russia to choose mega-regulator model. First, there is a historical trend in Russia for vertical

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control both political and economic life. Russian government prefer to have large integrated corporations in any sectors, and one large regulator with one responsibility and chain of command fits well into this model. Second, in financial markets, there is the same model where large banks control about 60–70% of the market, and they can transfer into conglomerates (create their “ecosystems”): banking division, investment division, real estate division, collection division, etc. So a one sector regulator will have limited power dealing with such conglomerates, and it would be more effective to control them by one large mega-regulator.

Since 2013: CBR as Mega-Regulator On September 1, 2013, FSMS was abolished, and all its functions were transferred to Central Bank of Russia. A mega-regulator was created with enormous administrative and financial power. If CBR of the 1990s was mostly busy with money circulation and banking system stability, CBR of 2013 became a very different institution and had a much bigger goal – to protect investors and consumers of the whole financial sector. This protection is very important to increase confidence in the market and economic growth. In 2014, CBR established a special department – the Service for Consumer Protection and Financial Inclusion – whose purpose was to reveal and prevent unethical behavior in the market. They should monitor violation of financial services consumers’ rights protection, accept complaints, and appeals and draft of amendments to laws and regulations. After 2016, the Service is headed by Mikhail V. Mamuta, a former self-regulatory activist of microfinance market. The Service conducts regular research revealing unethical conduct in financial markets and makes a lot of effort to detect unethical actors and introduce new restrictions for unethical practices. However, many experts claim that CBR as mega-regulator lagged behind the needs of its participants and in many cases is neither effective nor efficient. In 2019, ATON investment company conducted a survey of more than 100 professional participants of securities market. They mostly supported the positive effect of CBR regulation which increases the confidence and stability of the market but also provided some criticism to its relative inefficiency (Grekova 2019). This is the main points of their criticism. Large number of regulations. Nowadays, there are about nine thousands of regulatory documents (letters or instructions of CBR which are issued to mitigate current problems). The number of regulatory documents in South Korea was almost the same some time ago (11 125), but after this, South Korea conducted the regulatory reform and reduced this number by 50%. At the same time market capitalization per capita in South Korea is 27,000 dollars and in Russia is only 4000 dollars. Therefore, a six times larger stock market can be regulated with 50% less documents. Fast and unpredicted change of regulations. Experts say that the rate of newly introduced standards is high, but they are not clarified sufficiently before introduction. Standards are constantly updated and often adopted without assessing the

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consequences of their implementation. Letters and instructions of CBR often replace the law, but their speed and variety make the process of compliance very expensive. For example, over the past 30 months, the Federal Laws FZ-115 and FZ-224 were modified 26 times. Lack of communication with the market. Many financial companies complain on the low level of communication and interaction of CBR with financial market participants. Although there are 4–5 large financial conferences every year where CBR speakers come to participate in panels and plenary, many financial firms still do not understand the principles and ideology of regulation and complaint that CBR is death to their concerns in panel discussions. Untested regulations. Experts say that there is no feasibility assessment of compliance costs of new regulatory actions. As a matter of fact, CBR first decides to introduce new regulation and after this starts to assesses its impact and consequences. Of course, CBR has the right to decide whether a new regulation is needed, but it would be wiser to use some method of estimation of compliance costs before this regulation is introduced. Duplicating regulations. Sometimes requests from various departments of the CBR are not systemic and redundant, and the deadlines for execution are almost unrealistic. Moreover, different reporting forms require the same data to be provided in different formats (e.g., forms 0409711 and 0409101). Low level of interagency cooperation. Sometimes CBR does not harmonize its regulations with policies of other governmental bodies. For example, the amendments to Federal Law 54-FZ, which have obliged all noncredit financial institutions to invoice their services to individual clients and added significant regulatory burden to professional participants, are a vivid example for the inconsistent interaction between the CBR and the Ministry of Finance. Costs of regulation. As we see in Fig. 1, the regulatory costs were constantly growing from 2015 to 2017. In 2018, they reduced, but the real factor of their reduction was decreased number of participants of financial market. Andrey Paranich, the deputy director of the self-regulating organization in microfinance

Fig. 1 Regulatory costs 2012–2018 (Grekova 2019)

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market MiR, also provided evidence that CBR regulation led to serious additional cost of MFOs because they had to hire additional people to comply with regulations. As a result, the MFOs have to increase its interest rate for consumers which is a very sensitive issue for this market. Reduction of number of firms. As a result of regulatory pressure, the number of professional participants was falling and reduced by 50% during the last 8 years (Fig. 2). This is viewed by many market participants as a dangerous trend aimed at reduction of competition in the market. For CBR, it is easier to control several large participants of the market instead of hundred small ones. However, small professional participants of financial markets are very important because they may serve interests of small customers. Large players (Sberbank, VTB, Gazprombank, Alfa Bank) mainly work with large companies and rarely deal with securities placements less than three billion rubles. Therefore, the absence of small professional market participants will make it difficult for small companies to access the securities market and negatively affect Russia’s economic growth. Regulation of banking market by CBR was also a subject of strong criticism. The main concern is that the market is regulated in the interests of largest banks who have direct access to CBR executives. There are even legal foundations for the conflict of interests because CBR owns shares in Moscow Exchange and Sberbank (the largest commercial bank in Russia). The pressure for CBR to sell these shares was discussed many times, but there was not movement in this direction until February 2020, when CBR at last announced the plan to sell Sberbank shares to the National Reserve Fund. However, the problem is not only with Sberbank. After 2008, CBR several times provided special support for the largest banks but constantly increased pressure on the general banking system which was very sensitive to smaller banks. There were several reasons to increase these regulations. In 2010–2011, new Basel III requirements introduced for additional risk reduction, and CBR had to translate these regulations to the Russian banking system. At the same time, CBR introduces the criteria for distinguishing “systemically important” credit organizations which have rights for government support in crises. The whole system looked unfair and after 1,400 1,200 1,000 800 600 400 200 0

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Fig. 2 The number of professional participants of securities market (Grekova 2019)

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2016 CBR started to discuss introduction of “proportional regulation” where the banks would divide into two groups: (1) the largest with higher regulatory requirements but with more opportunities and (2) middle and small banks with reduced requirements but limited functions. In 2016, CBR suggested the term of “regional banks,” but many small banks did not like it, and the term was abandoned. In 2017, CBR finally introduced two types of banks: universal (more than 1 billion of capital, all types of operations, higher regulatory load) and basic (from 300 million to 1 billion, smaller capital requirements, limited number of operations, lower regulatory load). Banks with smaller capitals could be transformed into microfinance organizations. The purpose of this regulation was to reduce regulatory load of smaller banks and to reduce their costs to make them more competitive. However, in 2015–2016, many acts of CBR made the competitive positions of small banks worse and worse. In 2016, many CBR orders restricted small banks opportunities to participate in serving budget money, participate in governmental programs of subsidies, etc. Besides this CBR conducted a policy “cleaning” – withdrawing license from banks who made some mistakes or had some problems with liquidity instead of curing steps. All these measures were interpreted by many experts as a result of lobbying by large banks. In 2017 the Association of Russian Banks (about 400 members many of whom are medium and small banks) publicly criticized CBR for regulating the market in the interests of largest banks (limited competition) and hidden attempt to decrease the number of small banks and to limit competition. This criticism was very negatively met by CBR and the largest banks. In July 2017, seven biggest banks who represented 70% of all assets of banking system (Sberbank, VTB, Rosselkhozbank, Gazprombank, Alfa Bank, Bank Otkritie, and Binbank) announced their decision to withdraw from the Association of Russian Banks and join another banking association – the Association of Banks of Russia – who demonstrates a much more flexible position in relationships with CBR. However, recently, CBR made significant efforts into preventing unethical behavior in the financial market. In 2017, CBR announced a new ideology of market regulation with strict distinction between prudential regulation and conduct regulation. Prudential regulation deals with stability of financial organization and prevents unwise decisions which may lead to defaults and crises. Conduct regulation deals with unethical behavior of financial organization toward their customers. CBR declared conduct regulation which would have reactive and proactive components. The reactive component is the handling of complaints – CBR created the hot line to accept the complaints for all financial services. This helps to resolve complaints as such, but on the basis of analysis, two types of decisions were made: • If there is comparatively low number of complaints for some financial product (e.g., 3 complaints per 1000 of contracts) but some organizations generate significantly higher complaints (e.g., 10 complaints per 1000 of contracts), then there is something wrong with the organization. CBR sends additional inspections and requires additional control. This allows to reduce regulatory load on other organizations who do not generate complaints above average.

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• If there are a lot of complaints for some particular financial instrument (e.g., 100 complaints per 1000 of contracts), then CBR makes a conclusion that something is wrong with this instrument as such and develops systematic changes in this instrument regulation. For example, such instruments as foreign currency mortgage or microloans were severely limited on this reason. The proactive component is the establishment of rules for how and to whom financial instruments are sold and how the interests of the citizen are protected in the financial market. Recently, there were also some signs of reduction of massive regulatory pressure. In 2019, Russian government announced the idea “regulatory guillotine” – elimination of excessive and ineffective regulations, and CBR joined this initiative by creating several working groups. During several months, in 2019, they gathered about 700 suggestions from the market participants, and CBR already agreed to cancel first 100 obsolete or duplicated regulations. This is not much comparing to the total number of about 9000 regulations, but we may hope that this process will continue. However, the recent policy of Central Bank is evaluated quite critically by some experts. For example, Alexey Savatyugin, who served a president for several financial professional associations (NAUFOR, NAUMIR and NAPCA) and now works as an auditor of Accounts Chamber of the Russian Federation (the parliamentary body of financial control in the Russian Federation) admits that since the Central Bank became a mega-regulator, it began to pay much more attention to the ethical behavior of all participants in financial markets. However, in many aspects this attention is too paternalistic and impose unnecessary limitations onto free market. At the same time, the Central Bank itself has many hidden opportunities for conflicts of interests and for corrupt behavior.

Self-Regulation of Conduct in Different Markets In this chapter, we will describe several particular markets and will see how selfregulation of ethical conduct was developed. First, we describe the situation in consumer bank loans in 2008 when there were two unsuccessful attempts to introduce codes of conduct to reduce unethical practices. Second, we describe the evolution of microfinance industry and its unsuccessful attempts to introduce selfregulation ended by strong intervention of CBR. Third, we consider the debt collectors market and their successful work of implementing self-regulation for many years before the law about debt collection was finally adopted by the state.

Consumer Bank Loans In the late 1990s, in Russia, banks and retailers started to offer consumer loans at the place of purchase – in home appliance stores, electronic stores, etc. The pioneer of this model was the bank Russian Standard. These loans had a high interest rate

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(about 70–80% per year) but were granted very quickly (within 30 min) and with a minimum set of documents (no guarantors, certificates of employment, etc. were needed). In the early 2000s, the economy began to grow, and the demand for such loans was huge, and soon this business model attracted other banks. Many retail chains had 3–4 bank stalls into its trading floors, because consumer credit made it possible to significantly increase sales. The consumer lending boom began; the volume of loans increased significantly each year. For example, in 2004, the volume of consumer loans doubled compared to 2003 and reached 535.8 billion rubles. The share of sales on credit in chain stores reached 50–60%. The model was used most actively by the largest retail chains M-Video and Eldorado. However, new business opportunities came with new ethical challenges. Not all buyers coped with the repayment of loans, and at the same time with the rapid growth of loans issued, delays and defaults also began to grow rapidly. State regulation could not manage this situation and only made everything worse. For example, if the bank brought the debtor to court, the latter, as a rule, required to repay only the amount of the principal debt and exempted the debtors from payment of accumulated interest, interest, and fines. Up to some extent, this resolution restored justice, since the consumers’ debt was artificially inflated by tricky conditions of loan contracts (fines, etc.), but the complete exemption of interest and penalties had also bad consequences: (1) unethical borrowers began to use the court decision as a more profitable option than paying with the bank under the contract and (2) a large number of defaults lead to an increase in the interest rate for the entire market, as a result of which bona fide borrowers suffered. The failure of state regulation was caused in part by the fact that no specific legislation was provided for consumer lending contracts. It was regulated by general norms of the Civil Code of the Russian Federation and the law “On Protection of Consumer Rights” which did not take into account the real issues of consumer lending relationships. In May 2005, the Federal Antimonopoly Service (FAS) and CBR jointly published recommendations on disclosure standards for consumer loans. The recommendations assumed reliable and complete information about the conditions for issuing, using, and repaying a consumer loan in a standardized form, allowing the consumer to compare the conditions of consumer loans of different banks and make an informed choice. Compliance with the standard was monitored by the FAS, who annually published a “white list” of about 50 banks successfully applied these recommendations. However, this measure did not solve the problem. The amount of overdue debt continued to grow, and by the beginning of 2008, according to CBR, the total amount of citizens’ debt on bank loans amounted to more than 100 billion rubles. Experts say that the real situation was about two times worse, because not all indebtedness was reflected in official statistics. It was a good moment for self-regulation of the banking industry. There were two major banking associations: Association of Regional Banks of Russia, created in 1990 on the basis of regional Promstroybank branches and the Association of Russian Banks, created in 1991 as a result of the merger of banking associations in

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Moscow and St. Petersburg. In 2008, both associations adopted codes of conduct aimed at eliminating dishonest practices, but these attempts failed. The initiator of new ethical code in Association of Regional Banks of Russia was a small foreign GE Money Bank, which appeared in 2004 as a result of the acquisition of Delta Bank by GE Capital (a financial division of General Electric). In 2006, rebranding was carried out, and GE Money Bank entered the market with a completely updated product line: consumer loans, mortgages, cash loans, etc. GM Money Bank announced the idea of responsible lending, which was the company’s global strategy (GE Capital already implemented the responsible lending program in 55 countries). All details regarding interest rates, commissions, and lending conditions are communicated to the client. This allows our customers to make informed and independent decisions. According to Elman Mehtiyev, who at that time was the president of GE Money Bank, they were the first to introduce a number of self-restrictions, to which the vast majority of Russian banks were still very far away. For example, GE Money Bank was the first to limit the amount and terms of late payment penalties, introduced a strict policy of controlling the sale of additional products (borrower’s life insurance), controlling the ratio of the amount of debt to the borrower’s current income, etc. At the beginning of 2008, GE Money Bank suggested the Association of Regional Banks of Russia to develop and adopt a “Code of Responsible Consumer Lending.” According to Richard Gaskin, this code was to become a self-regulatory tool for ethical behavior of banks that preach not only the letter of the law but also its spirit. At the same time, it is important for the strategic development of banks, as ethical banks receive a long-term credit of trust from the population. The code received support from the Association of Regional Banks of Russia. The president of the association, State Duma deputy Anatoly Aksakov, said that the adoption of a corporate code of ethical principles would help, through joint efforts, create conditions to prevent and combat unfair competition. According to Aksakov, this code of mutual trust and respect between a responsible creditor and a bona fide borrower was supported by the Bank of Russia, the Ministry of Economic Development and Trade, and the Federal Antimonopoly Service. The code described in sufficient detail all the problems of unethical behavior that are encountered in the banking services market, although it did not specify exact criteria for determining ethical level for overdue penalties, maximum debt load, etc. Moreover, the code did not describe any mechanisms for monitoring compliance with the code and punishment for violators. In April 2008, the Association of Regional Banks of Russia invited all its members, as well as other Russian banks, to voluntarily sign this code. However, the code was signed only by GE Money Bank, and the remaining members of the Association of Regional Banks of Russia refused to do so. According to Elman Mehtiyev, at that time, Russian banks were not interested in using ethics as a marketing strategy, since overall competition was weak in the market. The main players relied on other strategic tools, and the code of responsible lending was not interesting to them. Another reason was rather passive support of the Association of Regional Banks of Russia, which formally supported the code but did not make any material steps to ensure that its members signed this code.

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In the same year, the second major banking association, the Association of Russian Banks, launched a similar initiative and wrote A Code of Ethical Principles of Banking. This code was much weaker than the previous one, because it was formulated in too general words, e.g., “assist in the selection of services that best meet the interests of the client”; “charge fees according to volume, quality and complexity of your services”; “to provide customers with complete and reliable information about the conditions the loan.” Obviously, this general level of norms was not enough judge about real ethical dilemmas in this area. A good side of this case was the mechanism of compliance with code – Commission for Monitoring Compliance with the provisions of the Code, which should consider cases of violation of the code and recommend, if necessary, to exclude a member from the association. However, no tools were suggested for detecting violations, which made the whole project unworkable. In April 2008, the ARB congress approved the text of this code and recommended to its members to sign the code. During the same year, about 20 members of the association signed the code, and each subsequent year the number of signatories increased by about 20 more banks. However, this code remained a declarative paper, and there were no signs of its influence on the conduct of the banks. Too abstract norms, as well as the lack of a tool for monitoring performance, made this project initially useless. The only thing we can find about the effectiveness of the application of this code is the number of its signatories, which is available on the association’s website (now it is about 140 banks – about 80% of all members of ARB).

Microfinance For a long period, the Russian microfinance market developed completely without government regulation. In 1990, the law on Banks and Banking laid the foundations for regulating banks but did not mention microcredits. In 1994, the new Civil Code of the Russian Federation was adopted, which also did not mention microloans, but created a general legal basis for credit transactions which could be used by microfinance organizations. Initially, microcredits were mainly associated with loans to entrepreneurs, and in 1999, the government even established the Russian Bank for the support of small and medium enterprises, which was supposed to provide such micro loans. The real growth of the microfinance market in Russia began in 2004, when the economic situation in Russia stabilized after the crisis of the 1990s. If in 2003 there were only 150 microfinance organizations (MFOs), by the end of 2008, there were already 2750 and by the end of 2011 – about 9000. All this growth took place without any state regulation, but there were some selfregulatory organizations. In 2002, the Russian Microfinance Center provide educational and methodological assistance to those who would like to give and take microloans. It was financed mostly by foreign grants and organized many free seminars and events for participants in the Russian market. Its training program loan manager became a standard preparation of staff for MFIs.

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In 2006, a membership-based association NAUMIR was created to unite all participants of the microfinance market with the aim of developing standards for microfinance activity with participants and new technologies for microfinance services, creating a positive image of microfinancing activities, and performing representative functions in the interests of its participants. NAUMIR was responsible for the “political” part of the organization of business events at the federal and international levels and ensured the interaction of legislative and executive authorities, public organizations, microfinance organizations, and their associations, as well as the media. The law On Microfinance Activities and Microfinance Organizations was adopted only in 2010 – after 8 years of successful self-regulation activities. The law simply fixed the existing practices which have already developed by market participants. Many existing MFIs simply re-registered under the new law without any material change in their operations. At the same time, the law attracted new entrepreneurs to the industry who wanted to get quick profit. Surprisingly, this new wave of MFOs was demonstrated the lowest ethical standards. One of the biggest ethical issues was the problem of excessive debt which resulted from high interest rate and overdue fines. Everyone understood that something needs to be done with it. In 2013, MiR together with NAPCA developed and published the Code of Ethics and Standards for Work with Overdue Debts in the Market of Microfinance Organizations. However, the code was mainly aimed at collecting overdue debts and did not do anything with the origins of the problem. It was obvious that MFOs and their associations will not be able to handle this task by themselves. So, CBR decided to take this responsibility and to change regulatory landscape in the microfinance market. In 2015, the state adopted the law On Self-Regulatory Organizations in the Sphere of the Financial Market, which required all MFOs to become members of a SRO. However, this law was very different from the basic Russian law on selfregulatory organizations. Here microfinance SROs actually became the remote hand of the regulator since CBR got the right to approve their directors and their budgets as well as prescribe them development of particular standards of conduct. The law defined also the minimum size of SRO – at least 25% of total number of market participants, i.e., there could not be more than three SROs in the market. After this law, three SROs were registered in Russia in the field of microfinance: MiR, Edinstvo (“Unity”), and Alliance. These SROs could develop their own standards for carrying out activities (risk management, corporate governance, internal control, consumer protection, etc.) and offer them to the Bank of Russia. If the standard was approved by the Bank of Russia, it became mandatory for all MFIs, regardless of their affiliation with a particular SRO. Membership of SROs was beneficial for MFIs because it allowed them to legally advertise their services, increase their reputation among clients, etc. However, some part of the market decided to stay in the shadow. In May 2016, the Bank of Russia published a list of basic standards that microfinance SROs should develop: (1) a risk management standard, (2) the standard for transactions in the financial market, and (3) the standard for protecting the rights

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and interests of individuals and legal entities of MFO clients. In February 2017, the Bank of Russia published requirements for a basic standard for protecting the rights and interests of MFI clients (instruction No. 4278-U) listing the areas that should be described in this standard (e.g., the requirements for providing information to clients, restrictions to change the terms of the contract, advertising rules, rules for interacting with a client, rules for considering customer requests, etc.). In accordance with these requirements, MiR has developed the Basic Standard for the Protection of the Rights and Interests of Individuals and Legal Entities – Recipients of Financial Services of Microfinance Organizations, which was approved by the Bank of Russia on June 22, 2017. This standard included many provisions aimed at protecting customers. Some of them were clearly worded and could be verified (e.g., ban on transferring MFOs to the credit history bureau with false information in order to prevent a client from concluding an agreement with another MFI), but some did not have any mechanism for monitoring (e.g., the ban on rewarding employees aimed exclusively at increasing the amount of debt) or clear criteria for recognizing violation (e.g., the ban of using advertising tricks to abuse the trust of the recipient of the financial service). Unfortunately, this mechanism regulation was not able to prevent the main problem of the microfinance market – the issuance of loans to borrowers who are unable to resist a serious increase in the amount of debt. The debt volume continued to grow catastrophically, and this forced CBR to take tough measures to regulate this market through administrative pricing. On February 2018, CBR announced strict restrictions on the terms of microcredits: introduction of a standard product “10 thousand rubles for 15 days” with maximum amount of payment 3 thousand rubles (with all fines and penalties) or interest ceiling for other loans 1.5% per day (and 1.0% since 01.07.2019). CBR estimated that 30–50% of MFOs will be forced to leave the market under these terms and explained this as a normal procedure to remove inefficient MFOs who can survive only through severe exploitation of their clients.

Debt Collection The first professional debt collection agencies began to emerge in 2004–2006. The collection market was initially a completely unregulated area with a huge number of ethical issues. Collection was carried out by poorly trained or semi-criminal firms that used psychological pressure, threats, insults, and even physical violence against their clients (debtors). It was obviously that without any collective actions, this market cannot function. In 2007, National Association of Professional Collection Agencies (NAPCA) was established by the initiative of three leaders in the collection services market: National Collection Service, Sequoia Credit Consolidation, and Financial Payments Collection Agency. The creation of NAPCA was supported by the Association of Regional Banks “Russia.” Immediately after its creation, NAPCA began active work to improve ethical conduct at the market. The process of creating a code of ethics was not easy, since

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many issues of interaction between the collector and the debtor remained unclear. For example, is it necessary to indicate in a letter from the collector that the debtor may, if he wishes, complain about the actions of collectors in a professional association? In May 2008, NAPCA published the Charter for Professional Collection Agencies of the Russian Federation which should be signed by all its members. In addition to developing a code of ethics, NAPCA has taken steps to establish a mechanism to identify violators. The main tool was filing a complaint on the NAPCA website about a specific agency. All complaints received by NAPCA should be carefully examined by a committee with disciplinary actions against violators of the code. This service played a huge role in motivating fair collection agencies to improve the quality of their collectors. After some contemplation, NAPCA decided to publish all complaints with the name of debt agencies to create public awareness about violators of the code. Currently, about 1000 complaints arrive every month, but only 10% of them are really substantive and require a reaction. Each complaint is dealt with by the Monitoring Committee, composed of representatives of NAPCA member agencies. If necessary, there is a trip to the agency, which received the lobby, and its audit is carried out. Fines, warning, or exclusion from NAPCA are used as punishment. An exception is a serious punishment, and everyone is afraid of it, because NAPKA means access to the largest customers of the market. These actions were very timely, because in the summer of 2008, the collection services market experienced a boom. The financial crisis led to a sharp increase in loan defaults, and the total past due debt reached 122 billion rubles. Banks began massively use services of collection agencies. However, the legal regulation of debt collection market was still absent. In 2009–2014, NAPCA made several attempts to submit a draft of a law on collection agencies, which could make the regulation more effective, but the government did not support this initiative for a long time. Only in 2016, the law was adopted under the title On the Protection of the Rights and Legal Interests of Individuals in the Activities of Returning Overdue Debts. Currently, NAPСA has the status of an SRO and brings together about 40 leading companies in the collection market, representing more than 90% of the collection market. Many debt agencies remain in shadow, and it is these agencies which generate most of the scandals and unethical behavior in the market.

Conclusion As we saw in this chapter, regulation of ethical behavior in Russian financial sector went through two main periods: coexistence of several different regulatory bodies (1989–2013) and Central Bank of Russia as mega-regulator (since 2013). In the first period, ethical aspects of behavior were mostly absent in the regulatory agenda. In the second period, CBR took the strong position for improving ethical conduct of financial market participants and introduced many important regulations protecting consumers in banking, microfinance, and other sectors. At the same time, selfregulation in many financial sectors does not work properly, because, by the words

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of Alexey Savatyugin, SROs in many sectors are essentially the “hidden hand of CBR” but not a genuine self-regulatory body. The only example of successful selfregulation in financial sector is NAPCA (association of collectors), but this area is controlled not by the CBR but by another government body – The Federal Bailiffs Service (an enforcement agency of Ministry of Justice of Russia). Self-regulation of ethical behavior in other financial markets is yet to be developed, but it requires a different role of CBR as a mega-regulator.

Cross-References ▶ Ethics in Finance as the Result of a Strong Systemic Commitment ▶ Financial Institutions and Codes of Ethics

References Buklemishev O, Danilov Y (2013) Effective financial regulation and creation of the mega-regulator in Russia. J New Econ Assoc 19(3):82–98 Ezangina IA, Evstratov AV, Jovanovic TG (2016) Challenges and perspectives for development of banking credit infrastructure in Russia. Int J Econ Financ Issues 6(2S):58–64 Farvaque E, Refait-Alexandre C, Weill L (2012) Are transparent banks more efficient? Evidence from Russia. East Eur Econ 50(4):60–77 Ferran E, Moloney N, Hill JG, Coffee JC Jr (2012) The regulatory aftermath of the global financial crisis. Cambridge University Press, New York Friedman J, Kraus W (2011) Engineering the financial crisis: systemic risk and the failure of regulation. University of Pennsylvania Press, Philadelphia Grekova I (2019) Optimization of Regulatory Load. A report at the XV International Forum of National Financial Association, December 3, 2018, Moscow Inderst R (2009) Retail finance: thoughts on reshaping regulation and consumer protection after the financial crisis. Eur Bus Organ Law Rev (EBOR) 10(3):455–464 Kawai M, Prasad ES (eds) (2012) New paradigms for financial regulation: emerging market perspectives. Brookings Institution Press, Virginia Knight MD, Petersen AB, Price RT (eds) (1999) Transforming Financial Systems in the Baltics, Russia and other countries of the former Soviet Union. International Monetary Fund, Washington Mwenda KK (2006) Legal aspects of financial services regulation and the concept of a unified regulator. The World Bank, Washington, DC Pistor K, Xu C (2004) Beyond law enforcement: governing financial markets in China and Russia. In: Creating social trust in post-socialist transition. Palgrave Macmillan, New York, pp 167–189 Porter RB, Glauber RR, Healey TJ (eds) (2011) New directions in financial services regulation. MIT Press, Cambridge MA Thießen U (2004) Financial system development, regulation and economic growth: evidence from Russia (No. 400). DIW discussion papers Thießen U (2005) Banking crises, regulation, and growth: the case of Russia. Appl Econ 37 (19):2191–2203 Tompson W (2000) Financial backwardness in contemporary perspective: prospects for the development of financial intermediation in Russia. Eur Asia Stud 52(4):605–625 Viktorov I (2015) The state, informal networks, and financial market regulation in post-Soviet Russia, 1990–2008. Soviet Post-Soviet Rev 42(1):5–38

Professional Ethics and the Financial “Professions” Jim Baxter

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . What Is a Profession? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Descriptive Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Normative Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Criticisms of the Professions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Financial “Professions” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cross-References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

A view of the “professional model” is developed, taking in both descriptive and normative features which are sometimes taken to be constitutive of that model. These features include the way professions are structured and regulated, the supposedly central “professional-client relationship,” employment structures, the fiduciary relationship, and the importance of trust and the public interest. Some criticisms of the professional model are canvassed, along with possible responses to those criticisms. The question of whether occupations in financial services, and particularly banking, are or should be considered professions is considered. Finally, the future of professionalism in financial services is briefly considered, and a “professionalization agenda” is identified, through which some actors are attempting to draw on elements of the professional model in order to improve standards of competence and conduct in financial services.

J. Baxter (*) Inter-Disciplinary Ethics Applied Centre, University of Leeds, Leeds, UK e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_29

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Keywords

Professions · Professionalism · Professionalization · Professional bodies · Standards · Ethics · Trust · Responsibility · Credentialism

Introduction The idea that all the various occupations that make up the financial services sector might constitute professions has been under pressure for several decades. In some occupations, and in some countries, professional qualifications are either a legal prerequisite for practice or else there exists an expectation that someone who is serious about wanting to work in that area will become professionally qualified. In many other areas, however, a professional qualification is required neither de jure nor de facto. An obvious example is banking, in which the trusted figure of the neighborhood bank manager, exercising professional autonomy and judgment to deal with the financial affairs of clients who know him as a pillar of the local community, has largely been consigned to the past. Instead, customers increasingly access the bank’s services online. When they do speak to a human representative of the bank, they do so by telephone, with someone who works in a call center, knows nothing about the customer beyond basic account information, and is unlikely ever to speak to them again after a 5-min call. It is difficult to know exactly what percentage of bankers have a professional qualification, firstly because the diversity of roles in the sector means it is unclear who counts as a banker and secondly because many people working in the banking sector may have a professional qualification in something other than banking (e.g., accountancy, law). However, in the United Kingdom, the Chartered Banker Institute, the biggest professional body specific to banking, reported a membership of 32,487 in 2019 (Chartered Banker Institute 2019). While this figure appears to be slowly increasing (The Chartered Banker Institute reported a 3% increase on 2018), it is clearly low when compared to a UK financial services sector which employed about 1.278 million people in the same period (Labour Force Survey 2019). By comparison, in 1977, the Institute of Bankers had a UK membership of approximately 80,000 (Green 2012, p. 173), against a sector which employed an estimated 791,000 (A Millennium of Macroeconomic Data 2016). One reason this decline in professional qualification and membership might be important is if it is related to problems of competence and ethics within the sector. The link here could be causal, in that bankers who have undergone full professional training might be better equipped to identify and deal with problems, perhaps because they are better aware of the broader context in which their work takes place. It could also be that a decline in professional qualifications and a decline in standards are both symptoms of a deeper problem of self-conception: bankers who value professional body membership might be more inclined to see themselves as having a rich set of duties and responsibilities to clients and the public, transcending the immediate demands of their role and the need to deliver on short-term financial

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targets. The problem, then, could be cultural: bankers may lack a professional mindset as much as they lack qualifications or professional body membership. The United Kingdom’s Parliamentary Commission on Banking Standards, reporting in 2013, found that “changing incentives in the sector, together with the impact of globalisation and technological change, have eroded cultural constraints upon individuals’ behaviour”: Banking now encompasses a much wider range of activities, has fewer features of a professional identity and lacks a credible set of professional bodies. . .. Banking culture has all too often been characterised by an absence of any sense of duty to the customer and a similar absence of any sense of collective responsibility to uphold the reputation of the industry. (Parliamentary Commission on Banking Standards 2013, p. 17)

Both this and the later Banking Standards Review (Lambert 2014) suggested that a decline in professionalism may have been one factor which led to the financial crisis of 2007–2008. Evidence to both of these reviews had suggested a possible role for professional bodies as a way to supplement the role of regulation in improving standards of competence and ethics in the sector. This was further supported by Baxter and Megone (2016) who found that there was an opportunity for professional bodies to play a greater role in supporting ethical culture in banks and building societies, by providing employees with an “alternative lens” through which to view their work. Questions relating to professionalism and the professions are therefore pressing for financial services organizations, for whom public trust has been a major concern since the financial crisis of 2007–2008 (Palframan 2018).

What Is a Profession? The word “professionalism” has several related but distinct meanings. One way the word “professional” is used is simply to distinguish an activity which is performed for pay. In this sense, professional is simply the opposite of amateur, so that we may talk about a professional footballer, say, or a professional musician. To say that someone is a professional in this sense says nothing about the nature of the activity or the way it is performed, beyond that the person performing it is paid for doing so. A second sense of professionalism is the one we are employing when we talk of someone in any occupation “doing a professional job” or “acting professionally.” A “professional” plumber, in this sense, turns up on time, takes pride in the quality of the work, does not try to charge more than is reasonable, and tidies up when the job is done. An unprofessional actor does not learn her lines or misses her entrance because she is in the theater bar. “Being professional,” in this sense, is essentially a matter of doing the job well, of not falling short of the standards that are expected of someone doing that job (Griseri (2005) develops a rich account of what it means to be professional in this sense, which he takes to be the centrally important sense). A third sense of professionalism goes beyond this by identifying one of a number of spheres of paid activity that are qualitatively different from ordinary jobs. These spheres

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of activity are characterized by several distinctive aspects of the work itself, of the knowledge and skills required to do the work, and of the relationships involved. Traditionally, professional work in this sense involves a relationship between a professional and a client, which is characterized by an asymmetry of knowledge and understanding between the two parties, a potential for the work to have a profound impact on the well-being of the client (and perhaps also on the wider public) and a corresponding need for the client (and the public) to place a high degree of trust in the professional. People who see themselves as professionals in this sense will have a sense of responsibility to their clients which goes beyond that involved in a merely transactional relationship, requiring that the professional act in the best interests of the client and show sensitivity to other ethical norms which the nature of the role makes pertinent. They will also, ideally, have a sense of a wider responsibility to the public interest, born of an understanding of the social purpose of their work. A profession in this sense is also an area of work which, because it has the characteristics noted above, has certain structures in place in order to better serve the public interest and justify the public’s trust. The central organization in such professions is the professional body. This body usually has some role in regulating the profession – though there may also be a separate regulatory body – by overseeing a code of ethics and disciplining those who breach the code. They will also have a role in setting the criteria for entry to the profession (e.g., through overseeing or accrediting professional qualifications), setting requirements for professionals to keep their knowledge and skills up-to-date through continuing professional development (CPD), and playing a thought leadership role, speaking on behalf of the profession and articulating what is at the cutting edge of thinking on technical and more broadly professional issues. The above sketch covers a lot of ground, and different commentators have sought to pick out different features as central to understanding the nature of professions. Some of these features are descriptive, while others are normative. Let us consider these in turn.

Descriptive Features One feature which might be thought to be distinctive of professions is the knowledge which forms the intellectual basis of the work. This knowledge is taken to be distinctive not merely because of the amount of knowledge which is required to do the job well but also because it has a distinctive character. Robert Sokolowski describes a type of knowledge which is “useful” and “practical” but which is also “more formal and abstract or general than that of the [nonprofessional]” (Sokolowski 1991, p. 26). Distinguishing the case of the mechanic (whom Sokolowski considers a nonprofessional) from that of an engineer (whom he considers a professional), Sokolowski elucidates this distinction: The mechanic may know that the terminals of the battery must be kept clean and that batteries run down after three years or so, but the engineer can see the car battery as an instance of the same forces that are at work in radios, lamps, generators, and bolts of lightning. Because the engineer’s knowledge is so wide-ranging, he or she can see other ways of doing what is done with the battery. (Sokolowski 1991, p. 27)

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This type of knowledge is taken to be characteristic of professions in general. A doctor, for example, understands more than just that a particular drug (say) will treat a particular illness. Her knowledge of this specific fact is situated in a broader set of knowledge about the way the body works – the mechanical, chemical, and electrical forces at play, for example – and thus she understands in a great level of detail why the drug is likely to have a desired effect. If it turns out that the drug does not have this effect, she may be able to recommend other solutions, pharmaceutical or otherwise, on the basis of this broader knowledge. And she will be able to have regard to aspects of the patient’s physical condition which might render an intervention which would usually be effective, ineffective, or even harmful. This example also serves to highlight two other important features of the knowledge possessed by professionals: it is greater than that possessed on the same subject by the client, and this subject is one which is important to the client, her interests and potentially her well-being. This means that when I go to see a professional, I delegate to her, for a time and within certain parameters, responsibility for something which is personally important to me (Pellegrino 1991). In the case of the doctor, I rely on her to help me overcome disease and otherwise to look after my health. The service provided by professionals to their clients is often said to be an “advisory” one (Bennion 1969). However, at least in the case of the paradigmatic professions, the relationship may go beyond the advisory to the fiduciary. If I find myself in legal trouble and engage the services of a lawyer, I have a lot at stake in the outcome of this engagement. I could, for example, stand to lose out financially or reputationally or even in extreme circumstances to lose my freedom. Because the lawyer’s knowledge of the law is so much greater than mine, I must rely on her to take effective care of my interests and perhaps even to take care of myself in some sense. As Sokolowski notes, “when I approach a professional, I subject something more than a possession of mine to the professional’s expertise”: in a distinctive way, “I subject myself and my future to his or her assessments and to his or her judgment.” (Sokolowski 1991, p. 27). This relationship has, in Eliott Freidson’s words, elements which are “social and moral” (Freidson 1994, p. 166). None of this is true of the relationship between other providers of services and their consumers. If I pay someone to repair my computer, for example, while it is undoubtedly true that they know more about how my computer works than I do, they have no power to affect my interests beyond the interest I have in a functioning computer. The broader, deeper relationship between a professional and her client, arising from the asymmetry of information and the personally important nature of the work, is therefore taken to be another distinguishing feature of professional work: whereas nonprofessionals might have customers, only professionals are thought to have clients. Related to this is the idea that professionals are engaged in an activity which is not “commercial.” F.A.R. Bennion, writing in 1969, observed that “it has long been an obsession with professional men, and still is today, that if they indulge in any activity which is ‘commercial’ they are to that extent less ‘professional’.” (Bennion 1969, p. 7). This distinction perhaps carries less currency now than it did, and it is difficult to translate it into a clear boundary between professional and nonprofessional roles; professionals, after all, provide a service in return for a fee. However, one way in

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which it perhaps survives is in a sense that there should be a limit to the extent to which professionals compete for custom. Competition between professionals does of course exist, but it exists in tension with an idea that the service provided by professionals should be to some extent standardized and consistent. This might be desirable to protect clients: in theory, a client should be confident that they will be well served by any qualified professional. It may also be a way of maintaining ethical standards: consistency across the profession means that professionals will be less tempted to cut ethical corners to satisfy clients, as they might be if competition were the only means through which professionals established their commercial viability. This brings us to a feature which varies greatly among professions, but which is often taken to distinguish professions from other occupations, which is the existence of some form of credentialism (Freidson 1994). Credentialism can take the form of a general license to practice, a protected term or one or more protected roles. But there are also cases where there are no restrictions on practice de jure but where there might be de facto barriers, due to the esteem in which professional membership is held in the industry in question. For example, in the United Kingdom, it is a criminal offense to practice as a barrister without holding the requisite professional qualifications and being professionally registered. The word “architect” is a protected term, but the roles performed by architects are not protected. Thus, one can be prosecuted for calling oneself an architect, but not for performing any of the roles traditionally performed by architects. “Actuary” is also a protected term, but there are also certain reserved roles which only qualified and registered actuaries can perform, including the role of “scheme actuary” to a pension scheme. The word “accountant” is not protected and neither are accountancy roles. However, due to the high regard in which accountancy qualifications are held, and the critical nature of accountancy roles, it is unusual for someone to practice as an accountant without holding an accountancy qualification. Credentialism in the professions, while it has attracted some controversy (see “Criticisms of the Professions” below), is defended largely for its role in protecting clients and the public. By achieving professional qualification and maintaining professional registration, professionals prove that they are competent to perform their roles, and that they are of good character, and motivated by their clients’ interests, by the public interest, and by the ethical standards of their profession. Another way in which professions are apparently distinctive is through the existence of a professional body or association. The professional body maintains a directory of members, either provides initial professional education itself or oversees and accredits other organizations to provide this; it typically also monitors and/or provides continuing professional development (CPD), coordinates and publishes thought leadership on behalf of the profession, provides a forum for discussion of professional issues among its membership, and, crucially, regulates the profession through a code of ethics (sometimes known as a code of conduct or code of practice). Professions are, in this way, typically self-regulating to some extent, although this hides a lot of variation in regulatory structure among professions and among jurisdictions. For example, in the United Kingdom, medical doctors are regulated by the General Medical Council (GMC), a statutory regulator which maintains a list of doctors who are licensed to practice and has ultimate responsibility for assessing

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fitness to practice. This is separate from the professional body for medical doctors, the British Medical Association (BMA). Actuaries, by contrast, are regulated by their professional body, the Institute and Faculty of Actuaries (IFoA) under the oversight of the Financial Reporting Council (FRC), an independent regulator. Engineers are regulated ultimately by the Engineering Council, which delegates responsibility to one of 35 licensed “professional engineering institutions” (professional bodies). The differences in structures of authority and division of functions among regulators, professional bodies, and other organizations in different professions are peculiar to the jurisdictions which the professions operate and are the product of professions’ different histories in different countries. A final descriptive feature of professions which is sometimes taken to be distinctive is their employment status. As Bennion notes, “until the middle of the nineteenth century activities now regarded as professional (in the wider sense of the word) were seldom carried on by persons in salaried employment” (Bennion 1969, p. 10). Instead, it was thought that true professional status required the professional to be in private practice. This view survives in many of the more established professions, such as the legal profession, in which the majority of professionals are employed by professional firms (Dinovitzer and Garth 2015). Of course, the size of these firms varies greatly, and in the larger firms, professionals will typically work as salaried employees for years and may never reach the status of partner, although this is supposed to be the aspiration. In other professions, such as accountancy, the picture is more mixed, with many professionals working as salaried employees for corporates, though many others work for professional firms (Financial Reporting Council 2017).

Normative Features As well as, and related to, the descriptive features noted above, writing about the professions also highlights its normative features. The professional-client relationship is as often described in normative terms as descriptive terms. As noted above, the professional typically has more knowledge and skill in the relevant domain than the client. Coupled with this, the domain in question is one in which the consequences for the client can be deeply impactful, either positively or negatively (negatively if the knowledge and skill is misused or is less than it is supposed to be). Therefore, the relationship between professional and client is, unavoidably, one of trust. Pellegrino (1991) emphasizes this unavoidability, observing that “circumstances force us to trust” the professional: We are forced to trust professionals, if we wish to access their knowledge and skill. We need the help of doctors, lawyers, ministers, or teachers to surmount or cope with our most pressing human needs. We must depend on their fidelity to trust and their desire to protect, rather than to exploit, our vulnerability. (Pellegrino 1991, p. 69)

This trust has two broad components: on the one hand, we trust the professional to be competent and to have the knowledge and skill necessary to do the job well; on

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the other hand, we trust her to have our interests at heart and to be motivated to apply her knowledge and skill in such a way as to make our life go well. In most cases, this trust is more or less explicit: I knowingly place my trust in my doctor, for example, when I go to see her. In the case of some professions, however, which are relatively invisible to the public, or in which the distance between the professional and those whose lives her work impacts is relatively great, the trust is implicit. For example, I may have no idea what an actuary does, but there is nevertheless a sense in which I place my trust in actuaries whenever I purchase an insurance product or sign up to a pension plan. The relationship of trust between professional and client can be expressed as a fiduciary relationship (used here in its broader ethical, rather than its legal, sense). The client entrusts some element of her life to the professional, in the expectation that the professional will act in such a way as to make that element of the client’s life go well. Of course, as Pellegrino notes, the trust placed in professionals has boundaries: the client trusts the financial advisor or financial analyst to manage some element of her financial affairs, within limits which it is ultimately the client’s prerogative to set. Nonetheless, dealing competently with the client’s affairs even within those boundaries may require the professional to have a knowledge and understanding of the client’s life, her desires, priorities, plans, and projects, as well as other facts about her such as those relating to her health. This knowledge is somewhat holistic. For example, if the financial advisor or financial analyst is to recommend an investment plan to an older client, doing a good job may require her to know not just the expected rates of return of different investment products but also, for example, the client’s state of health, whether her priority is to have ready access to money to spend on holidays or to have money which can be passed on to her children when she dies, perhaps something about her spouse’s financial situation, and so on. The professional must synthesize all of this information into a sense of what it is for the client’s life to go well, within the limits set by the professional’s domain of expertise, and must act competently in choosing the means to those ends. Because the judgment involved in such action is complex, depends on knowledge and understanding which may be unavailable to the client, and therefore may be opaque to the client, the professional’s responsibility goes beyond the merely transactional. The professional must act, as far as she is able, in such a way as to further the client’s best interests, which may be different from the client’s expressed preferences. This must be balanced against the client’s right to autonomy in choosing the means to her own ends, but there may be circumstances in which the professional must seek to persuade the client not to act against what the professional judges to be the client’s best interests. Imagine, for example, a barrister whose client is determined to enter a particular plea which, in the barrister’s view, has no chance of success and will likely only lead to a more severe sentence. Another way of conceiving the relationship of trust is that trust is placed not in the individual professional at all, but in the system of which she is a representative (Luhmann 2017). The structures of a profession serve the purpose of reducing the complexity of the decisions which need to be made by a client or prospective client and the risk attached to those decisions (Baier 1986). When I consult a lawyer about

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a legal case, I do not need to make a decision about whether the individual lawyer I am consulting is trustworthy. I know that the lawyer is a member of a professional body, is subject to some form of peer review, has undergone a standardized program of education, must keep her knowledge and skills up-to-date through continuing professional development, and is regulated through a code of ethics to which she must adhere, at pain of being struck off from the profession. I know that there are mechanisms through which I can seek redress if the lawyer turns out to be incompetent or unethical. There are, in short, several channels through which the lawyer stands to be held to account. As a result, the trust I have in the professional system transfers to the individual professional in front of me. Of course, in practice, my trust in the professional system is likely to be incomplete, and I may indeed need to make judgments about the trustworthiness of the individual professional (however, see Veatch (1991) for a discussion of the idea that trust in professions might be incoherent). A final normative feature of professions which is sometimes taken to be definitive is a duty to the public interest. This can be conceived either as a negative duty (the professional must not act so as to contravene the public interest) or as a positive duty (the professional must seek to further the public interest). In practice, the public interest is somewhat vaguely defined, and it can be difficult for the individual professional to judge what the public interest entails in a given case. The waters are further muddied by the fact that the public interest has a specific meaning in law, which is related to but distinct from its meaning in ethics. The ethical meaning of the public interest is itself contested. A persuasive suggestion arising from political philosophy is Brian Barry’s conception of the public interest as that which is in the interests of every individual in their capacity as member of the public (Barry 1964). This conception is motivated by the fact that we all occupy different roles in different spheres of our lives and that we have different, and sometimes conflicting, interests arising from each role. Barry posits a universal role of “member of the public” and then identifies the public interest with the interest of every individual which they have as a member of the public. So, for example, it may be in someone’s private interest for environmental regulations to be lax if they own a polluting factory. It may even be in their net interests, taking into account all of the different roles they occupy. However, since this person is also a member of the public, they have in that capacity an interest, shared by all members of the public, in the environment’s being well protected by stringent laws. Only what is in everybody’s interest in their capacity as members of the public can be said to be in the public interest, on Barry’s conception. Applying this conception of the public interest to the financial services sector, we might imagine a bank which is setting policy for when to call in loans to small businesses which may be experiencing financial difficulties. The bank’s own interest in protecting its capital is clearly relevant here, as are the interests of the businesses who may be affected, their employees, customers, etc. The public interest is relevant, not because those directly affected on both sides are members of the public, although this is obviously the case, but because all members of the public have an interest, in their capacity as members of the public, in living in a society with a healthy,

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well-functioning economy. The ability of small businesses in general to weather adverse financial conditions may contribute to this interest (though so, plausibly, may the natural wastage of businesses that are not viable). A strong conception of banking as a profession might lead one to conclude that the bank’s self-interest should at best be a secondary consideration in decisions of this kind, following the primary considerations of the client’s interest and the public interest. This might be motivated by something like Bennion’s notion that professionalism inherently involves a “tradition of service,” characterized by “an outlook which is essentially objective and disinterested, where the motive of making money is subordinated to serving the client in a manner not inconsistent with the public good” (Bennion 1969, p. 15).

Criticisms of the Professions The description of the professions that we have developed so far in this chapter has highlighted several ways in which they might be thought to be desirable or even necessary. A picture has been drawn of specific areas of work in which the practitioner’s knowledge and skill must be complex and highly specialized, and greater than the layperson, so that the layperson is unable to judge the professional’s competence and beneficence for herself. Moreover, the impact on clients and the public is potentially great, meaning that much is at stake in the relationship of trust between clients (and the public) and the professional. Professional structures serve the beneficial purpose of ensuring that clients’ and the public’s trust, for all that it is unavoidable, is nevertheless well placed. However, the professions, and indeed the professional model as a whole, have also been criticized on multiple grounds. Critics have pointed to various negative effects which they ascribe to the organization of sectors and occupations as professions while casting doubt on the sincerity of professions’ claims to have the interests of clients and the public at heart. One way of criticizing professions is to question the underlying motivation for their formation. Rather than seeking to protect clients and the public, according to this line of attack, professions are engaged in an attempt to restrict practice in such a way as to secure “more congenial conditions for themselves” by pursuing “occupational control”: Essentially, it is argued, professionals employ the rhetoric of [protection for consumers], but actually act in pursuit of self-interest rather than client/patient interest. Thus the characteristics of professionalism such as autonomy and self-regulation help to produce a situation in which. . . the practice of specific skills can be retained as a monopoly within the profession, helping to keep earnings higher, and career prospects better, than would otherwise have been the case. Harrison and Pollitt (1994, pp. 2–3)

This criticism, which also finds expression in the phrase spoken by the character Sir Patrick Cullen in George Bernard Shaw’s play The Doctor’s Dilemma, that “all professions are conspiracies against the laity,” has appeal because, for one thing, professionals do indeed tend to earn more than nonprofessionals, and it is easy to see them

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as cozy clubs that exist to serve the interest of their members. To have real force, however, it would need to be shown not only that professionals are often motivated by self-interest but also that their actions which are so motivated have significant negative effects, either on their own clients or the wider public, and that these effects are not outweighed by any positive effects along the lines already canvassed in this chapter. There are perhaps two broad ways in which professionalization might be thought to have negative effects. These might be summarized as the “too little regulation critique” and the “too much regulation critique.” The former is motivated by the thought that professions might serve the purpose of protecting their members from controls on their behavior which would be beneficial to clients or the public. These controls could come from managers or from statutory regulation which is not overseen or enforced by the profession itself. If this were true, then the self-regulation which is supposedly carried out in the name of protecting the public would actually have the opposite effect by preventing more stringent (and perhaps also more democratically accountable) regulation from being imposed (Brecher 2004). Defenders of professionalism against this line of attack might point to the necessity of regulators being well versed in the technical and ethical issues associated with the profession, i.e., professionals themselves. Professional work typically takes place in areas with considerable technical complexity, which are fast-developing. External regulation, then, might be less likely to be effective than regulation of the profession by the profession. Nonetheless, the model of pure self-regulation is now relatively rare. Most professions have some element of external regulation or are regulated primarily by the professional body with some degree of external oversight by a statutory or independent regulator. On the “too much regulation” side, it is possible to criticize professions as being too restrictive on free markets, thereby preventing positive effects associated with free markets. Critics who point to negative effects of this type suggest that “if exclusive licencing of the professions were abolished so as to create a genuinely free labour market, the intensified competition within and among occupations would lead to improving quality of work, developing innovative ways of performing it, and reducing its cost to the consumer” (Bennion 1969, p. 155). Restrictions on a free market might be thought to have negative effects, not just on consumers of the services but also on would-be practitioners, who are excluded from the provision of services by the varieties of de facto or de jure credentialism which were outlined at the beginning of the chapter. These would-be practitioners might point to what they perceive to be unfair and unduly conservative barriers to entry to the profession. If the choice were left to consumers, they might argue, instead of being paternalistically imposed by professional bodies who are in any case motivated primarily by self-interest; the interests of both consumers and workers would be better served. The most effective response to these lines of attack is perhaps simply to emphasize the necessity of restrictions to protect consumers and the public. While the idea of consumers making up their own minds about professionals in a completely open market might be superficially appealing, the reality is that consumers’ lack of understanding of professional work is attributable not only (if at all) to efforts by professionals to exclude outsiders but also to the inherent complexity of the work

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itself. In the absence of professional structures, consumers would be forced to rely entirely on their own ability to assess the competence and ethical probity of providers or services, and to compare them to each other, so as to make effective choices about which provider to engage. The inherent complexity of the work would make this difficult if not impossible to achieve. This would play to the advantage of deceptive or unscrupulous actors, who would be able to present themselves as superficially plausible to ignorant consumers. And without professional regulation, there would be no recourse for consumers who have been taken in by these actors. Furthermore, while one can argue that a free market would create a more effective incentive to give clients what they want, customer satisfaction is not exhaustive of our legitimate expectations of professionals. We also expect professionals to have regard to the client’s best interests, even when the client may be mistaken about her best interests. More than this, we expect professionals to have regard to the public interest. So, for example, a criminal lawyer whose motivations were entirely dictated by the market might be incentivized to ignore ethical norms about the conduct of criminal trials which are generated by regard for the public interest. We have good reasons to want professionals to exhibit these forms of behavior, and it would be folly to rely on markets alone to produce them. A further critique, which also focuses on the fact that professions have restrictions on entry, can be made on social egalitarian grounds: by restricting entry to the profession to those who are able to avail themselves of a long and probably expensive education, professionalization excludes social groups who cannot do this, but nevertheless might be able to prove their competence through experience and “on-the-job” training. There is little doubt that this critique highlights a real issue for the professions, which for the most part and in most countries are something of a middle-class cabal. However, the answer to this is perhaps not to do away with the professions altogether, since the nature of the work inherently requires a good deal of formal, general education if it is to be done well. Rather, one might argue that professions have a duty to put in place means of encouraging and supporting entry from people in excluded groups, such as bursaries for people from lower-income groups, or routes to entry through part-time or in-work education. Freidson (1994) also suggests that the “shelter” provided by restrictions on entry to the profession might be necessary since, without it, it may be unlikely that anyone would want to invest the time necessary to gain the kind of education that would enable them to do the job well. This factor would presumably affect those from lower-income backgrounds all the more, for whom the risks of investing time in education are greater and the consequences of failure graver.

The Financial “Professions” It is an open question whether jobs in the financial services sector, at least as they are currently constituted, are professions. One financial services job for which this question is relatively easy to answer is accountancy. Accountants are typically subject to either de jure or de facto credentialism, requiring a professional qualification and professional body membership, with monitored continuing professional

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development, to carry out their practice in most countries. They also for the most part retain a professional employment structure, working for accountancy firms with partners. While there is a reasonable level of specialization among different accountancy roles, there is nonetheless a clear body of requisite knowledge common to all those roles. In personal and business (perhaps especially small business) accounting, the fiduciary relationship is clear: clients entrust some element of their financial wellbeing to an accountant whose knowledge and understanding of financial matters is (or should be) superior. In audit, on the other hand, the public interest is a more salient concern, though duties to the client still exist. Another financial role in which the professional model can be seen to apply is financial advice. Independent financial advisors, chartered financial analysts, and their ilk have direct clients with whom, again, there is a clear fiduciary relationship. While there may not always be a legal requirement to be professionally qualified, some form of qualification is generally seen as desirable. In the United Kingdom, there has been in the last 10 years a tightening of the rules for financial advisers through the “Retail Distribution Review,” which requires that they sign up to a code of conduct and can no longer work on a commission model as opposed to charging professional fees. The question of whether banking is a profession, on the other hand, is open to debate. Firstly, it must be recognized that there is now a very wide variety of activities falling under the general term “banking,” not all of which look, at least at first glance, like a traditional profession. Private banking and some forms of commercial banking retain a central professional-client relationship with a fiduciary element: the individual or business entrusts an element of their financial well-being to the bank and may be assigned an individual relationship manager with overall responsibility for their affairs. Investment banking looks less like a profession in the traditional sense, although it could be argued that investment bankers take on fiduciary responsibility for the financial affairs of their employers. The sheer variety of roles, both among different forms of banking and within each form, also calls into question whether there is a common body of knowledge and skills which all people who call themselves bankers have or ought to have. Retail banking is an interesting case. Perhaps 40 years ago, this form of banking would have been widely considered as a profession, but since the deregulation and diversification which made up the “Big Bang” of the 1980s, combined with the merging of established banks into huge conglomerates, and the slow migration from a model of delivery through local branches to an increasingly online model, this has been called into question. The relationship of the average customer with her bank does not look like the professional-client relationship we have been exploring. Customers increasingly transact with their bank either online or via call centers, speaking with operatives with whom they are unlikely to communicate outside of the current transaction. While all banks will claim to have their customers’ interests at heart, they are commercial entities with products to sell, and there is no pretense of professional disinterest in their sales activities. Professional structures, too, are largely absent from banking. As noted at the beginning of the chapter, professional body membership in the sector is low, both

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compared with historic levels and with more established professions today. There is no widespread expectation that bankers will be professionally qualified and no “gold standard” qualification that has universal or even widespread recognition in the industry (Baxter and Megone 2016). It might be, then, that the status of banking as a full-fledged profession along the lines of medicine or law is lost and unlikely to be recovered. Nonetheless, banking certainly does share some of the features of the traditional professions, and it might be that these are enough to recommend an ethical framework for banking which derives at least partly from the professional model. Regardless of whether members of the public trust bankers, for example – and, as noted above, there is evidence to suggest that they do not – the relationship between customers and banks is certainly one in which an element of customers’ financial well-being is entrusted to the bank, suggesting that banks should see themselves as having duties to customers somewhat similar to those professionals have toward their clients. Moreover, banks as institutions serve a social function – acting as a custodian of people’s money, facilitating business transactions, investing in business, etc. – which suggests that the public interest ought to be a key consideration in what they do. Some of the anger directed at banks in the wake of the financial crisis of 2007–2008, perhaps, has been motivated by a perception that they have forgotten this social function and acted instead purely as self-interested, profit-motivated entities. Finally, while it may be true that banking roles have diversified in recent decades, meaning that the amount of specialized knowledge required to work effectively in banking exceeds the amount of general banking knowledge required, it might be nonetheless that a grounding in the basics of banking – including ethical concerns such as banking’s social purpose as well as technical financial matters – is desirable. And again, it might be that having a more holistic sense of the purpose of banking which could plausibly be derived from a professional education might lead to more responsible practice on the part of bankers. The normative aspects of professionalism – the emphasis on trust, the requirement to act in the interests of the client, and the idea of an alternative set of values that can act as a check on corporate self-interest, for example – have led some to recommend the professional model as a means of seeking to reverse the decline, not just in ethical behavior but also in competence, that many have perceived in the sector. Certainly, there is evidence that the public would prefer bankers to be professionally qualified, and media criticisms of individuals who have been involved in banking scandals often include surprise that they are able to hold a senior position in banking without holding a banking qualification (see, for example, the media coverage surrounding the former chairman of the UK’s Co–operative Bank, Paul Flowers). There has therefore been something of a professionalization agenda in the banking sector in recent years. In the United Kingdom, this agenda has been shaped by the Parliamentary Commission on Banking Standards, whose report in 2014 identified a central role for professional structures in improving standards of competence and conduct in banking (Parliamentary Commission on Banking Standards 2013), and the later Banking Standards (Lambert) review, which recommended the establishment of a new professional body for bankers (Lambert 2014). While the body that was actually set up in response to the Lambert Review, the Banking

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Standards Board, is not a professional body as such, it has pursued a professionalization agenda in the sector, publishing a “Statement of Principles for Strengthening Professionalism: the role of the firm” in 2018 and setting up working groups to drive forward the embedding of professional approaches in banking organizations. Another example is the Financial Conduct Authority’s Senior Managers and Certification Regime, which requires people in key roles in banks to demonstrate that they have the elements of competence and character required to earn the trust of the public. While there is no specific requirement to have a professional qualification in order to do this, this approach to regulation does involve a return to an emphasis on the qualities of individuals, as opposed to simply concentrating on rules and incentives, which can be seen as drawing on the tradition of professionalism. Whether these efforts at professionalization are effective, of course, remains to be seen. It may be that today’s financial corporations bear so little resemblance to their professional forebears that different approaches are required. Furthermore, developments such as banks’ increasing use of, and potentially reliance on, financial technology may indicate that a professional model becomes harder to sustain in the future, rather than easier. And we are still a long way from a situation in which failure to maintain professional status could seriously affect a banker’s career prospects. However, it could equally be argued that such developments indicate that a focus on clients’ interests, on the public interest, and on trust will become of greater rather than lesser ethical importance in the future.

Conclusions Professionalism is an ethical framework as much as it is a set of employment and regulatory structures. It requires individuals to earn the trust of clients and the public by achieving competence through professional qualification, maintaining that competence through continuing professional development, and adhering to a set of ethical principles overseen by a professional body. There are reasons to think that many of the financial occupations should be thought of as professional in nature, although various factors having to do with technical innovation and cultural change have led to a situation in which only some of those occupations can now be called full-fledged professions, and banking in particular has drifted away from its traditional self-conception as a profession. However, this decline in professionalism has been accompanied by (and may have partially caused) a decline in real or apparent ethical standards. It may be that the professional model offers an approach which can contribute to a reversal of this decline.

Cross-References ▶ Ethics in Finance as the Result of a Strong Systemic Commitment ▶ Financial Institutions and Codes of Ethics ▶ Stakeholder Accounting for Sustainability Applied to Nonfinancial Information in Banking

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References Bank of England (2016) A Millenium of Macroeconomic Data. Retrieved from: https://www. bankofengland.co.uk/statistics/research-datasets Baier A (1986) Trust and antitrust. Ethics 96(2):231–260 Barry B (1964) The public interest. Proc Aristot Soc 38(suppl):1–18 Baxter J, Megone C (2016) Exploring the role of professional bodies and professional qualifications in the UK banking sector. Retrieved from https://www.bankingstandardsboard.org.uk/wp-con tent/uploads/2016/10/160928-Professionalism-in-banking-publication-FINAL-WEB.pdf Bennion FAR (1969) Professional ethics: the consultant professions and their code. C. Knight, London Brecher B (2004) Against professional ethics. Philos Manag 4(2):3–8 Chartered Banker Institute (2019) Annual report 2019. Retrieved from https://www. charteredbanker.com/uploads/assets/uploaded/ed711b38-6a56-4955-8d6ac6f17b50b42f.pdf Dinovitzer R, Garth B (2015) Lawyers and the legal profession. In: Sarat A, Ewick P (eds) The handbook of law and society. Wiley, Hoboken Labour Force Survey (2019) Retrieved from: https://www.ons.gov.uk/employmentandlabourmarket/ peopleinwork/employmentandemployeetypes/datasets/employmentbyindustryemp13 Financial Reporting Council (2017) Key facts and trends in the rofession. Retrieved from https:// www.frc.org.uk/getattachment/77fc8390-d0d1-4bfe-9938-8965ff72b1b2/Key-Facts-and-Trends2017.pdf Freidson E (1994) Professionalism reborn: theory, prophecy, and policy. Polity Press, Cambridge Green E (2012) Debtors to their profession: a history of the Institute of Bankers 1879–1979. Routledge, London Griseri P (2005) The ideal of professionalism: a discussion of Bob Brecher’s ‘against professional ethics’. Philos Manag 5(3):71–78 Harrison S, Pollitt C (1994) Controlling health professionals: the future of work and organization in the National Health Service (state of health). Open University Press, Maidenhead, Berkshire Lambert R (2014) Banking standards review. Retrieved from: https://bankingstandardsboard.org. uk/pdf/banking-standards-review.pdf Luhmann (2017) Trust and power (trans: Davis H, Raffan J, Rooney K, eds: King M, Morgner C.). Polity, Cambridge Palframan M (2018) Ten years after the financial crisis – two thirds of British people don’t trust banks. Retrieved from https://yougov.co.uk/topics/finance/articles-reports/2018/08/29/tenyears-after-financial-crisis-two-thirds-britis Parliamentary Commission on Banking Standards (2013) Changing banking for good: report of the parliamentary commission on banking standards. Retrieved from London: https://www.parlia ment.uk/documents/banking-commission/Banking-final-report-volume-i.pdf Pellegrino ED (1991) Trust and ditrust in professional ethics. In: Pellegrino ED, Veatch RM, Langan JP (eds) Ethics, trust and the professions. Georgetown University Press, Washington, DC, pp 69–92 Sokolowski R (1991) The fiduciary relationship and the nature of professions. In: Pellegrino ED, Veatch RM, Langan JP (eds) Ethics, trust and the professions: philosophical and cultural aspects. Georgetown University Press, Washington, DC, pp 23–44 Veatch RM (1991) Is trust of professionals a coherent concept? In: Pellegrino ED, Veatch RM, Langan JP (eds) Ethics, trust and the professions. Georgetown University Press, Washington, DC, pp 159–176

Digital Financial Inclusion of Women: An Ethical Appraisal Paul Kofman and Clare Payne

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Digitization of Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hope That We Can Improve the Lives of Women . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Right Path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unlocking Financial Inclusion for Women . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Factors That Contribute to the Financial Inclusion of Women . . . . . . . . . . . . . . . . . . . . . . Unpacking Digital Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . An Ethical Assessment of Digital Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Is Digital Financial Inclusion a Good Thing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Does Financial Inclusion and Digital Finance Really Improve Equality and Reduce Inequity? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

Digital finance presents great hope for the financial inclusion of women. At last, more women may enter the world economy and benefit from financial products and markets as others have for generations before them. However, the risks of digital finance as a method to achieve financial inclusion are not insignificant – including personal security issues such as vulnerability to scams, and inappropriate products for their financial circumstances. There are also broader implications for communities and society. Despite increased financial inclusion globally P. Kofman (*) Faculty of Business and Economics, The University of Melbourne, Melbourne, VIC, Australia e-mail: [email protected] C. Payne The University of Melbourne and Vincent Fairfax Fellow for Ethical Leadership, North Sydney, NSW, Australia e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_34

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and improved access to digital financial services, inequality and inequity across societies in both developed and emerging economies persists. The risks and consequences of the growth and spread of digital finance must therefore be anticipated and mitigated in order for women to achieve financial inclusion and ultimately financial well-being. Through an ethical analysis of digital finance as a method to achieve financial inclusion of women, this chapter concludes that policy makers, established financial institutions, new providers, NGOs, and philanthropists engaged in the development and promotion of digital finance should recognize a concurrent responsibility to actively mitigate the forces that could threaten the well-being of women. Women with money are set to grow as an economic force. Given the right protections, all of society stands to benefit from women finally gaining the power that money affords. Keywords

Financial inclusion · Digital finance · Financial well-being · Ethics

Introduction Despite significant advances in technology and new ways of providing financial services, almost one third of adults worldwide are still considered “unbanked” according to Demirgüç-Kunt, Klapper, Singer, Ansar, and Hess (2018). The unbanked adults have a bank account neither at a financial institution nor through a mobile money provider. While account ownership is almost universal in high-income advanced economies, it is very different in developing economies where almost all the unbanked live. Demirgüç-Kunt et al. (2018) observe that nearly half of those who remain unbanked live in seven major emerging economies, including China and India. Those in the poorest households are more likely to be unbanked, as they live without any formal banking services such as the ability to receive and make payments or secure insurance (World Bank 2017). With women most affected by poverty, they are overrepresented among the unbanked in most economies, developing and developed (Molinier and Quan 2019). The reality of having no access to financial services is that payments are received in cash or, in some cases, not at all. Almost half of women in developing countries do not have formal identification, as compared with one-third of men. Having no identification often means that women are not recognized for their contribution through a formal and legitimate payment system.

The Digitization of Financial Services Digital disruption affects all sectors of the economy, especially the services sector, and none more so than the financial services. Digital finance characterizes products,

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applications, processes, and business models that have transformed the traditional operating model in financial services (European Commission 2020). Digital finance offers individuals and small businesses the ability to connect to financial service providers on the internet or through mobile devices such as smartphones. They can then make and receive payments, initiate transfers, borrow, and invest money using service applications that were not previously available. Investment in these new technologies, by large established institutions and new market players, has been significant. As a result, there has been an increase in access to financial services in both developed and developing economies, and in efficiencies for the global financial system. The International Monetary Fund (IMF) Financial Access Survey (2019) – a global database on access to, and use of, basic financial services – noted that “traditional banking is changing.” The IMF reported global growth of just 1% in commercial bank branches, with negative growth in high-income countries in contrast to 20% growth in low- and middle-income countries. Rather than indicating a decline in access to financial services, these observations indicate a change in the way people are accessing banking services with a clear shift to internet and mobile banking. Although the growth of mobile and internet banking is not as high in lowand middle-income countries, it is still significant in terms of the future of financial services.

Hope That We Can Improve the Lives of Women Digital finance has presented great hope for the inclusion of more of the world’s population in local and global economies, particularly for women. McKinsey (2015) estimated that comprehensive participation and integration of women in the economy could add $12 trillion to global GDP by the end of a decade. Recognizing financial inclusion as crucial to eradicating poverty and inclusive economic development, the Global Partnership for Financial Inclusion (GPFI 2013) agreed on the following three indicators to capture financial inclusion: 1. Access to financial services 2. Usage of financial services 3. Quality of the products and the service delivery Financial inclusion of women is about more than economics as many have hopes that the uptake of digital financial services by women will finally reduce inequality and the inequity that exists across the globe. Various positive possibilities have been identified and promoted, such as digital financial services lifting women, their families, and communities out of poverty by drawing them into the financial system in numbers not seen before and not considered possible through traditional banking services. There is the opportunity for dignified life through recognition as citizens and workers for the first time, and security through managing and controlling their own money, thereby reducing

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opportunities for theft and loss. Relieved of the burden of traveling for days to pay bills and collect wages, women might experience the freedom to use their time for other pursuits, grow their personal wealth, and reach financial prosperity. Financial inclusion through digital financial services has been on the agenda for some time. At the 2015 World Bank Group–International Monetary Fund Spring Meeting, both institutions adopted targets to improve financial inclusion and achieve universal financial access by 2020. This commitment was made in partnership with the public and private sector. Billionaires like Bill and Melinda Gates talk of helping women “unleash their power to control their own economic futures” (see Hendriks 2019) by investing in financial inclusion. Influential leaders like Kristalina Georgieva, Managing Director of the International Monetary Fund, also agree to this view. She argues that “financial inclusion through technology could achieve the same for women in business what the curtain achieved for women in music” (Council on Foreign Relations 2018), that is, address gender bias and increase participation by women (Goldin and Rouse 1997).

The Right Path This chapter provides a critique of the financial inclusion of women through the advance of digital finance in both emerging and developed economies. Through an ethical analysis that focuses on financial well-being, equality, and equity, it becomes evident that digital financial services alone, and left unmitigated, will not deliver the benefits of which so many are hopeful.

Unlocking Financial Inclusion for Women Economic development creates new market opportunities for (in)formal financial institutions, reaching out to the unbanked, although not necessarily to the unbankable. At the same time, the presence of a formal financial system with traditional financial institutions – banks and markets – is often deemed to be a prerequisite for successful economic development. Economic development requires financial development and vice versa, see Levine (1997). Regardless of the causality – for example, DFID (2004) and Hossein and Kirkpatrick (2005) argue that financial sector development is in fact a prerequisite for economic growth and financial inclusion – we do observe a global improvement in financial inclusion over time, accelerating in the last few decades. This acceleration is driven by, or coinciding with, double digit economic growth rates in emerging developing economies like India and China. The potential benefits of financial access, and more broadly financial inclusion, are well documented. Financial inclusion can provide people with the opportunity to transition from subsistence living to full-fledged economic participation. Welfare measures like health and social/cultural well-being can improve alongside economic

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prosperity. Yet, while financial inclusion has improved globally for both men and women, the gap between male and female inclusion has persisted. According to Demirgüç-Kunt et al. (2018, p. xii), “Still, in most of the world women continue to lag well behind men.” Only in the last decade or so did we observe women catching up – in high-income economies more so than in developing economies. We attribute this improvement to widespread access to mobile banking as the single most effective technological innovation unlocking financial inclusion. Demirgüç-Kunt et al. (2018, p. 25) suggest that these are “. . .early signs that mobile money accounts might be helping to close the gender gap.” However, access is only one dimension of financial inclusion. Of course, the introduction of mobile banking has not been the only change over this period of improving women’s financial inclusion. The last decade – book-ended by the 2008 global financial crisis and the 2020 COVID-19 crisis – saw unprecedented economic growth with historically low unemployment levels and increased women’s participation in the labor force. A surge in global economic activity was particularly prominent in low-income developing economies. Women’s participation in the (formal) labor force increased significantly. Millions of people were lifted out of extreme poverty and started using informal and formal financial services. This demand-pull for financial services was matched by a supply-push. Both traditional providers (local and global banks) and new entrants (shadow banks and Fintechs) seized the market opportunity. The delivery of financial services at scale and low cost became feasible with digital technology. When inferring the positive relationship between digital financial services and women’s financial inclusion, we need to account for contributing factors that share a positive impact on women’s financial access. We also need to take a closer look at the key features of mobile banking technology that are particularly relevant for women, and might explain the unique role of digital finance in unlocking women’s financial inclusion.

Other Factors That Contribute to the Financial Inclusion of Women There are a range of factors that can improve the financial inclusion of women. These include increased education, workforce participation, economic development, and the legal and regulatory context. In addition, there are behavioral factors specific to women that should be understood in order to effectively tailor financial products and services to achieve inclusion.

Education and Workforce Participation Increasing women’s education and workforce participation are significant contributing factors to improving financial inclusion. There is a strong positive correlation between a woman’s education and her employment and income. The World Bank (2018c) notes that women with secondary school education earn almost twice as much as those with no education at all. UNESCO in alliance with the development agencies like UNICEF, the World Bank, UNFPA, UNDP, UN Women, and UNHCR,

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agreed on the mission to transform lives through education, thereby recognizing the crucial role of education to unlock economic development (UNESCO 2016). The Malala Fund (2018) promotes girls’ education as “the world’s best investment.” The fund emphasizes the need to provide girls with quality education to prevent shortage of educated workers that may have serious consequences in the labor markets and economies. The nature of education also matters, as Argentina’s President Macri (2018) stated in his address to the World Economic Forum, “The G20 should help ensure that technological change will not increase exclusion or social disintegration. Education is at the centre of this debate: the future will require substantial investment in training and updating skills.” According to Atkinson and Messy (2013), it is financial education that will be the key to financial inclusion through improved financial literacy. In 2014, the G20 agreed on a target of 100 million additional women in the labor force, significantly reducing gender inequality (Bracht 2014). At the 2017 G20 Labour and Employment Ministers Meeting, it was noted that there was progress toward reducing the gap but also signaled that stronger efforts were required (Commonwealth of Australia 2017). The prioritization of workforce participation was recognized by the adoption of the 2030 UN Agenda for Sustainable Development, with signatories committing “to achieve full and productive employment and decent work for all women and men, including for young people and persons with disabilities, and equal pay for work of equal value” (Sustainable Development Goal SDG 8, target 8.5) and “to achieve gender equality and empower all women and girls” (SDG 5) (Sustainable Development Goals Knowledge Platform 2020). Increased women’s workforce participation has clear benefits for the women and their families. Economic independence derived from participation in the paid workforce allows women to have increased control of their lives, provide financial security for themselves and their family, and save for retirement. The financial independence that results from workforce participation has also been identified as an important factor in assisting women to leave violent relationships (Costello et al. 2005). Increasing workforce participation is an economic priority of many countries. Intergenerational reports mention the positive impact on economic productivity and prosperity, and diminishing reliance on the provision of welfare. A report by the Commonwealth of Australia (2015) notes, “If we are to achieve these goals we need to encourage those currently not in the workforce, especially older Australians and women, to enter, re-enter and stay in work, where they choose to do so.” Workforce participation varies considerably across countries. The differences are driven by a range of factors including economic development, education levels, access to child care, and social norms. According to the International Labour Organisation (ILO 2018), women’s labor market participation rates are catching up with those of men in most developed countries. However, according to the ILO (2017), the labor market gender gap persists globally, especially in the Middle East, Northern Africa, and Southern Asia where restrictive gender and cultural norms are a factor in reducing the options

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for women to seek paid employment. As the number of women enrolled in formal education increases, which initially can lead to a delay in their entry into the labor market, there is hope that the gap will eventually narrow as participation increases, and financial inclusion will follow.

The Legal and Regulatory Context Discriminatory laws also impact financial inclusion. The World Bank Group’s Women, Business and the Law (World Bank 2018b) maps what it calls the “hidden laws” that impact the economic empowerment of women. Laws relating to inheritance, property rights, business, employment, equal pay, marriage, reproductive health, and human rights can hinder or facilitate financial inclusion. The World Bank (2018a) gives an example where constrained access to and control over property severely limits women’s ability to provide collateral when applying to borrow. Another example of the gender gap is in having identification, which denies women to open a bank account where formal identification is required. Progress in addressing and removing these legal barriers is a significant contributing factor in increasing financial inclusion for women. Economic Development and Macroeconomic Growth Allen, Demirgüç-Kunt, Klapper, and Martinez-Peria (2016) nominate a range of economic development factors that ultimately determines the level of financial inclusion. Those factors extend from the quality of institutions, good governance, and access to reliable information to a sound regulatory environment. The World Bank Development Research Group (Allen et al. 2016) noted that the relationship between financial inclusion, inequality, and macroeconomic growth has not been well understood due to the limited availability of historical data. Analysis of the factors shaping macroeconomic growth and inclusion require data collected over long time periods. Until recently, data on financial inclusion has not been available on a comparable, global level, limiting the ability to assess impact (Demirgüç-Kunt et al. 2017). However, as data collection and analysis becomes more advanced, we anticipate that the links between economic development factors, macroeconomic growth, and financial inclusion will be better understood. Behavioral Factors Historically, there has been much focus on the supply of financial services, rather than the demand and behavioral factors that impact financial inclusion. More recently, economists and those in management and leadership positions have turned to better understanding the behavioral factors that impact decisions and therefore either accelerate or hinder progress toward financial inclusion for women. Those behavioral factors are identified by behavioral scientists, borrowing from the disciplines of economics, sociology, psychology, and neuroscience. They uncover a long list of behavioral barriers that explain why people may be reluctant to effectively engage with financial services providers, and ultimately fail to achieve financial well-being. In a World Bank (2014) report, Jim Yong Kim (then President

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of the World Bank) stated that “Recent research has advanced our understanding of the psychological, social and cultural influences on decision-making and human behavior and has demonstrated that they have a significant impact on development outcomes.” This World Bank (2014) report also explains how minor considerations (like context, convenience, and salience) may have the potential to significantly tweak life’s decisions on education, health, or even whether to start a business. The World Bank therefore recommends that financial development services do not just consider which interventions are necessary, but specifically address their implementation in light of behavioral factors. Although this work is still in the early stages of theoretical development, we anticipate there will be a growing understanding of the significant role of behavioral factors in achieving financial inclusion for women. By better understanding how women digest information, how choices are made and preferences expressed, action can be taken accordingly. Products and services can then be designed to close gaps and accelerate progress. Historically, factors specific to individual households at the microlevel have received little attention in research studies. Those working in the field have noted that very few studies have attempted to explore the behavioral finance tendencies that influence the usage of financial services, although a study by Thomas and Natarajan (2018) indicated that Low Income Households (LIH) prefer to use informal financial services despite being aware of its limitations. As late as 2018, researchers pointed to a “dearth of research on LIH and on the role of behavioural factors in financial inclusion” (Thomas and Natarajan 2018). Behavioral factors that impact financial inclusion include the following: • Trust in the financial institution: A study by Dupas, Green, Keats, and Robinson (2012) observed that rural Kenyans list a lack of trust when deciding not to use the services of a local bank, despite being granted a fee waiver for those services. • Loyalty: A study by Napier, Melamed, Taylor, and Jaeggi (2013) observed loyalty to informal financial products and services due to their social dimension. • Social proof and approval: A study by Chetty, De Villiers, Dudar, and Smit (2018) noted that individuals may be influenced by members of their own gender groups, consistent with literature on peer effects influencing women. According to a study by Datta and Desai (2018), a Tanzanian bank that adjusted its communication approach according to behavioral factors showed the potential for accelerated financial inclusion. Client engagement improved markedly for those clients who received communications that were behaviorally adjusted. Especially the notion of loss aversion (whereby losses are perceived more negatively than gains are perceived positively) improved engagement significantly. There are other behavioral factors unique to women that position them well to manage their money and grow their wealth. However, these are rarely the topic of discussion in the research literature or in public commentary. They include:

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• Attitude to money: In a speech by its President, the World Bank (2010) suggests that child survival rates improve when the mother is in charge of household income. A study by Morgan Stanley (2015) shows that when women have extra money, they are more likely than men to invest it responsibly, providing longterm financial security with ethics. Women are also more likely to embed personal values in their investment decision-making. As a result, women invest proportionally more in ethical funds than men do. This led Morgan Stanley (2015) to conclude that women carefully traded off investment returns against the (positive) impact their investments might have. • Attitudes to saving: A study by Vanguard (2015) shows that, on average, women save more than men irrespective of age and earnings. That characteristic prepares women better for home ownership. Riemer (2013) confirms that single women in the USA bought their own homes at twice the rate of single men. Riemer also finds that Australian women not only buy their own homes, they are more likely to own them outright. A habit for saving makes women more resilient to mortgage stress and maintain payments even if interest rates increase. As a result, women benefit from the long-term appreciation in home values. • Attitudes to risk: Studies have concluded that women tend to take fewer risks with money. This risk-averse approach can lead to steady gains. In an analysis of spending and investment habits by Betterment (2015), women are found more likely to follow a low risk strategy to achieve long-run financial goals. Women are also less prone to gamble according to Wong, Zane, Saw, and Chan (2013), avoiding a financially destructive cycle. Women tend to seek advice and factor that advice into their decisions (more so than men), also serving to minimize risk (Betterment 2015). There are a range of behavioral factors that impact the financial inclusion of women. When properly understood, financial services can be tailored accordingly, and financial inclusion can become a more likely outcome.

Unpacking Digital Finance In order to better understand the potential of mobile banking and digital finance to improve financial inclusion for women, we need to unpack the key features of digital finance. Digital and technological disruption affects many hitherto face-to-face delivered services, perhaps none more so than financial services. Early manifestations of digital finance like ATMs, EFTPOS terminals, and automated equity trading systems were introduced by the financial institutions (banks and asset markets) for cost saving purposes rather than fundamentally changing their business model. The financial institutions “controlled” the introduction of expensive new technology initially, further raising the barriers to competitive entry, as indicated by Clemons (2015). Financial deregulation in the 1980s turned banks worldwide into conglomerate financial institutions. At the same time, they found cost reductions by providing

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basic retail services through ATMs and closing branches (see Gujral et al. 2019), yet charging fees for using these services. This business model opened an opportunity for Fintech entrants specializing in retail business lines not considered core to the conglomerate business and strategy of the traditional banking institutions. Increased adoption of digital technology has seen a proliferation of new retail financial services and products from mobile banking to Peer-to-Peer (P2P) lending; from crowdfunding to online financial literacy programs all the way to general financial robo-advice apps on a smartphone. A common feature of digital financial technology is its provision of low-cost financial services to a vastly larger customer base than what was previously possible within the constraints of geographical proximity to branches. As is sometimes the case with innovation (Braun and Herstatt 2008), many traditional financial institutions were slow to adapt to new technology, secure in their market share position. However, as Fintech start-ups increasingly succeeded in attracting market share, those financial institutions started to focus their attention on the new technologies. The disintermediation of financial services – characteristic of many Fintech innovations (think P2P or Blockchain) – has been the key to offering those services at much lower cost. But this became only possible after the introduction of technological platforms facilitated by the Internet and by smartphone technology, offering massive benefits of scale at extremely low cost. Traditional banking and bank branches all of a sudden look like they are stranded, stuck in physical space. For example, the COVID-19 pandemic has accelerated the transition to mobile banking, to the point where even ATMs may become obsolete. Physical presence has since been supplemented by a virtual presence. However, shutting down or reimagining physical assets represents a costly transition for large traditional banks. This has resulted in the following three distinct business models: 1. Banks providing smartphone apps and internet banking directly to their customers 2. Third-party services providers (like Google Pay, WeChat, or Alipay) using smartphone apps linked to their customers’ bank accounts 3. Mobile networks (like Xinja or QPay) operating altogether independently from financial institutions, also known as digital or neo-banks Ironically, the retail customers that the banks are now targeting with their smartphone banking apps are the same customers many previously considered low value customers. These are also the customers who are most likely to be affected by the closure of bank branches and increasing account fees, yet many rely on these basic financial services. Unlike the banks, the third-party providers and independent providers, such as Fintech start-ups, do not bear the burden of stranded physical assets and their access to low cost digital platforms has significantly reduced the entry barrier. As a consequence, competition has increased and Fintechs are constantly “reinventing” their service and products for market share gain, leading to a flood of finance and banking apps, specifically mobile banking services.

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So, what are the common characteristics that distinguish the digital finance sector from traditional finance providers? According to Donovan (2012), the International Finance Corporation attributed in excess of 50 characteristics that explained the increase in mobile money services. Key features of digital financial services include: • Low cost (following initial investment) – Virtual, cloud-based digital platforms are cheap and can easily be scaled up. • Digital intermediation – Eliminating layers of physical service providers through operational process transformation (e.g., credit rating agencies, brokers, and financial planners replaced by digital verification and robo-finance, respectively). • Monopolistic competition – Product differentiation through new features and technological upgrades and brand prominence; platform/brand dependency linked to customer loyalty and inertia to switch. • Competition for market share – Reaching out to cohorts that were thus far ignored (the unbanked and financially excluded); enhanced by customer data analytics (tracking use of integrated linked accounts). • The presence of “unknown” digital providers – Lacking substantive track records in financial services, which would normally create a trust issue for customers (suggesting that people trust new digital finance technology more easily than finance professionals). • Focus on customer ease of use – Remote access and mobility enhance the customer experience through digital transformation (connectivity of smartphone, social media, and internet). • Attempts at customer personalization – Services can be tailored to customer interests, needs, and suitability to personal circumstances (which can be a distinguishing feature in monopolistic competition). • Integrated personal finance system – Linking payments to browsing, social media, and e-commerce. • A patchwork of applicable regulation – Uncertainty and compliance cost due to multiple regulatory oversight (e.g., financial services regulation paired with mobile network regulation) as well as regulatory “sandpits” that allow Fintech innovators to experiment. • Presence of dominant global operators – Reflecting global brand power (consider companies like Alipay, Ant Financial, Google Pay, PayPal, and WeChat wallet) scale benefits and global market coverage into developing countries. • Tendency for ethical claims – Digital financial technology is less likely to have conflicts of interest (although algorithmic bias exists); business model (and purpose) is to be inclusive, making technology available to all. So how do these features of digital finance translate into the improved financial inclusion of women? Donovan (2012) summarizes the three most important factors in the IFC (2011) mobile money study as competition, regulation, and customer ease of use. First, mobile banking competition needs to ensure that the service is complementary to existing sources of financial support (family, cooperatives, savings, and loans utilities), rather than crowd them out. Women seek new layers of service in

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addition to the traditional financial infrastructure, not substitute for existing providers. Second, regulation needs to create a safe environment for women’s engagement with the digital service provider. To improve women’s financial inclusion, regulators need to provide the necessary protections for the vulnerable and often less than financially literate women. In particular, minimizing fraud and risk of theft should take priority in a financial “safety net.” Third, the digital finance provider needs to tailor its service to the needs and circumstances of women – to overcome entrenched distrust of financial institutions that offer a one size fits all, tailored to men’s needs and circumstances. Trust needs to be established early on in the customer engagement to ensure financial access turns into financial activity and financial inclusion. The reality remains that there are gender-specific economic and market factor barriers that impact achieving financial inclusion for women. These barriers have complex cultural and socioeconomic aspects that cannot be underestimated. According to Demirgüç-Kunt, Klapper, Singer, Ansar, and Hess (2018), one billion financially excluded adults globally own a mobile phone and approximately half a billion have internet access. There is, however, a significant gender gap in internet usage and it is growing wider. The gap is largest, at 31%, in the least developed countries. Mobile phones are crucial to increasing access to digital finance. However, again there is a gender gap in mobile phone ownership. Demirgüç-Kunt et al. (2018) estimate that women in low- and middle-income countries are 10% less likely to own a mobile phone than men. Even when women do own mobile phones, they tend to use them less frequently than men. Demirgüç-Kunt et al. (2018) estimate that women are 26% less likely to use mobile internet and 33% less likely to use mobile money. Their marital status is also a factor, with single women sometimes discouraged from owning and using a mobile phone and married women having their use monitored and controlled by their husband or their father and brothers. This demonstrates the interconnected nature of technological and social factors that must be understood in order for digital financial services to change lives for the better. In addition, there are other factors at the individual, local, and global level that must be mitigated in order for digital finance to deliver all that it promises.

An Ethical Assessment of Digital Finance Digital technology has transformed our interaction with the financial services sector. In developed economies, individuals no longer have to venture to their local bank branch to pay bills, withdraw money, or get a loan. They can do all these things wherever and whenever they want or need to by simply accessing finance, banking, and payment services online or on their mobile devices. This transition to convenient “virtual banking” has also attracted new providers (in addition to the traditional bank virtual offerings) for individuals to choose from. It has even been suggested that this technological disruption heralds the “democratisation of finance (source: https://www.bbva.com/en/new-banking-

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ethics-created-digital-transformation/).” Finance accessible for everyone with no one left behind, and with customer interest at heart. Targeted advertising (for example: With a presence in seven sub-Saharan countries, Atlas Mara aims to be a positive disruptive force in the markets in which we operate by leveraging technology to provide innovative and differentiated product offerings, excellent customer service and accelerate financial inclusion in the countries in which the Company operates. Source: www.atlasmara.com) can create the impression of financial inclusiveness and financial well-being as the ultimate purpose of digital banking. However, can we be sure that increased financial access due to digital finance will really increase the financial well-being of women? In the previous section, we identified and evaluated the traits of digital finance that make it more likely for women to engage and become financially included. Low cost, customer focused regulation, and ease of use are most prominent among those traits. But there are some features of digital finance that could spell trouble for women previously financially excluded. These features are not usually admitted or even recognized by the financial service providers or their customers. Take for example disintermediation in mobile P2P (Peer-to-Peer) lending services. Mobile borrowing transaction costs are lower than for personal loans at a bank. Note that the personal loan interest rate may be lower at a bank, but the bank would not normally extend personal loans to the financially excluded! Yet, by directly connecting borrowers to lenders, the P2P platform has shifted responsibility and risk from the now absent intermediary (who assumed that risk in exchange for a fee or premium) to the counterparties in the loan. Regulatory supervision of the intermediaries – including an ombudsman for customer recourse – has been replaced by caveat emptor. Now consider that this P2P platform is available as a mobile app that can be downloaded free of charge from the app store. When these P2P platforms are targeted to the most vulnerable and disadvantaged customers – those with limited or no access to traditional lending services, and lacking in financial literacy, would they be able to recognize and evaluate the risks, and fully understand the terms and conditions? Financial literacy (or lack thereof) is a key concern in using digital finance to unlock financial inclusion. While financial literacy is globally on the rise, there is still considerable dispersion across countries and basic financial literacy rates are still at best around 75% in countries with high financial inclusion rates for women, see Preston and Wright (2019). Among women, financial literacy rates are on average 10–20% less than among men. Hasler and Lusardi (2017) document evidence of a persistent gender gap in financial literacy across the world. Fonseca et al. (2012) find that financial decision-making in households depends on the relative financial literacy of the household members. Given the persistent gender gap, this suggests persistent financial exclusion of women. Digital finance may seem like a pathway to fast track financial inclusion, but without adequate financial literacy or digital literacy (OECD 2018) women will be disproportionately exposed to the ethical pitfalls of digital finance. In this section we will take a closer look at those pitfalls by considering the ethical signposts of equality, equity, fairness, duty of care, prudence, loyalty, suitability, and

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the absence of conflicts of interest. First, we will discuss whether improving financial inclusion is the ethically right thing to do. Compare this, for example with the sudden availability of online gambling opportunities in disadvantaged and vulnerable communities that were previously gambling free. Certain types of inclusions are obviously not desirable from (most) ethical perspectives. Only an ethical utilitarian could possibly arrive at a positive outcome for allowing the most vulnerable improved access to gambling. For financial inclusion to have a positive impact on women’s well-being that extends to positive externalities for their families and communities, digital finance platforms need to take ethical responsibility for their customers’ use of their services. An independent assessment of ethical and social impact could filter out the predatory and high-risk apps among the many that deliver a valuable service to financial inclusion. If self-regulation fails (for example, due to excessive forces of competition), a customer well-being focused, government legislated entity should be established to fulfill that role. Nonetheless, when we consider whether the growing inequality and inequity in (effective) financial inclusion can be arrested, we obviously first need to narrow the entrenched gender gap in financial and digital literacy. Digital finance has opened the door to women’s participation and ownership of their financial affairs. But it is not enough in itself.

Is Digital Financial Inclusion a Good Thing? In evaluating the impact of digital finance on women’s financial inclusion, we made the intuitive assumption that equitable financial inclusion is in fact desirable. Questioning that assumption raises a number of questions. Is financial inclusion a necessary condition for women’s financial well-being? Is financial inclusion always beneficial to financial well-being? Does it also improve the financial well-being of the family, the community, and the economy? And what about the more broadly defined mental, physical, and social well-being? Before we can infer the well-being benefits of women’s financial inclusion, we need to be clear what is meant by financial well-being. Muir et al. (2017) define financial well-being according to three interrelated financial dimensions: • Meeting living expenses and saving for emergencies – To satisfy basic needs, paying off debts, and covering unexpected expenses – To manage future shortfalls • Feeling and acting in control of one’s finances through – Understanding one’s financial position – Active financial decision-making • Feeling financially secure – To be satisfied with current circumstances – Provides lifetime prosperity

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These three dimensions map into McKinsey’s (2020) five-point financial inclusion diamond: making everyday transactions, accessing credit, planning ahead for big goals, insurance against key risks, and accumulating long-term wealth. Demirgüç-Kunt et al. (2018) list the benefits of financial inclusion as 1. 2. 3. 4. 5.

Improving income earning potential Managing financial risk Reducing the cost of receiving, saving, or paying money Accumulating savings and making productive investments Reducing corruption and improving efficiency in government transfers

From this list, we can now see how financial inclusion – progressing from access to basic financial services, to financial risk management, and ultimately to saving and investing for the future – improves financial well-being. In many developing countries, this means an opportunity to escape from entrenched poverty, particularly if financial inclusion allows women to invest in the health of their family (improving physical well-being), education of their children (enhancing mental well-being), and business opportunities (creating economic well-being). These dimensions of wellbeing interact and feedback on each other to further improve overall well-being. Consider an investment in a mature age financial literacy class. The educational experience improves mental well-being and builds financial skills that improve financial well-being, or an investment in a child’s health (physical well-being for the child and mental well-being for the mother) leads to a more productive life (economic well-being). But is financial inclusion a sufficient condition or even a necessary condition for well-being? To address that question, we need to look at the ethical implications of digital finance:

Lack of Knowledge and Understanding: Financial and Digital Literacy It would appear that the spread of digital finance has overtaken the growth in financial literacy. For example, “. . .it may be difficult for mobile banking [in India] to act as a vehicle for financial inclusion. . .despite plummeting [cost] . . . the penetration rate for mobile phones . . . far outnumbers that of bank account holders in India. . .” OECD (2011, p. 141). Providing vulnerable and financially illiterate individuals with the tools to borrow, invest, and spend seems reckless at the least. Without a clearly stipulated duty of care, the digital finance providers like any other financial service provider will not necessarily act in the best interest of their customers at all times. Information Asymmetry: How to Choose the Right Digital Platform? In highly competitive markets (which applies to both financial services and mobile phone providers), customers will be presented with choices and a range of products. At present there is no globally agreed framework that helps customers make informed choices – particularly if their information set is constrained to the app

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store or the internet. The impact of the informational disadvantage can be compounded by a lack of financial and digital literacy.

Confusing Needs and Wants: Impulse Buying and Other Behavioral Concerns Even financially literate customers are susceptible to making mistakes in financial decision-making. Behavioral biases can drive customers away from rational considerations (see, for example, Datta and Desai (2018)). Digital finance makes acting on those biases easier and can lack a “reality check” by a traditional banking professional enacting prudence in their duty of care for the customer. Wijland, Hansen, and Gardezi (2016) discuss the potential of “nudging” modifications to mobile banking apps as a means of unbiasing young people’s engagement with mobile banking. Being Financially Responsible As individuals reach financial independence they are likely to have increased responsibility and obligations in financial decision-making. If the financial circumstances (and outcomes) subsequently deteriorate, this may cause severe mental anguish, without a knowledgeable network of financial service providers to offer face-toface support. The experiences with digital microfinance (see Mader 2018) – where the suicide rate was linked to a vicious cycle of indebtedness – are a sad point in case. Privacy and (Un)wanted Insights Digital finance allows the providers to “learn” from their customers’ financial behavior to an extent that was never feasible before. Data analytics provide insights into spending, saving habits and social media use. Some products and services have become particularly adept at determining customer “wants.” This can lead to unwanted manipulations, e.g., women who fall behind in their mobile loan repayments being targeted by payday lenders or by lay-by shopping apps. However, learning about customers is not necessarily a bad thing if done with consent, transparency, and full disclosure, as it may improve tailored financial solutions that account for customer suitability and circumstance. Vulnerability to Fraud and Scams Poor people in many developing countries, already struggling with the impact of natural disasters and health-related pandemics, are simultaneously being targeted by online fraudulent activity taking unfair advantage by exploiting their vulnerability. To illustrate, a research report by the Consultative Group to Assist the Poor (2016) found that 83% of people surveyed in the Philippines had been targets in mobile phone scams, with one in five losing money while in Tanzania, 27% had been targeted and 17% fallen victim. The Economist (2020) reported that globally expanding mobile financial services facilitated access to cheap and reliable financial services to thus far unbanked people. As an example, the innovative mobile money provider M-Pesa (operating in Tanzania) transacts billions of dollars annually. Disappointingly, those mobile financial services do also attract criminals and fraudulent activity.

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Neo-finance Regulation These ethical concerns combined raise doubts as to whether digital finance and financial inclusion – if left to their own devices – inevitably lead to financial wellbeing. Why have mobile financial services not been able to effectively self-regulate? After all, monopolies and oligopolies self-regulate to “control” access by new entrants. Yet, in the monopolistic competitive digital finance market, self-regulation appears not to be a priority, indicating perhaps a reluctance to bear the cost of the regulatory burden (Wallace et al. 2000). As the digital finance market matures, regulators would therefore be wise to progressively shut down the “regulatory sandbox” and assume its regulatory duty. Whereas traditional financial regulation focuses on systemic market problems and finance professionals’ behavior, we believe that “Neo-finance” regulation should instead focus on customer’s interests and (biased) behaviors. Through information and education that includes financial and digital literacy, we are much more likely to see the inclusion–well-being nexus come to fruition.

Does Financial Inclusion and Digital Finance Really Improve Equality and Reduce Inequity? Much of the commentary on digital financial inclusion assumes that digital finance is “good.” The focus of studies and data collection is therefore on growth in access to digital financial services, the range of services offered, and infrastructure and regulation developments to support continued expansion. There is less focus on whether technology and digital finance actually improves financial well-being or leads to less inequality and more equity across society. In order to assess whether financial inclusion improves inequality, we can look to advanced economies where financial inclusion is common and digital financial uptake is already widespread to places where there is access to a wide range of services and infrastructure and regulation is generally supportive. Even with these foundations in place, a divide remains between men and women, and rich and poor. For example, income inequality is a major political issue in the United States, despite being the birthplace of many of the digital financial innovations that are being enthusiastically promoted as solutions to inequality elsewhere. Contrary to much public commentary and general understanding, the digital economy has been found to accelerate inequality (White 2015). While there are examples of women advancing in wealth accumulation in developed economies, significant divides across these societies remain. This suggests that financial inclusion through digital financial services does not necessarily have the transformative effect hoped for and championed by those in the development community, the philanthropists, and the financial service providers. In a “review of reviews,” Duvendack and Mader (2018) evaluated the evidence on economic, social, behavioral, and gender outcomes from financial inclusion and concluded that “On average, financial services may not even have a meaningful net positive effect on poor or low-income users, although some services have some positive effects for some people.”

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Duvendack and Mader warned of the “fragile” results of financial inclusion and recommended treating positive reports with caution. It is evident that further analysis is needed to better understand the factors that impact financial inclusion and might bring us closer to equality and improved equity.

The Importance of Saving An area that should be highlighted for positive outcomes is savings. In contrast to other financial products, such as the provision of credit, savings have been identified as having both immediate positive outcomes and a positive impact on poverty measures (Steinert et al. 2018). As demonstrated in the section on Behavioral Factors, women have a good record in relation to saving. According to Vanguard’s (2019) How America Saves Report, women are more likely to save than men, even when they earn less. However, saving and financial products that encourage saving behavior do not appear as a priority for financial service providers. Learning from Past Initiatives Designed to Accelerate Financial Inclusion Much economic development activity over the last two decades has focused on credit, specifically microcredit, extending very small loans to the poor. Microcredit was widely promoted as a tool for development that could alleviate poverty by providing opportunities for entrepreneurship and promoting empowerment of women (Robinson 2019). After decades of promoting microcredit, in 2006, Muhammad Yunus and the Grameen Bank were jointly awarded the Nobel Peace Prize for their efforts through microcredit to create economic and social development (Nobel Prize 2006). However, when the development impact of microcredit was formally evaluated by Demirgüç-Kunt, Klapper, and Singer (2017), it showed only a mixed effect for lowincome recipients of microcredit. In a study of three villages in Bangladesh, Banerjee and Jackson (2017) found that microfinance increased indebtedness and worsened economic, social, and environmental conditions in impoverished communities. Banerjee and Jackson concluded that microfinance is a “discredited model” that promised more than it delivered. Findings like these have led to the more recent shift from loans to account ownership and the provision of a range of financial services. If we are to learn from past initiatives, we should be careful in promoting and focusing efforts singularly before the impacts and interrelations are properly understood. The Limits of Digital Technologies According to Wei (2019), the World Economic Forum confirmed that digital technology was not invented to tackle inequality, acknowledging there was a risk it could actually widen existing economic and social disparities. Qureshi (2019) references the simultaneous rise in income inequality and introduction of digital technology, with income inequality increasing in most advanced economies since the advent of digital disruption. Qureshi concludes that more inclusive outcomes from digitization are possible but require improved policies. In order to achieve better outcomes, the United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP 2018) recommends that countries should ensure that technological progress does not exacerbate inequality. UNESCAP

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identifies investment in infrastructure, capabilities, and learning as pillars of this policy focus. Importantly, such policy needs to be framed in the context of persistent accumulation of wealth. The revision and enforcement of competition law, intellectual property protection, and the agency of customers should be key policy areas underpinning future digital innovation.

What We Know from the Advance of Technology in Developed Economies Brei, Ferri, and Gambacorta (2019) provide evidence that income inequality and wealth disparities have increased despite financial growth. While an increase in bank and market activity initially reduces income inequality, the impact can then reverse as financial activities increase beyond a threshold. Brei et al. conclude that the recent (digital) development of financial markets could well have produced an increase in income inequality. Guellec and Paunov (2017) explore the sources of these inequalities and conclude that digital innovations may have contributed to magnifying “market rents.” As those market rents mostly go to investors and high net worth individuals, they disproportionately benefit high-income groups. The result is increased income inequality. In addition, labor-saving technology can replace jobs that otherwise paid well, forcing impacted workers to move to lower paid jobs (Hernaes 2017). Rather than closing gaps, technology can widen inequality and lead to further division. Unintended Consequences of New Technologies Qureshi (2019) notes that much technological innovation in financial services has focused on trading and asset management of most value to the already wealthy without significant benefit to economic productivity. Innovative financial technology has in fact distorted market competition by concentrating market power in a “winnertakes-most” manner. Customers, community, and local economy lost out against increasingly powerful financial service providers. Haskel and Westlake (2017) identify that digital technologies encourage the rise of dominant firms due to first-mover advantages, scale economies, network effects, and the ability to leverage big data. Globalization then reinforces the scale economies by facilitating easy access to markets in emerging economies. Stewart (2015) finds that real economic growth has not kept pace with financial growth. In the past half century, bank and financial institution lending has outstripped economic growth three to one. Extrapolating that observation suggests that further financial growth might actually obstruct real economic growth and thus worsen inequality. And so, we find ourselves in a situation where private wealth has grown and poverty remains, all while digital financial technology finds its way into economies across the globe. Wealth Concentration and the Role of Philanthropy Some may counter the rise of private wealth and wealth concentration by pointing to philanthropy as having a role in redistribution and in addressing societal issues. Yet

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again, inequality remains despite new modes of philanthropy such as entrepreneurial philanthropy, planetary philanthropy, venture philanthropy, innovative philanthropy, and hybrid philanthropy. According to Laskowski (2011), philanthropy arises from increasing inequality caused by intense financialization of the economy. Ironically, philanthropy itself has been affected by financialization. Trusts and foundations are in fact financial constructs that can be marketed as tax-offsets for the wealthy. That makes philanthropy sit uneasy with a genuine desire to reduce inequality. Philanthropy was once predicted to be the “salvation of capitalism” (Acs 2013). More recently we have seen a critical lens applied to this claim (Rogers 2013), with a call for more focus on the social context in which wealth concentration and the subsequent wealth gap is generated. Other criticisms include the undue influence of philanthropists on policy making, the use of public funds, and a lack of accountability when programs fail to reach their goals or have unintended negative consequences. Most recently, as inequality has become hard to ignore, particularly as a result of the COVID-19 pandemic, there have been calls for structural change rather than relying on philanthropy to fund solutions. Dasgupta and Kanbur (2011) conclude that in the context of reducing inequality, philanthropy and direct redistribution (through taxes) are better viewed as complementary, rather than substitutes. Philanthropists, most notably Bill and Melinda Gates, are playing a role in funding and promoting initiatives designed to increase financial inclusion through digital services. However, a critical lens needs to be applied to such activities, to ensure the underlying causes of inequality are simultaneously understood and addressed, rather than aggravated or exacerbated. According to Kauflin and Adams (2019), a Forbes magazine headline, “The $100 Trillion Opportunity: The Race to Provide Banking to the World’s Poor,” should stand as a warning against potential underlying motivations of philanthropists, venture capitalists, and those who advise them.

Conclusion Despite concerted efforts from governments, NGOs, financial institutions, and philanthropists, a large part of the world’s population remains financially excluded. Women are vastly overrepresented among those who do not have access to common financial services such as savings accounts, loans, and payment systems – let alone investment services or financial advice. Digital finance has arrived with the promise of unlocking women’s financial inclusion on a global scale. More women than ever before are given the opportunity to fully participate in the world economy, with some being recognized as “people” for the first time. With access to a range of financial products and services, women can make their money grow, start to plan for a financially secure future, and benefit from global markets as others have for generations. However, the ethical implications of digital finance are not insignificant. Accessing digital financial services and entering global financial markets increases vulnerability to

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manipulative targeting and scams. Instead of advancing equality, financial inclusion can lead to increased inequality and inequity in society. If not understood and mitigated, this could mean that efforts to achieve the financial inclusion of women are ultimately unsuccessful despite the hopes and efforts by many. Women’s financial inclusion is not just a matter of fairness and equality. It is about making the world a better place for families, communities, and society. Billions of people, across borders and socioeconomic divides, are already customers of digital finance. Women, however, warrant special consideration. We must turn our attention to protecting women not only because of the historical financial disadvantage from which many emerge, but also because of the distinct ways in which women spend and think about money. When money is in short supply, women prioritize expenditure on their children, food, accommodation, and education to protect their families and communities in their immediate needs. When money is in abundance, they prioritize responsible saving and investment to address future needs. Recognition of these tendencies to “do good” with money, demands the financial empowerment of women as critical to economic development on a global scale. Many policy makers and established financial institutions, along with Fintech entrepreneurs and philanthropists, are engaged in initiatives designed to bring women into the world of finance. Digital technologies – from electronic payment systems to digital wallets – can assist women in making their mark in the world economy, to which they have long contributed, but not always benefited from. Digital finance can make that contribution transparent throughout supply chains, which means that many female workers will have the opportunity to progress from the informal to the formal economy. More than that, women would finally be recognized financially for their economic contributions. Through digital payment systems women can make deposits and transfers that previously involved days of travel to a distant bank branch. Digital finance, when designed well and effectively regulated, can strengthen financial autonomy. However, the risks resulting from digital finance are both local and global. They could range from local issues, such as password protection and hacking, or impulse buying and investing in high risk investment schemes, to global cross-border conflicts which could involve the suspension of trade agreements affecting digital services, as well as susceptibility to global volatility, financial crises, and cyberattacks. This chapter proposes that those who are facilitating and promoting the introduction of digital finance should recognize a concurrent responsibility to actively mitigate the forces that could threaten the benefits of financial inclusion for women. Only then will financial inclusion actually improve financial well-being and bring us closer to equality and a more equitable society.

References Acs ZJ (2013) Why philanthropy matters: how the wealthy give, and what it means for our economic well-being. Princeton University Press, Princeton Allen F, Demirgüç-Kunt A, Klapper L, Martinez-Peria MS (2016) The foundations of financial inclusion: understanding ownership and use of formal accounts. J Financ Intermed 27:1–30

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Part II Ethics in Financial Products and Services

Microfinance Services and Women’s Empowerment Nina Hansen, Marloes A. Huis, and Robert Lensink

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From Microcredit to Microfinance and Microfinance Plus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Why Focus on Women? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Defining Women’s Empowerment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . How Can Microfinance Affect Women’s Empowerment: A Theoretical Framework . . . . . . . . . Financial Services and Women’s Empowerment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Insurance and Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nonfinancial Services and Women’s Empowerment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Business Training . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Social Training (Gender) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Technical Training . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impact of Services on Women’s Empowerment and the Role of Husbands . . . . . . . . . . . . . . . . . . . Ethical Criticism on Offering Microfinance Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Future Research Avenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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N. Hansen · M. A. Huis Department of Social Psychology, University of Groningen, Groningen, The Netherlands e-mail: [email protected]; [email protected] R. Lensink (*) Department of Economics, Econometrics, and Finance, University of Groningen, Groningen, The Netherlands Development Economics Group, Wageningen University, Wageningen, The Netherlands e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_4

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Abstract

Empowering women and increasing gender equity is assumed to be crucial in achieving economic growth and improving well-being around the world. Offering women access to microfinance services is one prominent approach to improve the position of women in society and to help them move out of poverty. This chapter provides a short introduction to microfinance services in general and introduces the theoretical explanations how financial and nonfinancial microfinance services may empower women. Furthermore, the chapter summarizes relevant research on the impact of the provision of these services on women’s empowerment. Different insights are presented to illustrate how gendered power between female loan borrowers and their husbands may be influenced by the impact of microfinance services. The chapter concludes with a critical ethical and empirical discussion on the contribution of offering microfinance services to women to empower them and suggest new avenues for future research. Keywords

Microfinance · Women’s Empowerment · Gender Inequity · Male Backlash

Introduction Around the world, women typically have less access to power than men do. For example, globally 330 million women and girls live on less than US$1.90 a day, below the poverty line (4.4 million more than men do). 15 million girls of primaryschool age will never get the chance to learn to read or write in primary school (5 million more than boys), and women earn less than men (global gender pay gap is 23%). Furthermore, 1 in 5 women and girls under the age of 50 reported experiencing physical and/or sexual violence by an intimate partner within a 12-month period (UN Women 2018). Empowering women and increasing gender equity is assumed to be crucial in achieving economic growth and improving well-being around the world (e.g., UN Women 2018). Improvements in women’s rights can stimulate sustainable development as well as economic progress (e.g., Duflo 2012). However, 155 out of the 173 nations still have laws in power which limit women’s economic opportunities (i.e., types of jobs women can hold; husbands’ required permission to have a job or passport; World Bank Group 2015). Gender inequity is especially prevalent in nations with lower incomes. Offering women access to microfinance services may be a promising approach to improve the position of women in society and to help them move out of poverty (e.g., Armendáriz and Morduch 2010). This chapter provides a short introduction to microfinance services in general and describes why and how these programs aim to empower women. Next, we summarize relevant research on the impact of the provision of the different financial and non-financial microfinance services, such as access to small loans, savings, insurance, and training. Finally, the chapter ends with a critical discussion of the ethical criticism and progress of empowering women through microfinance services and suggests future research avenues.

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From Microcredit to Microfinance and Microfinance Plus While modern microfinance has its roots in the informal rotating savings and credit associations (ROSCAs) and nineteenth-century credit cooperatives, most people associate the formal start of the microfinance movement with the founding of the Grameen Bank in Bangladesh by Muhammad Yunus in 1983. Since the first implementation of microfinance, the number of microfinance institutions (MFIs) and microfinance borrowers has exponentially increased (Hermes et al. 2011). Since the launching in 1997 of the Microfinance Summit Campaign, a grassroots organization focusing on microfinance, the amount of microfinance customers globally increased from 13 million to 211 million in 2013, of which more than 80% are women (Lensink and Bulte 2019). Initially, the official microfinance movement relied on two ideas. First, it was assumed that poor people, especially women, remained poor because of a lack of capital. Offering a small loan would have high returns and lead to an increase in wealth as poor people are assumed to possess sufficient business knowledge. Thus, there was a strong emphasis on microcredit. Credit, and nothing but credit, was all that was assumed to be needed. Second, it was argued that poor people should be able to pay high interest rates and consequently that microfinance institutions (MFIs) could be self-sustainable. Moreover, by providing microcredit in the form of joint liability group loans to women, default rates would remain very low. The group lending joint liability strategy requires that an individual can only borrow from an MFI after a group has been formed. It also implies that the entire group is responsible for the repayment of loans of individual group members. By providing group loans to women, it was argued that microfinance institutions could achieve a so-called double bottom line: reducing poverty and remaining self-sufficient at the same time. Traditionally, microfinance thus mainly consisted of group lending to poor women. These loans are characterized as being short term, unsecured, and repeating. In general, the loans have to be repaid at a weekly basis during group meetings. A consequence of the structuring of microfinance repayments as weekly installments is that microfinance loans often are not so attractive for farmers as their incomes, and hence repayment possibilities, very much depend on crop cycles. More importantly, traditional microfinance group lending systems have become less popular. Many MFIs even have stopped using group lending practices and returned to individual lending in line with traditional commercial banking. In addition, MFIs have started to diversify and enlarge the set of financial products they provide. Most importantly, MFIs started to realize that poor people need more financial products than credit. Especially the supply of savings and insurance products could be very important. Consequently, several MFIs nowadays collect savings and provide different forms of insurance products, especially health insurance and life insurance. The change from only microcredit to a more sophisticated bundle of financial products is in the literature referred to as the move from microcredit to microfinance. Traditionally, as stated above, many MFIs assumed that poor people had the necessary entrepreneurial skills and therefore did not consider business training or additional social services to be important. However, practice in most developing

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Credit Savings

Financial services

Insurance

Transfers

Payments Microfinance institutions Social training Social services Personal assistance

Non-financial services

Business training Business services Individual business consulting Technical training Technical assistance

Individual technical assistance

Fig. 1 Microfinance services provided by MFIs

countries is not quite so simple. Many small shop owners do not follow the standard business practices, like formal record keeping and appropriate marketing. Moreover, because of the multidimensional character of poverty, a combination of microfinance and other development services is probably needed to ensure that poor people overcome their poverty (Khandker 2005). MFIs have therefore expanded their portfolio even further by offering nonfinancial services – like business trainings, technical assistance, social trainings (gender trainings), and personal assistance – to their clients as well. This strategy has become known as microfinance plus (Biosca et al. 2014). Figure 1 below summarizes the current set of financial and nonfinancial activities employed by many MFIs (see also Garcia and Lensink 2019, for a survey of microfinance plus). Over the years, the set of microfinance services have therefore evolved. The majority of microfinance clients are still female, based on the assumption that women are more trustworthy clients and invest more in household health, education, and nutrition. Often it is assumed that providing microfinance services mainly to women should increase gender equity (for a discussion, see Armendáriz and Morduch 2010). However, whether women can be empowered through access to

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microfinance services is debated, and studies show mixed results (e.g., for an overview see Duvendack and Mader 2019). The following sections will first discuss why focusing on women may be beneficial for MFIs and the society. Next, we define women’s empowerment and present a theoretical framework about how decisions are made within households and how microfinance may improve the position of women. We then provide an overview of the impact of providing different types of financial microfinance services such as small loans, savings, and also nonfinancial services such as training on women’s empowerment. Finally, we discuss the achievements so far and suggest avenues for future research.

Why Focus on Women? MFIs have always predominantly lent to women, in some cases even exclusively, with average percentages around 80%. Women represent even 85% of the poorest clients of MFIs (ILO 2019). Why do MFIs prefer to target women? An important reason is that research strongly suggests that repayment rates of women clients are higher than that of men. Women are said to be more reliable and risk-averse than men and therefore prefer to invest in safe non-risky projects (e.g., Armendáriz and Morduch 2010). D’Espallier et al. (2011) found strong support for the hypothesis that lending to women is advantageous for MFIs. Using a global sample of MFIs, they showed that lower portfolio risks, fewer write-offs, and lower provisions were related to higher percentages of female clients in MFIs. There are also strong public policy reasons for targeting women. As women, on average, are much poorer than men are, lending to women would reduce worldwide poverty immediately. Moreover, there is evidence that women have other preferences than men and are biased to within-household expenditures, such as children’s health and education. This implies that if women would have more power in the household, household decisions would be more in favor of education and health, two important social development goals. Access to microfinance services may affect bargaining power within families such that household choices would be more in line with preferences of women.

Defining Women’s Empowerment Governments around the world aim to increase gender equity as stated in the fifth sustainable development goal (UN Women 2018). They strive to provide women with equal access to education, healthcare, decent work, and representation in political and economic decision-making processes. This access should empower women, which is a multifaceted process, starting from a state of disempowerment (e.g., Huis et al. 2017; Kabeer 1999). It describes the process through which women develop the ability to influence or take strategic decisions for their life, in contexts where this so far has been denied to them, for themselves, their families, communities, and society (e.g., Kabeer 1999).

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To understand on which dimensions women may experience empowerment, it helps to differentiate between three distinct but related dimensions: personal, relational, and societal empowerment (Huis et al. 2017). Women’s personal empowerment can be observed through individuals’ personal beliefs and actions at the microlevel such as their level of self-esteem and control beliefs. Women’s relational empowerment can be studied through an individuals’ beliefs and actions in relation to relevant others at the meso-level such as women’s say in financial decisionmaking within the household. On the macro-level, women’s so-called societal empowerment can be observed through, for example, their political representation and leadership position in the broader societal context. However, the specific meaning of women’s empowerment at each of these dimensions is context-dependent. What women’s empowerment means in a specific cultural context is highly influenced by both formal and informal regulations, norms, and customs (e.g., Ibrahim and Alkire 2007; Alsop and Heinsohn 2005). Importantly, as will be reflected in the studies discussed in the remainder of this chapter, research so far has studied a variety of very different components of women’s empowerment. Before summarizing the empirical evidence on the impact of microfinance services, we briefly discuss theoretical thinking about microfinance and women’s empowerment.

How Can Microfinance Affect Women’s Empowerment: A Theoretical Framework Traditional neoclassical economic thinking about household decision-making is based on so-called unitary household models in which households are acting as a single unit and maximize a common household objective function (Becker 1981). This neoclassical approach, which is sometimes called the pure investment model, argues that households aim to maximize total household income. Total household income will be affected by the allocation of time and different tasks over the household members, depending on their comparative advantages. However, the distribution of income between household members is completely irrelevant. Therefore, the traditional neoclassical model cannot be used to analyze intra-household conflicts and thus leaves not much room for analyzing impacts of microfinance on women’s empowerment, other than via increasing total household income. Over time economic thinking about household decision-making has evolved, though resulting in different intra-household allocation models. Some of these models are based on cooperative behavior and collective decision-making of household members (e.g., Chiappori 1988, 1992; Manser and Brown 1980). In line with neoclassical thinking, these models assume that partners pool their individual income into a common pot and that allocations are based on Nash bargaining, yielding Pareto efficient outcomes. However, there are also intra-household allocation models that assume inefficient noncooperative bargaining, where household members are noncooperative and advance their own interests. Sometimes, hybrid strategies are followed in which spouses pursue private interests in some domains

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and cooperate in others. An example of such a hybrid strategy is to hide part of one’s income from the spouse (Ashraf 2009; Bulte et al. 2018; Castilla and Walker 2013; Malapit 2012). The different intra-household bargaining models imply that access to microfinance services may affect women’s empowerment in various ways. Microfinance interventions may aim at improving economic empowerment and/or social empowerment of women. Economic empowerment can be achieved by raising women’s income by means of, e.g., providing access to financial instruments (credit, savings, or insurance) or by a business/financial literacy training. These economic empowerment interventions may improve women’s bargaining power if the increase in income changes the appreciation of women. These interventions may also improve women’s bargaining power if they increase post-marriage “outside options.” A traditional intra-household bargaining model would also predict that the increase in outside options realized by the microfinance intervention would reduce violence against women, as husbands do not want to lose their wives (Bueno and Henderson 2017). However, in cultures where divorce is stigmatized, the increase in the outside option induced by access to microfinance services may invite adverse behavior by men, as the threat of divorce will not be credible. Men, for instance, may react by extra violence against their wives, which may increase males’ bargaining power and undo the initial positive effects of access to microfinance services. This can also be explained based on the gendered power model (Pratto and Walker 2004), which argues that power between men and women is distributed on gendered lines, overall men hold more power compared to women on four bases of power. More precisely, men hold more power over resources and can exert more force compared to women, whereas women traditionally have more social obligations and cultural ideologies/ norms that restrict women more than men. Giving women more resources (such as access to microfinance services) may result in more force (such as intimate partner violence) against women by their partners. Some men may exert domestic violence or controlling behavior over their wives (e.g., the loan or their behavior) to regain greater control which results from the breaking of traditional gender roles (for a discussion, see Dutt et al. 2016). Hence, in societies with traditional norms providing microfinance services to economically empower women may be counterproductive as they may lead to a so-called male backlash (Bulte and Lensink 2019; Luke and Munshi 2011). Relational empowerment may be affected by microfinance interventions in the form of a training, which focuses on gender aspects, by education programs that focus on changing gendered power imbalances and traditional gender norms, or by inviting husbands to attend the group and training discussions. These interventions intend to improve bargaining power of women and reduce conflicts within families. However, as can, for example, be explained by the intra-household models that assume inefficient noncooperative bargaining, the increase in bargaining power of women may induce husbands to hide income and lower their contribution to the common pot, possibly reducing the overall welfare effects of the interventions. Moreover, the participation in the training by husbands may improve their information about their wives’ behavior and income-generating activities. This may in turn

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induce income hiding of the wife, with counterproductive effects on social welfare (Bulte et al. 2018). The main insight of the analysis above is that financial and nonfinancial microfinance services may affect women’s empowerment through a variety of channels such as by enhancing income, by influencing bargaining power, by increasing outside options, and by changing traditional gender norms. However, traditional gender norms may be very difficult to change, leading to counteractive behavior of husbands and a so-called male backlash which may undermine the positive effects of the microfinance interventions and even induce more conflicts. This may call for inviting husbands to join the microfinance activities to, for example, discuss and renegotiate traditional gender norms (i.e., ideologies/norms) and household responsibilities (i.e., social obligations). However, the trade-off of allowing men to participate in the microfinance activities may be that women will increasingly hide their income from their husbands. Thus, theoretically it is unclear whether microfinance will empower women and, if so, on which dimensions. Empirical analyses need to provide a better understanding of whether and how microfinance contributes to women’s empowerment. The next section focuses on these empirical studies.

Financial Services and Women’s Empowerment As mentioned above, microfinance programs greatly differ in their offered services (see Fig. 1). Empirical studies report the impacts of these different services, which also differ in the content and length, or combine different services in one program (e.g., savings, micro loan, and training). Furthermore, the study designs differ and include results from nationwide demographic survey data (e.g., Banerjee et al. 2015), randomized control trials (e.g., Huis et al. 2019b), behavioral games (e.g., Bulte et al. 2016), or semi-structured in-depth interviews (e.g., Sanyal 2009). Together, these two main differences make it difficult to systematically compare results. In the following two sections, we have therefore decided to describe relevant studies and discuss – if possible – the underlying theories of change to understand the possible pathways of women’s empowerment. A recent systematic review of reviews (Duvendack and Mader 2019) concludes that the effects of financial services on women’s empowerment are generally positive but heavily depend on program features, context, and empowerment measures.

Credit Microcredit refers to the provision of small loans to poor self-employed people who are excluded from the commercial bank system because they cannot provide traditional collateral. Worldwide, over 211 million clients have received a microcredit. The size of the microcredit varies greatly but commonly does not exceed a few hundred dollars. These microcredit loans generally have to be repaid in weekly to monthly installments over the course of a year. Interest rates usually range between

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10% and 25%. The vast majority of microfinance borrowers is female (Microcredit Summit Campaign 2015). The provision of microcredits to female entrepreneurs is expected to improve the position of women and their families by creating a stable income and thereby breaking the cycle of poverty. Women’s control over financial resources through access to microcredit should result in greater income independence and greater empowerment – more precisely in women’s greater bargaining power within the household (e.g., Guérin et al. 2010; Kulkarni 2011). Several mechanisms can explain how women’s involvement in microcredit programs should result in their empowerment (see also Duvendack and Mader 2019). For example, women’s access to microcredit allows them to create an independent source of income, which could result in increased independence and translate in increased bargaining power (e.g., Mayoux 1999). Moreover, the additional income procured by female microfinance borrowers adds to the household income thereby reducing financial strain. This added financial support of the family could result in greater appreciation within the household and thereby empower female microfinance entrepreneurs (see also Johnson 2016). Interestingly, the type of loan acquired by women may also influence empowerment outcomes. Garikipati et al. (2017) found that women’s obtainment of small loans through informal networks resulted in more bargaining power than their obtainment of planned loans. The authors suggest that procuring loans through informal networks is perceived as socially dishonorable. If women thus undergo the social humiliations of obtaining these loans, they are met with more appreciation and bargaining power within their households. In addition, women’s physical act of acquiring and repaying microcredit loans could increase their mobility and visibility in society – perhaps even more so in group lending programs where women’s groups come together on a regular basis. This could scrutinize potentially disempowering acts of intimate partner violence inflicted by women’s partners and result in greater empowerment. According to this reasoning, financially including women, through access to microloans or savings, will allow them to provide for their family and increase their bargaining position. This positive relation between offering women access to microcredit and women’s empowerment has been shown empirically (e.g., Chliova et al. 2015; Pitt et al. 2006; Swain and Wallentin 2009). For example, Kato and Kratzer (2013) showed that female microfinance borrowers in Tanzania report greater empowerment on an array of personal empowerment indicators (e.g., self-esteem, self-efficacy) and relational empowerment indicators (e.g., mobility, household decision-making) compared to a control group of nonmembers. Other research examining the relationship between women’s access to microcredit and the development of women’s empowerment has also reported strengthened empowerment findings. Specifically, previous research shows that women reported higher levels of personal empowerment (i.e., self-esteem, personal agency; e.g., Basargekar 2009; Morgan and Coombes 2013) and relational empowerment (i.e., bargaining power; social group membership; e.g., Pitt et al. 2006; Hansen 2015). However, the link between women’s access to microfinance services, especially in the form of microcredit, and women’s empowerment has been heavily debated

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over the last decades (e.g., Agier and Szafarz 2010; Garikipati et al. 2016). For example, Banerjee et al. (2015) conducted a large-scale randomized control trial to examine the impact of a group lending microcredit program on women’s household decision-making in India. Results indicated that women who had participated in a microloan program did not show an increase in women’s empowerment assessed with intra-household decision-making power compared to a comparison group of women without access to the program (for other RCTs showing no empowerment impacts, see Crépon et al. 2015; Tarozzi et al. 2015). More critically, several mechanisms can explain how women’s involvement in microcredit programs can result in their disempowerment (see also Vaessen et al. 2014). For example, targeting women in financial microfinance services may merely shift the burden of financial responsibilities within the household onto women. First, putting the responsibility to take out and repay microloans on women may absolve men of their household responsibilities. Second, if men do control loans given to women, this can inhibit the potential empowering impact of women’s access to microfinance services. Third, women may procure microloans and become responsible for repayment without having control of the expenditures on which the loans are spent (e.g., Garikipati 2008). This may affect women’s ability to repay the loan and might even compel them to borrow from other sources to repay their microcredit loan (e.g., Kabeer 2001; Mayoux 2002). Issues around the repayment of microloans may even result in weakened women’s position in the household, and access to microcredit may result in an increased (risk of) intimate partner violence (e.g., Ahmed 2005; Goetz and Sen Gupta 1996; Rahman 1999). First, women may be subjected to marital conflict when their husbands force them to hand over their microcredits. Second, women’s acquisition of microcredit could imbalance the existing gendered power relations within the household (see Pratto and Walker 2004). As men may use one base of power to regain power in another, this could explain the increased (risk of) intimate partner violence when women take out microcredit. Rahman (1999) qualitatively examined the implications of a microcredit lending program in Bangladesh and showed that most female microfinance borrowers reported increased violence and aggressive behavior within the household and in the village because of their involvement with the bank. In conclusion, previous research shows mixed results on the relationship between offering women access to microcredit and women’s empowerment (for a survey of the literature, see Armendáriz and Morduch 2010). Importantly, one meta-analysis showed no reliable evidence for impacts of microcredits on women’s control over household resources (Vaessen et al. 2014).

Savings Only approximately 10 percent of the people living below the poverty line in developing countries save in formal saving institutions (Banerjee and Duflo 2011). Some MFIs offer saving programs, commonly in conjunction with microcredit loans. Microfinance borrowers may deposit surplus capital in MFIs as insurance

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against unforeseen life events and economic setbacks, to save for longer-term goals, to safeguard for uneven income (i.e., in farming), or to save for future investments. Micro-savings should give women the chance to save without interference from their family and herein create safe avenues for women to work toward their future saving goals. Importantly, MFIs differ in the types of micro-saving facilities offered, for example, in the extent to which women can or cannot withdraw from their saving account at any time during the loan cycle. Only a few papers provide evidence of the impact of micro-savings on women’s empowerment. Anderson and Baland (2002) provide a very interesting explanation why especially women participate in (informal) savings groups. By using information from informal savings groups in the slum of Kibera in Kenya, they show that women participate in informal savings groups (similar to microfinance groups) in order to protect savings from their husbands who would otherwise had used the money for consumption purposes. Moreover, after women received the savings pot, their husbands appeared to be willing to agree with her plans to spend the accumulated savings, even if the husband did not agree with her plans ex ante. Anderson and Baland (2002) argue that participating in savings group therefore improve women’s welfare. Ashraf et al. (2010) examined whether access to a “commitment” savings account improved female empowerment. They designed a savings product called SEED (Save, Earn, Enjoy, Deposits) with a microbank in the Philippines, the Green Bank of Caraga. Potential savers were not allowed to withdraw any of their savings before they had reached a certain goal (hence the name commitments savings account). The study showed that access to the commitment savings account improved female bargaining power, especially for women with below median bargaining power before the intervention. Importantly, this study showed that some husbands opposed their wives’ participation in the saving program to keep control over their funds. A systematic review examining saving promotion interventions in sub-Saharan Africa (Steinert et al. 2018) provide evidence that these saving programs may not be best suited for female entrepreneurs precisely because women traditionally hold less intra-household bargaining power. Another interesting study has been done by Karlan et al. (2017). They examined in a randomized controlled trial the impact of so-called savings-led microfinance programs in Ghana, Malawi, and Uganda, which promote and develop (informal) Village Savings and Loan Association (VSLA). These VSLA programs share three components: (1) a group-based savings requirement, (2) the possibility for members to request a loan from the group, and (3) an emergency fund financed by the members, which can be accessed in times of emergencies. Interestingly, in contrast to the rather disappointing effects of the RCTs focusing on microcredit (not finding strong positive impacts on women’s empowerment), this study showed that the savings programs in the three countries improved women’s empowerment (measured by a women’s empowerment index containing self-reported evidence on decision power regarding household decisions, in relation to food expenses, education, and healthcare; Karlan et al. 2017). To conclude, offering women access to saving opportunities in general seems to positively impact women’s financial situation and thereby empowerment. Thus,

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access to (micro) savings seems to have a more positive impact on female empowerment than access to microcredit. Yet, due to the limited empirical evidence, these first positive findings should be considered with caution (see also Duvendack and Mader 2019).

Insurance and Transfers Nowadays MFIs offer additional financial services to the provision of microcredit and saving products. This broader array of products set out to financially include the poor has been growing over the last years – when the initial optimism regarding microcredit as a panacea settled down. Two commonly offered financial products are micro-insurance and micro-transfers. Micro-insurance refers to the insurance of low-income people offering modest benefits but also modest premia. Microinsurance products allow microfinance entrepreneurs to insure against different types of risks, for example, related to their health (e.g., illness, pregnancy complications) but also extreme weather (i.e., drought, insects). Microfinance entrepreneurs are generally not covered by social security and as such are exposed to various risks. For example, one common income-generating activity in which female microfinance entrepreneurs are involved in is agricultural production. As such, women are typically responsible for their family’s food security, which may be at risk from drought, from death of livestock, from personal accidents, etc. Micro-insurances may be a solution for female entrepreneurs who lack the resources to protect themselves against risks associated with agricultural production. Interestingly, previous research suggests that risk aversion – which is more characteristic of women than men – is an important predictor for insurance demand (e.g., Hill et al. 2013). Thus, female entrepreneurs may be more inclined to take out insurance. This insurance may next cover financial blows and thereby contributes to profitable businessman ship. As suggested above, women’s financial contributions to the household income may next strengthen their position within the household. Micro-transfers refer to the recurring transfers of small amounts of money that accumulate to larger funds. These micro-transfers can be used to automatically repay microcredit loans to MFIs. As such, transfers can mitigate women of the responsibility to actively and frequently repay loans – and hence the need to reserve money for repayment. In turn, women may be able to make more long-term high-return rather than short-term low-return investments, as they do not need to keep cash aside for the frequent repayments. Additionally, if women no longer need to keep cash aside for repayment of the loans, this may reduce their responsibility to repaying loans over which they may not have control within their households. Interestingly, regular cash transfer programs – providing stipends or vouchers to the poor in return for targeted behavior (e.g., enrolling their children in school) – show first possible empowerment effects. For example, a recent field study in Panama examined the impact of autonomy (i.e., cash transfers) or dependencyoriented help (i.e., vouchers) in the context of a conditional cash transfer program and showed that women report stronger empowerment and autonomy if they

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received cash transfers compared to women who received access to vouchers (Alvarez et al. 2018). The authors reason that receiving cash rather than vouchers may signal to women that they are deemed capable of making important decisions independently, which in turn could empower women. As such, the provision of cash transfers in the context of microfinance services may contribute to women’s sense of autonomy and empowerment while reducing their responsibility over loan repayments that may be out of their control. In conclusion, the majority of studies focused on the impact of being a MFI client. To date we know very little about the unique impact of each separate financial microfinance services on women’s empowerment. Conceivably, offering women access to financial microfinance services alone may not be enough to overcome patriarchal systems of control at the household and community levels (e.g., for an overview, see Duvendack and Mader 2019: Huis et al. 2019a).

Nonfinancial Services and Women’s Empowerment As mentioned above, nonfinancial services include social, business, and technical training. This section summarizes research on the different types of training.

Business Training Many MFIs provide different types of business training ranging from basic financial literacy training to bookkeeping and more advanced skills in business development to help clients to manage their income-generating activities. These trainings can greatly differ, for example, with respect to their content but also their length. Multi-study papers and meta-analyses have systematically tested the impact of business training on business outcomes (e.g., Bulte et al. 2017). While some research has provided evidence on the positive impacts of training on business outcomes in low-income countries (for reviews, see Frese et al. 2016), other research reports only small or no impacts (e.g., McKenzie and Woodruff 2014). Interesting to note, even though these studies did not explicitly focus on impact of training on women’s empowerment, three studies provide evidence that a business training improves business outcomes for male entrepreneurs, but not for female entrepreneurs (Berge et al. 2015; De Mel et al. 2009; Giné and Mansuri 2014). Men seem to be able to profit from the training content and develop improved business skills, whereas women may be constraint. One study provided evidence for some positive impacts of training. This study compared female MFI clients living below the poverty line who had participated in the microfinance program for a period of 12–18 months in the north of Sri Lanka with a matched comparison group (no access to the program, Hansen 2015). They had participated in savings group and different business training, and the majority had qualified to receive a microcredit. Women in this program showed stronger control beliefs to influence strategic life decisions and reported larger social

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networks compared to the comparison group. Interestingly, women who received training showed stronger effects than women who did not, illustrating the importance of training to capacitate women. This study suggests that women develop a stronger capacity for action. However, it did not test the impact of bargaining power. To conclude, the majority of studies testing the impact of business training on women’s empowerment seem to suggest that women do not profit from the training to the same extend as men or they might not be able to put their new knowledge into practice. It remains open why this is the case. Some scholars have suggested that business training for female entrepreneurs should be focused on the specific needs and barriers, which women may face when managing their income-generating activities (e.g., Berge et al. 2015; Huis et al. 2019a, b).

Social Training (Gender) Next to business training, some MFIs have started developing trainings, which focus more on the specific role of female entrepreneurs. The goal of these types of trainings is to make women aware of their role and encourage them to take business-related decision, which may have previously been denied to them. To the best of our knowledge, only a few studies have started to systematically investigate the impact of it. One training which addresses the specific role of female entrepreneurs is the Gender and Entrepreneurship Together Ahead (GET Ahead) training. This training was developed by the International Labour Organization and has been implemented in over 17 countries. This gender and business training aims to stimulate women’s entrepreneurial skills including basic business and human management skills by focusing on the specific role of women (i.e., gender roles: 9 training sessions, 32 exercises, Bauer et al. 2004). A recent randomized control trial showed that female loan borrowers who were invited to the GET Ahead training showed an increase in women’s personal (e.g., personal control beliefs) and relational (e.g., stronger financial intra-household decision-making power) empowerment compared to a control group of borrowers who did not receive training in Vietnam (Huis et al. 2019b). Importantly, the observed changes in women’s empowerment were driven by an increase in women’s awareness of gender roles and responsibilities and not business knowledge. In other words, this is the first evidence that shows that engaging women in a training, which focuses on the gendered power imbalances and traditional gender roles in addition to business skills and makes them aware of this, can increase women’s empowerment, such as increase in personal control beliefs to make strategic life decisions and engage in intra-household decisionmaking. However, contrary to these hopeful results, Bulte and Lensink (2019) showed that female borrowers who participated in a GET Ahead training in Vietnam, while indeed experiencing improved bargaining power, also indicated to experience more intimate partner violence (as measured with a so-called list experiment, guarantying the anonymity of individual respondents) compared to female borrowers who were not invited to the training. They argue that in countries where

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divorce is stigmatized (as is the case in Vietnam), improving women’s outside options, e.g., by giving them access to a business training, may lead to a male backlash and lead to more intra-family violence. Another study conducted among female loan borrowers and their husbands in Sri Lanka tested the impact of husbands ‘participation in a training session on women’s empowerment (Huis et al. 2019a). Couples were invited to one training exercise from the GET Ahead training on setting business goals, and their interaction was videotaped in a subsequent task. Even though not significant, women showed some initial evidence of increased women’s empowerment in the interaction (e.g., first say). The authors discussed how gendered power imbalances might need to be addressed to stimulate social change toward gender equity. In conclusion, this first evidence suggests that nonfinancial services which focus on the specific role of female entrepreneurs and the barriers of gendered power imbalances and traditional gender roles in addition to pure business training are a promising avenue for the development of effective trainings for female microfinance clients. Yet, nonfinancial services may have opposite effects on different dimensions of female empowerment such as a business and gender training may improve economic independence and bargaining power of women but at the same time may increase intimate partner violence due to a male backlash.

Technical Training Technical trainings focus mainly on vocational training. Participants can learn how to cultivate new crops or to increase productivity. For example, Bandiera et al. (2012) found that a combined life skills and vocational training diminished engagement of adolescent girls and young women in sexual risky behavior and increased participation in income-generating activities. Adoho et al. (2014) found that the Economic Empowerment of Adolescent Girls and Young Women (EPAG) project in Liberia increased employment, empowerment, and earnings of adolescent girls. At this point, we can only speculate through which channels access to these trainings can empower women. Important to note, technical trainings are often part of larger programs. There is little evidence regarding the unique impact of these types of trainings on women’s empowerment.

Impact of Services on Women’s Empowerment and the Role of Husbands Are microfinance services the “magic bullet” to empower female entrepreneurs as the founders have assumed? It seems fair to conclude that this may not be the case. In line with previous research (e.g., Duvendack and Mader 2019), we reach a more nuanced conclusion. Based on the diversity of programs and methods used to investigate the impacts, it is impossible to draw clear conclusions. The literature on the impact of business trainings (and microfinance in general) is starting to

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mature, and one key feature seems to be that gender is important, as it is seemingly harder to move female entrepreneurs than male ones (Berge et al. 2015; De Mel et al. 2008; Holloway et al. 2017). Generally, the impact of financial microfinance services on women’s empowerment is positive. However, these effects are mixed and seem to be dependent on program features which are often unrelated to the financial service itself (such as awareness raising about women’s rights), the cultural context, and what aspects of empowerment are addressed or assessed (Duvendack and Mader 2019). Power barriers and prescribed gender roles may strongly inhibit women’s abilities in general (e.g., Connell 1987). However, recent meta-analyses and review studies suggest that addressing gendered power imbalances and traditional gender roles in addition to microfinance services may help to strengthen the position of women (for a broader discussion, see Duvendack and Mader 2019). As such, microfinance institutions may need to consider women’s human capital and gender relations if access to microfinance should strengthen women’s empowerment (e.g., Kabeer 1999; Kulkarni 2011).

Ethical Criticism on Offering Microfinance Services The debate on ethical criticism about offering microfinance services to the poor in general started when it was discovered that some MFIs were making profits from poor borrowers’ having to pay usurious interest rates. Furthermore, other MFIs have been accused of using exploitative lending techniques such as using forceful loan recovery practices. Some critics even questioned the ability of microfinances services to reduce poverty (for an overview, see Hudon and Sandberg 2013). These three points of ethical criticism apply to all poor borrowers and are still debated in the literature. In addition, there are ethical concerns about the trend toward commercialization, which seems to be detrimental to the social aims of most MFIs. It is argued that commercialization may lead to a mission drift and induce MFIs to shift from nonprofit to for-profit lending. Commercialization and the related shift from nonprofit to for-profit lending have raised concerns with respect to the amount of borrowers, as well as the types of borrowers, that are served by MFIs. A direct consequence of commercialization may be that MFIs start to focus less on poor clients, reducing the “outreach” of microfinance. This discussion relates closely to an ongoing discussion in the literature about the possible trade-off between financial sustainability and outreach or in other words the possible trade-off between economic aims and social efficiency of MFIs. In a special issue of World Development edited by Hermes and Lensink (2011), several papers on this potential trade-off are presented. Several papers provide evidence for a negative relationship between social efficiency and financial sustainability. Yet, there also appears that suggest otherwise (see, e.g., Gutierrez-Goiria et al. (2017)) who suggest that better social efficiency and better economic performance can be positively related.

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The discussion about the trade-off between social and economic aims, as well as the related discussion on the advantages and disadvantages of commercialization of microfinance, also relates to the position of women. While it is not unambiguously clear to what extent the commercialization has negatively affected women’s empowerment, the evidence strongly suggests that the percentage of female borrowers served by MFIs decreases if MFIs start to commercialize (see, e.g., Armendáriz and Morduch (2010), Chap. 7). With respect to female borrowers, there is one major additional ethical concern, which questions the assumption of empowering especially women. As discussed above, the underlying assumption is to offer women access to microfinance services, which should help them to set up their income-generating activities and by this strengthen their position and move out of poverty. However, the literature overview in this chapter also shows that female borrowers often face controlling behavior by their spouses or even intimate partner violence. The following section offers ideas for future research avenues, which aim to overcome these negative side effects.

Future Research Avenues The majority of microfinance borrowers live in low-income countries. People living in these nations are strongly embedded in social networks such as families and communities. Power barriers and prescribed gender roles often inhibit women’s abilities to develop stronger feelings of empowerment (e.g., Connell 1987; Pratto and Walker 2004). However, some men felt excluded from microfinance programs because most borrowers are women, and some women even faced intimate partner violence (e.g., Rahman 1999). Some men may exert domestic violence or controlling behavior over their wives (e.g., the loan or their behavior) to regain greater control that stems from the breaking of traditional gender roles (for a discussion, see Dutt et al. 2016; see discussion on “male backlash” above). To understand how female entrepreneurs could profit more from microfinance services, programs need to take the cultural context of gender norms into account, with respect to their close relationships and their broader role in society. Future research should further investigate two promising directions to change traditional gender norms. First, one way is to address this issue in programs, and other avenues could be to (partially) involve husbands as well. To change existing gendered power imbalances, for example, in intra-household decision-making, it requires the involvement of women who need to renegotiate the responsibilities and men who need to be involved and willing to change existing pattern. Second, as discussed in the beginning of this chapter, the underlying assumption of microfinance service is that women’s engagement in the financial market should stimulate women’s personal growth. However, individual growth and increases in bargaining power may not be the only pathway toward women’s empowerment. One study conducted among Maasai women in Tanzania showed that women who were members of cooperatively owned business groups showed stronger women empowerment compared to women who owned businesses independently via microcredit

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loans and women who did not own businesses (Dutt et al. 2016). Interestingly, participation in cooperatives versus independent or nonbusiness ownership was associated with fewer experiences of intimate partner violence and enhanced psychological well-being via the effects of less partner control, stronger agency, and stronger financial decision-making power. Thus, in interdependent cultures, such as in all low-income countries, interventions focused on women’s cooperation rather than individual growth may offer more promising pathways to empowerment.

Conclusions Microfinance services have been assumed an efficient way to empower the poor and reduce poverty around the world, especially for women. However, results are less optimistic. This chapter provided an overview of previous research and discussed the underlying mechanism of women’s empowerment, if empirical evidence is available, and discusses its ethical concerns. Based on this review, future research should focus on the constraints, which may hinder especially women. Programs in addition to microfinance services should address gendered power imbalances and traditional gender roles. Changing the traditional gender norms seems to be a promising avenue to strengthen the position of women and in turn stimulate sustainable development for all.

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Socially Responsible Investors Exploring Motivations and Ethical Intensity Silvana Signori

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Defining Socially Responsible Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Screening . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Engagement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Community Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impact Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Business Case for SRI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trade-Off Between “Ethics” and “Profit” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Motivations for Socially Responsible Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cross-References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Differences in investor motivations have been largely neglected as a topic in the literature on socially responsible investment. Most research studies consider all investors as a homogeneous group. This chapter aims to contribute to the strand of literature that focuses on dissimilarities. Particular attention is given to motivations that drive individual investors toward socially responsible investment. Motivations, in fact, may influence the financial instruments chosen, the strategy adopted, the amount of money invested, and the level and direction of the tradeoff between the two main sources of utility for ethical investors, which are ethics and profit. S. Signori (*) Department of Management, Economics and Quantitative Methods, University of Bergamo, Bergamo, Italy e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_5

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Furthermore, the concept of “ethical intensity” is introduced to achieve a better understanding of investors’ willingness and effective choice with regard to the ethical investment process. The suggested components of “ethical intensity” are (a) “proximity,” that is, the closeness of an investment’s ethical criteria to an investor’s ethical set of values or moral justification; (b) “social efficacy,” such as the perceived ability to encourage social change; (c) “centrality,” that is, the “position” of the investor in the process; and (d) the temporal immediacy (“urgency”). Keywords

Socially responsible investment · Ethical investment · SRI · Motivations · Efficacy · Trade-off · Ethical intensity

Introduction The financial sector plays a fundamental role in most modern economies. The functioning and the structure of the economy depend strongly on how the financial system works and how it is organized. It is, therefore, not surprising that policy makers, like the European Union, identify the critical role of investors in supporting the transition toward more sustainable economic systems (see, e.g., the establishment of the EU High-Level Expert Group on Sustainable Finance and the foreword of the 2018 European SRI Report – EUROSIF 2018). At the same time, as also confirmed by the growing volume of socially responsible investments (SRI) in Europe and the USA (EUROSIF 2018; USSIF 2018), investors are becoming more and more aware of their role, and initiatives in which they combine ethical, social, and sustainability-related principles with more traditional investment selection criteria (return, risk, liquidity, etc.) have become increasingly common. As expected, the “phenomena” of socially responsible investment have also attracted the interest of many academics belonging to a variety of disciplines. One of the most widely investigated aspects of SRI is the financial performance, that is, whether taking ethical or social considerations into account results in better or worse returns on investment. Indeed, based upon modern portfolio theories, a number of research studies have shown that including restrictions (like avoidance criteria based on ethical commitment) could lead to suboptimal portfolio with consequences in terms of expected return or risk. Conversely, other studies show that a more careful selection of stocks to be included in a portfolio reduces the risks and that the investment universe remaining after an ethical screening is still likely to be sufficient to permit a well-diversified portfolio. This is a point still under debate in the literature. The most probable outcome is that SRI does not necessarily imply a sacrifice for investors nor that this sacrifice is likely to be so great.

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However, the motivations that steer investors toward these kinds of financial choices still remain under-investigated. The questions that until now seem to have been scantily debated are why individual investors choose to make (or not to make) such investments and what they are looking for. For that reason, the aim of this chapter is to argue that while researchers, scholars, and academics are constantly monitoring the financial performance of such investments, what motivates ethical investors could or should not (or not always) be the expectation of a return similar to more traditional investments, but rather (or also) the ability to use their money to fulfil ethical requirements. In fact, the reasons driving investors’ ethical choices may shape the type of investment they chose and their willingness toward profit renunciation. In this chapter, a possible link between the different aspects is proposed. Furthermore, the idea is advanced that the willingness to invest and the subsequent choices (in terms of amount invested, specific product, trade-off, etc.) also depend on (a) the closeness of the ethical criteria adopted by SRI to the investor’s moral justification (“proximity”), (b) the perceived ability to encourage social change (“social efficacy”), (c) the position/importance of the investor in the process of financing (“centrality”), and (d) the temporal immediacy (“urgency”). We suggest that all these components should be included in a broad concept of “ethical intensity.” In the following pages, the basics of SRI will be introduced as a short description of what is meant by ethical investors and the behaviors characterizing them. Then, the chapter will focus on the various reasons that drive investors to make this specific choice and how these reasons could shape the trade-off between ethics and profit. Finally, the concept of ethical intensity will be advanced and some conclusions proposed.

Defining Socially Responsible Investment According to Cowton’s definition, “ethical investment can be described, in broad terms, as a set of approaches which include social or ethical goals or constraints in addition to more conventional financial criteria in decisions over whether to acquire, hold or dispose of a particular asset [. . .]” (Cowton 2004: 249). There are various names indicating investments made with “ethical,” “social,” “environmental,” or, more recently, “sustainability” criteria: ethical investments, socially responsible investments (thus the acronym SRI), sustainable investments, alternative investments, environmentally sustainable investments, “ecological” investments, green investments, and so on (Revelli and Viviani 2015). Although some authors have highlighted slight differences in the terminology (see, e.g., Cowton 1999; Viganò 2001; Burke 2002; Sparkes and Cowton 2004; Kurtz 2005), in this chapter, the terms “ethical investments” and “socially

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responsible investments (SRI)” will be used interchangeably, with their distinguishing characteristics, leaving aside all judgments regarding their effective ethical nature and the comparison with more traditional investments. Ethical investors traditionally adopt three different strategies for introducing their values into investment choices which are often combined together: • Screening • Engagement (mainly through shareholder activism) • Community investing More recently, a new way of financing has arisen, that is, impact investing. The forms of investment may be various: the term SRI usually refers to investment in stocks or bonds of listed companies or countries, while community investing (and sometimes also impact investing) usually refers to other equities or lending activities. Where not explicitly specified, this chapter refers to investments in stocks or bonds of listed companies.

Investment Strategies Screening The practice of excluding or including companies in portfolios based on environmental, social, or government (ESG) criteria is widespread all over the world (EUROSIF 2018; USSIF 2018). More specifically, the most common and basic approach used by investors is the avoidance strategy, that is, the application of negative screenings to exclude specific companies, sectors, products, or practices that are deemed to be morally unacceptable or problematic (Schueth 2003; Michelson et al. 2004; Renneboog et al. 2008a; Cowton and Sandberg 2012). Together with the more traditional and religion-linked “sin stocks” (Miller 1991) – such as alcohol, tobacco, and gambling, new principles more closely connected with corporate social responsibility or sustainability concepts and practices have been developed. The most frequent negative social screens used by ethical investors are controversial weapons (like antipersonnel mines), arms and military contracting, tobacco, pornography, nuclear energy, gambling, violations of fundamental human rights and ILO conventions, child labor, GMO, alcohol, products harmful to human health/environment, excessive environmental impact and consumption of natural resources, oppressive regimes, animal testing, furs, and factory farming. It is important to emphasize that the above sectors are, in general, all legal (some exceptions may be due to particular religions such as the production and consumption of alcohol in Islamic countries). The decision to exclude them is not linked to a nonconformity to a law, but to a pre-established ethical or moral order. Indeed, these sectors are not unequivocally “good” or “bad,” but such judgment depends on the usage of these products or sectors, the contexts in which the companies operate, and

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so on (Cowton and Sandberg (2012) offer an interesting discussion on the ethics of SRI and on the different ways to implement avoidance screening). Quite often avoidance is only a first step in a portfolio construction. Together with negative criteria, or as an alternative strategy, investors adopt a supportive strategy. In this case, ESG or ethical considerations are employed to identify particular companies, sectors, practices, or activities that are considered especially worthy of investment, being “socially or environmentally helpful” (e.g., organic agriculture, green energy, low-carbon management practices, gender equality, etc.). A growing number of complete and complex methods of analysis on the different aspects of the whole company and its management have been progressively asserted, in order to consider corporate social responsibility (or sustainability) as a holistic way of being a “responsible” company (Schueth 2003; Michelson et al. 2004). The set of values on which the supportive or inclusion strategy is based could be self-defined by the investor, or it could refer to compliance with international standards and norms (like UN Global Compact, OECD Guidelines for MNCs, or ILO Conventions). The latter case is known as “norms-based screening.” Furthermore, a new trend in the market is the (positive) selection of assets that are related to specific themes of sustainability. These kinds of investments are called single- or multi-themed investments (e.g., such as water funds and low-carbon funds). In this case, commitment to these specific themes is explicit and more defined.

Engagement In the USA and the UK in particular, but in recent years also in other countries in which SRI is becoming increasingly important, the screening process is often supported by practices of engagement. If the ethical screening aims to “punish” or “reward” some practices, the objective of engagement is to modify a specific behavior in accordance with socially responsible principles. Investors can act in different ways: by preparing and passing resolutions, by voting on shareholder proposals, and/or by entering into dialogue with companies (Carleton et al. 1998; Graves et al. 2001; O’Rourke 2003; Lydenberg 2007; Vandekerckhove et al. 2008; Rojas et al. 2009, Logsdon and Van Buren 2009; Rehbein et al. 2013, Ferraro and Beunza 2014; Goranova and Ryan 2014). Depending on the intensity and type of action, we may call it “soft” or “hard” engagement (Solomon et al. 2004). The reason encouraging investors to move toward such activities, therefore, is mainly linked to the possibility of using the voting rights attached to ordinary shares to assert social, ethical, or environmental objectives and to interact with companies whose social or environmental performances do not meet investors’ expectations. Besides the different aspects of socio-environmental policies, shareholders also seem to be very active on questions linked to corporate governance. Quite frequently, the practice of engagement is combined with screening selection (Scholtens 2006; Renneboog et al. 2008a). The target companies have already been

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selected, and, therefore, the engagement aims to improve specific virtuous behavior. Conversely, shareholder activism could be an effective way for advocacy groups to stop or put pressure on companies involved in “questionable” practices to radically change their “wrong” or “unfair” behavior.

Community Investing Community investing is the third way in which ethical investors can operate. This practice consists of “financing that generates resources and opportunities for economically disadvantaged people in urban or rural communities [. . .] under-served by conventional financial institutions” (Social Investment Forum 2001: 20). The name “community investing” is mainly used in Anglo-Saxon countries, whereas in other countries, financial actions aimed at supporting economic development are referred to and defined by terms such as “credit policy” or “cause-related investments.” Cowton (2002: 397) suggests the term “affinity,” because “in various fields it stands for relationship by choice, a mutual attraction or resemblance and hence it seems ideally suited to the coming together of like-minded parties around a particular value-based product offering” (on this point see also San Jose et al. 2011; Cowton 2010). Similarly, in Francophone countries, the term “proximité” is used (with both a geographic, spiritual, and cultural meaning). This practice, mainly consisting in lending, could be considered ethical in its ability to reach sectors, people, countries, or geographical areas under-served by the more traditional financial instruments and the consequent enlargement (and in some cases the completion) of financial markets (Viganò 2001). Experiences in this sector are quite numerous and varied, even if they are all generally characterized not only by the possible support in accessing credit services for activities or for people who would otherwise be excluded or penalized but also by the particular attention to the socioeconomic impact the investment has or can have on the whole community, thus extending the benefits beyond the financed project. In this category, we can consider most of the major investment experiences in the so-called third sector (or nonprofit sector), as well as microcredit and microfinance projects in underdeveloped countries or in other contexts of socioeconomic marginality.

Impact Investing As stated in the recent 2018 EUROSIF SRI Report, a fair share of “first-time” investors are now finding impact investing their natural match. Impact investing refers to investments made with the intention to generate positive, measurable social, and/or environmental impact alongside a financial return (for further information see, e.g., the Global Impact Investment Network website www.thegiin.org). The combination of a positive social/environmental impact together with commitment to a return represents the key feature of this investment approach. The key requirements

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of impact investing are (a) intentionality, that is, the intention to generate a positive and measurable social/environmental impact; (b) additionality, that is, to be able to realize a positive impact beyond the provision of private capital; and (c) measurement of the financial, social, and environmental performance (EUROSIF 2018).

The Business Case for SRI One of the aspects that has most interested academics and scholars, mainly in recent years, has been the economic and financial sustainability of SRI. Hundreds of research studies, often empirical, have been dedicated to the analysis of the existence and the direction of the correlation between financial performance and corporate social responsibility, in general, and ethical investment, in particular (see, e.g., Pava and Krausz 1996; Tasch and Dunn 2001; Burke 2002; Signori 2006; Margolis et al. 2007; Belghitar et al. 2014; Revelli and Viviani 2015). In fact, following the modern portfolio theory (Markowitz 1952), it would be expected that the adoption of screening criteria would restrict the investment universe with a consequent lower risk-adjusted financial return. Indeed, through the selection and exclusion constraints criteria, SRI reduces investment opportunities and, as a consequence, the ability to diversify the portfolio. Portfolio managers, therefore, have a smaller universe of stocks in which they can invest, and this may result in poorer performance by shifting down the efficient frontier. In other words, as Cowton and Sandberg (2012: 149) emphasize: “As a general rule, it is more difficult to achieve a particular goal when other goals – whether in the form of actual goals or constraints – enter the equation. Put simply, social investors cannot do all that mainstream investors can do, but a mainstream investor can always construct the same portfolio as a social investor if it appears financially rewarding to do so. Thus, some form of financial sacrifice as a result of SRI seems likely.” Supporting this line of reasoning, Fabozzi et al. (2008) and Hong and Kacperczyk (2009) find that “sin” companies – like those dealing in weapons, tobacco, alcohol, or gambling – tend to perform better than “non-sin” and, therefore, not investing in these sectors implies missing an opportunity. Furthermore, the complexity of the selection process leads to additional costs absent in conventional investment (Boatright 1999). These costs can be divided into two main parts (Revelli and Viviani 2015): (1) the costs for selecting the stocks that could belong to the SRI universe (“universe selection cost”) and (2) the cost of active management. In fact, if SRI portfolios are relatively small, their management could generate comparatively higher information and transaction costs and managerial fees (Bauer et al. 2005; Tippet and Leung 2001). However, some authors note that these “costs” can explain only transitory deviations between SRI and conventional investing: Bauer et al. (2005), for example, advance the idea of a “learning effect” for which SRI would tend to underperform in the short term, with a reduction in this gap in the medium term to then outperform in the long term.

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Conversely, empirical research shows that SRI funds may perform even better (or at least not worse) than conventional investments (see, for instance, Bauer et al. 2005; Kempf and Osthoff 2007). This could happen for different reasons, such as the possible better financial performance of “responsible companies”; the better and deeper knowledge of the companies they invest in (the so-called information effect (see Moskowitz 1972 and 1997)); and the counteractive practices, like “best-inclass” selection, that the investor adopts to contrast any downward pressure caused by lack of diversification (Berry and Yeung 2013). Furthermore, complete diversification is no longer the best strategy in the presence of the investors’ asymmetric information. As Revelli and Viviani (2015: 161) suggest, citing Merton (1987), “in the presence of incomplete information, a perfectly diversified market portfolio is no longer efficient and the expected returns on assets with concentrated information increases compared with the returns on assets that benefit from more information. That is, if information on SR assets is concentrated within SR investors, who only hold SR assets, they can obtain higher returns, even if they appear under-diversified.” On a similar point, Laurel-Fois (2018) examines the motivations underlying the conflicting results in support of or against SRI and produces evidence on the presence of a curvilinear relationship between screening intensity and two measures of risks. In particular, she shows that whereas limiting the investable universe increases the risk specific to the portfolio, very high screening intensity can reduce this risk, for the very reason that fund managers have more information and, therefore, will select less risky firms. Furthermore, the variety of results obtained in empirical studies is also due to the heterogeneity of SRI practices and of methodologies used to measure their effects. In any case, in the same way as these opposing pieces of evidence, a number of studies reach the conclusion that SRI performance is not significantly different from that of other types of investments (Kreander et al. 2005; Bauer et al. 2007; Galema et al. 2008; Renneboog et al. 2008b). It seems that managers, particularly in large stock markets, are able to construct a portfolio with the desired investment style attributes (Humphrey et al. 2016). Therefore, it is reasonable to share the opinion of Cowton (2018: 297) that “even if there is, at least sometimes, an impact on performance, it tends to be much less than was apparently supposed by early SRI sceptics.” Despite the attention dedicated to this field, some academics have already highlighted the need to extend the evaluation beyond strictly economic considerations. Since 1971, Malkiel and Quandt have interpreted socially responsible investing as an application of the old issues of externalities. They suggest that portfolio managers should consider the social, political, and moral effects of a company’s activities when making investment decisions: this is so because of a growing awareness of the effects of corporate activity upon society and a corresponding increase in demands by pressure groups for corporate compliance with certain social standards. To the formerly objective task of fund managers to maximize financial return, subject only to risk, a third dimension has been added, that is, the social, ethical, and moral concerns of the community (Tippet and Leung 2001: 45). Tippet and Leung have also interpreted in a similar way Rudd’s expression “the financial cost can be weighed directly against the perceived social benefit”

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(Rudd 1981: 55). The authors, in fact, emphasize that the possible “financial cost” “is a private cost borne by the investor, whereas the ‘social benefit’ is a public benefit, external to the investor.” Ethical investors care not only about the size of their prospective financial return and/or risk, but they want to know how this return is produced, where the company is located, what kind of goods or services it offers, how business is conducted, etc. (Sparkes 2002). In a wider sense, it can be asserted that financial return remains an important outcome, but it is not the sole criterion driving investments. Ethical concerns should be included (Michelson et al. 2004). From the discussion above, we can summarize that ethical investors derive their utility from both the ethical and the financial “return” of their investment and both of these aspects have to be taken into consideration for an effective understanding of socially responsible investing. In the next paragraph, an overview of the debate on the possible trade-off between ethics and financial performance is offered.

Trade-Off Between “Ethics” and “Profit” The reasons driving investors’ ethical choices may shape their willingness toward profit renunciation (Rosen et al. 1991). Mackenzie and Lewis (1999), for example, conclude that it is not unusual for responsible investors to waive their right to receive a return and that it is quite common for investors to have holdings in both “ethical” and “unethical” funds. The authors’ interpretation draws on the ideas of framing and mental accounts: essentially, they argue that the money invested in SRI is seen by the investors as “spare cash.” They are ready to trade off profit for ethics. However, in a broader study, they found that while ethical investors have ethical concerns, they are not prepared to sacrifice all their “essential” financial needs, which means that a minimum level of financial return must be guaranteed. Furthermore, Lewis and Mackenzie (2000) found investors wishing to increase their investment if ethical funds outperform conventional investments, but insensible to underperformance. In a similar way, Bollen (2007) and Webley et al. (2001) found support for the idea that poor financial performance of ethical funds does not necessarily lead to a reduction in investments. Peifer (2014) also demonstrated that dual investors (i.e., those who invest in both SRI and conventional funds) are more loyal to their SRI funds. In particular, he found that ethical motivations, and not economic motivations, induce SRI fund loyalty. In a similar way, Laurel-Fois (2018) found that the flow of money coming in and going out of a fund follows a curvilinear relationship with the intensity of the screening. In particular, high screening makes investors less likely to divest because they “stick” more with its ethical qualities. Furthermore, Webley et al. (2001) put great emphasis on ethical investors’ unwillingness to trade off ethics for profit. They stress how ethical investment is based on ideology and identity, and it is not just a matter of financial return or of the impact of ethical investment. For the participants of the research, ethical investment is a substantial part of their portfolio. Ethical investors are not only ethical but also committed: having decided to invest ethically, there is a very strong tendency for

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them to stick with this decision (on this point, see also Laurel-Fois 2018). Riedl and Smeets (2017) find that investors are even willing to pay a significantly higher management fee for SRI than for conventional funds, while Gutsche and Ziegler (2019), with two stated choice experiments, demonstrate a considerable willingness to pay (i.e., the willingness to sacrifice returns) for sustainable investments, especially for “certified” products. As regards the amount of money investors are willing to invest, Nilsson (2008) found a significant relationship between the perception of SRI return and the percentage of portfolio invested in SRI, while Lewis and Mackenzie (2000) suggest that the amount invested is a proxy of the ethical commitment. In fact, the majority of those who answered their questionnaire would keep their portfolios much as they are now even if ethical investments were to give lower returns. These preferences are unrelated to the amount invested ethically which suggests there is no simple trade-off between values and profit. Similarly, Riedl and Smeets (2017: 2508) suggest that strong social preferences are needed initially to buy an SRI fund but that they are less important to determine the percentage of portfolio to be allocated to SRI. Moreover, the authors also identify a group of “selfish” investors who hold SRI only for signalling reasons (i.e., to talk about it). These investors tend to minimize the amount of SRI they hold. Far from presuming to be exhaustive, the literature above shows that ethical investors are by no means a homogeneous group. A first suggestion to group investors based on their motives has been proposed by Anand and Cowton (1993). With their study, they showed a “cognitive hyperspace” constituted by a variety of investors’ concerns. A few years later, Nilsson (2009) explores heterogenous behaviors in ethical investors in an attempt to segment them on the basis of their perception of the importance of financial return versus social responsibility. Three segments of socially responsible investors were identified: (i) the “primarily concerned about profit” who value financial return over social responsibility; (ii) the “primarily concerned about social responsibility” who value social responsibility over financial return; and (iii) the “socially responsible and returndriven” investor who value both return and social responsibility when deciding to invest in SRI. Also Berry and Yeung (2013), in the aim of investigating the willingness to sacrifice ethical considerations for financial reward, found three different subgroups of ethical investors. Specifically, they describe (i) a “committed group” for which “no amount of financial gain provides an increase in utility as greater as that provided by the improvement in ethical performance” (Berry and Yeung 2013: 485); (ii) an “opportunistic group” where the largest possible improvement in the financial performance offers exactly the same increment in utility from poor to good ethical performance; and (iii) a “materialistic group” for which any amount of improvement in financial performance offers more utility than an increase in ethical performance (Table 1 offers an overview of the studies quoted in this paragraph). These considerations suggest that different motivations will probably lead investors to give different weight to ethical and financial aspects or, in other words, to trade off ethics for remuneration differently. Despite the interest shown in SRI by

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Table 1 Results of previous studies on private socially responsible investors Author(s) Mackenzie and Lewis (1999)

Aim/research question Empirical psychological study of the relationship between the ethical and financial beliefs and desires of ethical investors

Methodology Semi-structured interviews of 20 ethical investors

Lewis and Mackenzie (2000)

Exploratory study to know who invests in SRI, perceptions on SRI returns, and elasticity of demand for SRI

Questionnaire survey of 1,146 ethical investors in the UK

Webley et al. (2001)

To explore what differentiates ethical from standard investors

Experiment with 56 investors: 28 standard and 28 ethical investors

Main results (relevant for this specific analysis) It is quite common for investors to have holdings in both “ethical” and “unethical” funds Willing to trade off profit for ethics but not prepared to sacrifice their essential financial requirements to address ethical concerns Money invested in SRI is considered as “spare cash” (only a small proportion is invested in SRI to assuage investors’ consciences) Ethical investors were found to be neither cranks nor saints holding both ethical and not so ethical investments at the same time. A case is made that people are prepared to put their money where their morals are although there is no straightforward trade-off between principles and money. That is, a minimum level of financial return must be guaranteed Investors wish to increase their investment if ethical funds outperform conventional investments, but are insensible to underperformance The amount invested in SRI is a proxy of the ethical commitment They found ethical investors unwilling to trade off ethics for profit. For the participants of the research, ethical (continued)

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Table 1 (continued) Author(s)

Aim/research question

Methodology

Bollen (2007)

To study the dynamics of investor cash flows in socially responsible mutual funds

Analysis of the cash flows of CRSP SurvivorBias-Free US Mutual Fund Database, covering the periods 1961 through 2002

Nilsson (2008)

Examine the impact of a number of “pro-social” and “financial” variables on SR investment behavior To address reasons for consumer investment in socially responsible investment (SRI) profiled mutual funds

Questionnaire answered by 439 SR investors and 89 “traditional” investors

Nilsson (2009)

Cluster analytic approach where 563 SR investors were classified into different segments based on their perception of importance of financial return and social responsibility

Main results (relevant for this specific analysis) investment is a substantial part of their portfolio. Ethical investors are not only ethical but also committed: they stick with their ethical decision (even if less profitable) The monthly volatility of investor cash flows is lower in socially responsible funds than in conventional funds. Cash flows into socially responsible funds are more sensitive to lagged positive returns than cash flows into conventional funds. Cash outflows from socially responsible funds are less sensitive to lagged negative returns (weak evidence) He found a significant relationship between the perception of SRI return and the percentage of portfolio invested in SRI Three segments of SR investors: (i) the “primarily concerned about profit” who value financial return over social responsibility; (ii) the “primarily concerned about social responsibility” who value social responsibility over financial return; and (iii) the “socially responsible and return-driven” investor who values both return and social responsibility when deciding to invest in SRI (continued)

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Table 1 (continued) Author(s) Berry and Yeung (2013)

Aim/research question To investigate willingness to sacrifice ethical considerations for financial reward

Methodology Questionnaire responses provided by a sample of ethical investors (n. 106 wholly or partially completed). Conjoint analysis is used to allow quantification of the utilities derived from different combinations of ethical and financial performance

Peifer (2014)

To consider how economic and ethical concerns shape shareholder investment behavior with a particular emphasis on investor fund loyalty

Multivariate analysis of a random sample of investors from an American SR mutual fund A total of 499 investors completed the phone survey

Riedl and Smeets (2017)

To understand why investors hold socially responsible mutual funds

Administrative data, survey responses, and behavior in incentivized experiments (n. 3,254 respondents)

Main results (relevant for this specific analysis) Three different subgroups of ethical investors: (i) a “committed group” for which no amount of financial gain provides an increase in utility as greater as that provided by the improvement in ethical performance; (ii) an “opportunistic group” where the largest possible improvement in the financial performance offers exactly the same increment in utility from poor to good ethical performance; and (iii) a “materialistic group” for which any amount of improvement in financial performance offers more utility than an increase in ethical performance Dual investors (i.e., those who invest in both SRI and conventional funds) are more loyal to their SRI funds Economic motivations reduce SR fund loyalty and that ethical motivations induce SR fund loyalty Both social preferences and social signalling explain socially responsible investment (SRI) decisions. Financial motives play less of a role. Socially responsible investors in the sample expect to earn lower returns on SRI funds than on conventional funds and pay higher management (continued)

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Table 1 (continued) Author(s)

Aim/research question

Methodology

Laurel-Fois (2018)

To examine the theoretical motivations underlying the conflicting beliefs in support of and against responsible investment

Data set of n. 187 European responsible equity mutual funds

Gutsche and Ziegler (2019)

To examine whether and which investors are willing to pay for sustainable investments

Econometric analyses with mixed and latent class logit models on data from a computerbased survey (n. 1,173 German investors)

Main results (relevant for this specific analysis) fees. Investors are willing to forgo financial performance in order to invest in accordance with their social preferences Strong social preferences are needed initially to buy an SRI fund, but these are less important to determine the percentage of portfolio to be allocated to SRI She found a curvilinear relationship between the flow of money coming in and going out of a fund and the intensity of the screening. High screening makes ethical investors “stick” more and less likely to pull money out of a fund because they are attracted to its ethical properties They demonstrate a considerable willingness to pay (i.e., the willingness to sacrifice returns) for sustainable investments, in particular for “certified” products

academics and businessmen, an understanding of the motives, psychology, and decision-making of individual socially responsible investors is still incomplete and concentrates largely on descriptive accounts, comparing the characteristics of ethical versus mainstream investors (Beal and Goyen 1998; Glac 2009). For instance, a number of studies have focused on demographic characteristics (age, sex, education, etc.) of individual ethical investors, for the purpose of both drawing up a sort of portrait and finding some of their distinguishing characteristics (Rosen et al. 1991; Beal and Goyen 1998; Tippet and Leung 2001; McLachlan and Gardner 2004; Williams 2005). In the next paragraph, an overview of individual “ethical” motivation for SRI is proposed with a particular focus on the moral foundation of this

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motivation. Then, a discussion on if and to what extent a different trade-off between the two dimensions (ethics and profit) could exist for different “categories” of investors will be proposed.

Motivations for Socially Responsible Investment Socially responsible investors integrate ESG or ethical values in their investment decisions for different purposes. Sometimes these aims are linked to the investors’ desire to be coherent with their set of values, while others are more “pro-social,” insofar as they represent an attempt to promote better, fairer, more inclusive, or more just business practices and, therefore, a better society. Schueth (2003), investigating the reasons why investors are attracted to socially responsible investing, underlines that the motivations tend to fall into two often complementary categories. One group feels the need to put their money to work in a manner that is more closely aligned with their personal values and priorities. Investors who are primarily motivated by this desire are sometimes described in the modern media as “feel-good” investors, and they base their decisions mainly on information about the past. Another group feels a strong need to put their capital to work in ways that support and encourage improvements in the quality of life. This group is more focused on what the money can do to catalyze positive change in society at large. They tend to be more interested in the “social change” strategies that form an integral part of the socially responsible investment. They are inevitably projected toward the future. Other studies (Rosen et al. 1991; Lewis 2001) show a further motivation. SRI is an extension of the investor’s way of life “as part of a wider thing as well like buying organic produce” which consumers do “sometimes but not always” (quotation from Lewis 2001: 338). This concept leads to a model in which every economic action (investing, consuming, etc.) follows the same sort of principles (Lewis 2001). To investigate the ethical concerns of responsible investors, Dembinski et al. (2003) identified four different categories: (a) value- or conviction-based ethics, (b) fructification-oriented ethics, (c) impact- or consequence-based ethics, and (d) “opportunistic” ethics (the original name of this category, given by authors, was “ethics as financial selection criterion”). Investors motivated by valued-based ethics are those that Schueth (2003) identifies as “feel good,” that is, people looking for “peace of mind” who refuse to support (or want to contribute to) activities, practices, or systems of which the investor disapproves / approves (Some examples could be given from the main screenings reported above. As far as avoidance is concerned, a mention could be made of alcohol, controversial weapons - like antipersonnel mines-, arms and military contracting, tobacco, pornography, nuclear energy, gambling, violations of fundamental human rights and ILO conventions, child labor, etc., while activities to be promoted could be organic agriculture, green energy, low-carbon management practices, gender equality, etc.). “Feel good” investors are not motivated by any attempt to have an impact on the company, and usually, as we will see below, they

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are absolutory bounded: no trade-off between ethical commitment and financial return is permitted. “Social change” investors, instead, are motivated by consequence-based ethics, that is, the commitment to induce companies (and financial intermediaries) to adopt practices and activities consistent with their own ethical requirements. As the name suggests, fructification-oriented investors, instead, are patient and willing to wait for the rewards of their financial contribution. They usually become partners of the companies in which they invest and are committed “to hold out the investment for the time it takes for the investment project to yield a profit” (Dembinski et al. 2003: 207). This is often the case for community investing or unquoted microenterprises and SMEs. The growing form of impact investing could be motivated by this commitment, too. Anyway, in this case, the investor assumes the risk of his/her choice and waivers the opportunity to exit the investment to take advantage of other opportunities the market can offer him/her. Conversely, ethics could be a selection criterion for those investors who hope to gain additional information or explore new market opportunities. Beal et al. (2005) also include the possible superior financial return as a potential reason why people may invest some or all of their funds ethically. In this case, ethics is considered to be an additional indicator of performance and/or a factor reducing the risk. Ethics is a means of obtaining a profit, which is the investor’s ultimate goal. For that reason, in this chapter, this kind of “commitment” is called “opportunistic ethics” and the investor an “opportunistic ethical investor.” Cullis et al. (1992) call this investor a “consumption investor” who gains utility from investing ethically, in contrast to an “investment investor” who is interested in the social outcomes of his investments and, therefore, more oriented to a long-term perspective. Moreover, the “affinity” or “proximity” finance suggests the idea that investors could also be motivated by the desire to build a relationship and/or to take an active part in a project they feel close to (see, e.g., the case described by Signori 2017). This is also the case for investors who, through shareholder activism, engage with companies to start a fruitful dialogue and a mutual and virtuous enrichment (see, e.g., Alford and Signori 2014). Even if discussing the ethical foundations of SRI is not the purpose of this work, it is worth briefly mentioning that a “feel-good” investor follows a (valued-based) deontological approach to finance, while a “social-good” or a “fructification-” oriented investor seems more inclined toward a consequential attitude. Investors looking for a relationship or a mutual enrichment could even be close to a virtue ethics approach. As Sandberg and Nilsson (2015) suggest, these different motivations for, or justification of, ethical investment result in different time perspectives and different ethical commitments. In particular, they suggest two main perspectives: the moral purity and the moral effectiveness perspective with a backward-looking view for the former and a forward-looking vision for the latter. Figure 1 represents the links between motivations for, or justification of, type of investment and willingness to trade off profit and ethics. Feel-good investors follow a moral purity (deontology) perspective. The strategy that best suits their requirements is avoidance, as it makes them sure to steer clear of “sin stocks.” They have a backward-looking view as they consider more the past

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Motivation

Ethical Justification

Feel-good

Extension of one’s way of life

Moral purity perspective

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Relationship

Fruitification

Social change Moral effectiveness perspective

Virtue ethics perspective

Opportunistic ethics Outside any moral justification …

Time perspective

Backwardlooking

Type of investment

Negative screening

Ethics-profit trade-off

Possible profit renunciation. Ethics is a strict commitment

Motivation

Ethical Justification

Feel-good

All the practices depending on investors’ value

Mainly engagement

Community and impact investing

Forwardlooking

Present

Positive screening + engagement

All the practices depending on expected return

Possible trade-off between ethics and profit (willingness to renounce profit for ethics, the oppositeis difficult)

Extension of one’s way of life

Moral purity perspective

Relationship

Fruitification

Social change Moral effectiveness perspective

Virtue ethics perspective

‘Free’ trade-off between ethics and profit (willingness also to renounce ethics for profit)

Opportunistic ethics Outside any moral justification …

Time perspective

Backwardlooking

Type of investment

Negative screening

Ethics-profit trade-off

Possible profit renunciation. Ethics is a strict commitment

Allthe practices depending on investors’ value

Mainly engagement

Community and impact investing

Forwardlooking

Present

Positive screening + engagement

All the practices depending on expected return

Possible trade-off between ethics and profit (willingness to renounce profit for ethics, the opposite is difficult)

‘Free’trade-off between ethics and profit (willingness also to renounce ethics for profit)

Fig. 1 Links between motivations for, or justification of, type of ethical investment and trade-off

behavior of the companies and less the future perspectives. They are very committed to their values and do not give any consideration to possible remuneration or profit renunciation. Usually no space is allowed for a trade-off between profit and ethics (This is an important point as, following Berry and Yeung’s (2013) suggestion, it casts doubt on Jensen and Meckling’s widely used claim that trade-off behavior is ubiquitous Jensen and Meckling (1994). In this case, investors are not willing to trade off a source of utility gain for another). On the other side, social change investors look for change in companies and economic systems. They look at the future (forward-looking) and are motivated by an “effectiveness perspective.” They are willing to trade off profit for ethics but, usually, under specific conditions. As an “extreme” case, this category could also

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include advocacy groups who invest their money with the aim of stopping or changing specific behaviors perceived to be unfair or dangerous. Often, they even leverage possible damage (to the reputation or to the performance) of the companies in which they invest to induce a specific social change. Somewhere in the middle, there are investors looking at the present, they want to be and to become a more “sustainable” or virtuous person, and investment is one of the tools to achieve this. They usually stand with their decision long enough for it to pay off. For specific financial products, like impact investing, both the impact generated and the return on investments are important, while in other forms of community investing, it is not unusual to find investors willing to renounce all or a part of their remuneration for “social” purposes. Opportunistic ethical investors are not really motivated by ethical issues, so they do not fall within any possible ethics perspective. They will use the ethical strategy and the investment product that best suit their desire to make money. They are also ready to sacrifice ethics for profit. Furthermore, Sandberg and Nilsson (2015) found that investors have difficulties in choosing between a moral purity and a moral effectiveness perspective in ethical dilemma. This finding could support the idea that even the single, individual investor could experience different ethical commitments depending on the situation he/she is experiencing. On this point, Beal et al. (2005) suggest three possible ways to incorporate this aspect of ethical investing into a theoretical economic framework. The first one consists of treating the psychic returns from ethical investing as being equivalent to the gambler’s fun of participation: the investor, in fact, aims to achieve close to a market rate of return with the additional feel-good factor from the label “ethical.” In the second model, they include a perceived level of ethicality in the investor’s utility function. The flexible and useful model obtained is limited by the abstractness of the quantification or measurement of the psychic utility. To overcome this obstacle, the authors apply some new methods of happiness research and propose a third model in which they consider the psychic returns from ethical investing as being equivalent to the happiness or well-being derived from other pleasurable activities (experience utility). Experience utility is subjective in nature, and the model captures the variations in the level of ethical intensity investors may experience. In a similar way, through an experimental study, Glac (2009) demonstrates that the framing of the investment situation influences the likelihood of engaging in SRI and the level of trade-off that investors are willing to make. The presence of different types of behavior (e.g., holding “ethical” and “nonethical” investments at the same time, different trade-offs between ethics and profit, etc.) suggests that investors perceive the need to invest ethically (and the subsequent willingness to renounce profit) with varying intensity at different times of their life or, more probably, as a result of the specific situations they experience. This assertion suggests extending the investigation into socially responsible investment and considering a new variable, the “ethical intensity” which seems to be able to influence the likelihood of investing in SRI, the motivation, and the level of trade-off investors are willing to make.

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Motivation

Investment decision fl Proximity

Ethics vs profit trade-off

Ethical intensity

fl Social efficacy fl Centrality fl Urgency

Fig. 2 Investment decision determinants

The concept of “ethical intensity” could include several aspects that influence the investor’s decision, with different levels of intensity. They are mainly: 1. The degree of adherence of an investment’s ethical criteria to an investor’s ethical requirement (we could call this attribute “proximity”) 2. The perceived capability of inducing positive social change (“social efficacy”) 3. The crucial role the investor perceives to have in a specific investment (“centrality”) 4. The temporal immediacy (“urgency”) We would like to suggest that investments of high ‘ethical intensity” are those with ethical criteria closer to the investor’s set of values or moral justification, with a high potential social impact, where the investor perceives his/her role as crucial for the success of the project and/or for a social change and where financial support is urgent. The higher the ethical intensity, the higher the possibility that individuals will engage in socially responsible investments and renounce a part of their profit (Fig. 2).

Conclusions Differences in investor motivations are a topic that has been largely neglected in the literature on socially responsible investment. In fact, most of the research conducted in the last few years has, to a large extent, considered all SRI investors as a homogeneous group. This chapter aims to contribute to the strand of literature that focuses on dissimilarities. Particular attention has been given to motivations that drive individual investors (but not only) toward SRI. Motivations, in fact, can influence the financial instruments used, the strategy adopted, the amount of money invested, and the level

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and direction of the trade-off between the two main sources of utility for ethical investors, that is, ethics and profit. Furthermore, the concept of ‘ethical intensity” has been advanced to achieve a better understanding of investors’ willingness and effective choice with regard to the ethical investment process. Indeed, as previous studies highlight, investors perceive the need to invest ethically with varying intensity at different times of their life or, more probably, as a result of the specific situations they experience. The idea of ethical intensity is linked with different aspects, that is, “proximity,” defined as the closeness of an investment’s ethical criteria to an investor’s ethical set of values; “social efficacy,” such as the perceived ability to encourage social change; and “centrality,” that is, the “position” of the investor in the process and the pressure in terms of “time urgency.” These considerations further advance the need for research on individual ethical investors and their motivations, attitudes, and perceptions. Some consequences in terms of accountability of ethical investments are also evident. While some ethical investors, who are more motivated by the respect of self-ethical assessment, may be mainly interested in information about the past to avoid being held responsible for specific behavior perceived to be wrong or harmful, “social change investors” are looking at the future and interested on the effectiveness of their action. Ethical investment agencies should be aware of the information investors are looking for or could be interested in. The measurement and accountability of the efficacy of investments is a field that is still under-investigated. This is a great challenge for ethical investment agencies which could use accountability as a strong tool for increasing ethical commitment and the ‘ethical intensity” of their proposals.

Cross-References ▶ A Virtue Ethics Approach in Finance ▶ Ethics in Finance as the Result of a Strong Systemic Commitment ▶ Microfinance Services and Women’s Empowerment ▶ Social Banks Acknowledgements I am very grateful to Chris Cowton for the comments and advice on a first draft of this chapter and to the editors of this book for the precious suggestions on how to further improve my work. My gratitude goes also to Susan Kingshott for her valuable support and timely and accurate editing work.

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Ethics and Digital Innovation in Finance Antonio Argandoña

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Big Data and Algorithm Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From Data to Algorithm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics in Fintechs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payment Systems: Platforms, Digital Currencies, Blockchain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Customer Relations: Mobile Banking, Electronic Trading Platforms, Robo-Advisors, Credit Scoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Products and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Putting Ethics into Practice in Fintechs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Digital technologies are a powerful innovative and disruptive factor in finance. They have several dimensions, including an ethical dimension, that call upon the people and organizations that take part in financial activity to take into account the consequences of their actions on others, first of all, their users and customers, but also the stakeholders of the financial or technological organization in question, other organizations, sometimes in distant places, local communities and society in general, including when their decisions are supported, facilitated, or even replaced by programs and machines. This chapter explains the ethical

A. Argandoña (*) Department of Economics and Business Ethics, IESE Business School, University of Navarra, Barcelona, Spain e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_9

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dimension of digital technologies applied to finance and offers ideas for guiding the work of the agents who design or use these technologies so that they can contribute positively to the good of the people and society. Keywords

Algorithms · Artificial intelligence · Data · Ethics · Finance · Fintech · Machine learning

Introduction Digital technologies are a powerful innovative and disruptive factor in finance, impacting on competition, comparative advantages, and even the survival of many traditional agents, with social effects such as creating opportunities for millions of citizens who have traditionally been excluded from financial services in emerging markets or changing the culture and practices of newcomers and incumbents alike, from small start-ups to large bigtechs. The purpose of this chapter is to offer some reflections on the ethical dimension of the fintechs, which the Financial Stability Board defines as “a technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions, and the provision of financial services” (Bank for International Settlements 2018a). The digital technologies are based on the use of machines such as computers and smartphones, which enable access to a much larger volume of information than was possible with any past technology and to process these huge databases quickly, efficiently, and flexibly. These technologies also exploit the ability to relate with other machines, people, and even things, increasing opportunities and reducing the cost of analyzing, forecasting, producing, validating, and controlling (Abrardi et al. 2019). Computers solve problems and make decisions using artificial intelligence (Poole et al. 1998), a technology that is at the intersection of robotics (which provides the design and the operational framework), machine learning (which allows the machine to learn and even improve its own performance), and big data (the raw material for machine learning). In the beginning, the interest in fintechs was due to their disruptive effects on traditional finance (cfr. Barba Navaretti et al. 2017), changing consumers’ behavior, the markets’ rules of play, the nature of competition, and agents’ competitive advantages. These technological and economic problems also have an ethical dimension, but this dimension is not new: financial innovations have been a constant in our economic lives for centuries. Viewed from this perspective, there is no specific ethics for fintechs: the moral problems that agents must address are always the same, transcending changes in the institution (a small start-up, a bigtech, or a traditional bank), its scope, or its culture. For example, in considering a loan application, the questions concerning the decision’s fairness, the risk in which the organization

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incurs, and the consequences for the institution and the customer are the same, whether they are decided by a person or a computer. One corollary of this is that there are no “ethical decisions”: decisions have economic, sociological, psychological, political, and also ethical dimensions, and any assessment of a decision’s quality must take into account all of their dimensions. But there is another reason for concern about digital technologies: they “mimic” human beings in “cognitive” tasks, such as perceiving, understanding, relating, reasoning, learning, and deciding (Russell and Norvig 2009), which raises fears that the decision-maker will no longer be a person but a piece of software or, at least, it will force a “different” relationship between human being and machine. This is not the appropriate place for developing this matter, which belongs to the philosophy of technology (cfr. Floridi 1999). It is sufficient to point out here that “machines also have limitations compared with human intelligence, with which they cannot compete, for example, in tacit knowledge and common sense . . . A computer does not know ‘what’ a cancer is, even though it may be able to identify the presence of pathological tissues . . .; and if it ‘tells’ a lie, it does not know that it is telling a lie nor what it entails for a person to tell or hear a lie. Algorithms can find the best alternative in preset conditions but not when faced with judgements in which the person’s humanity is at stake . . . The digital technologies’ fantastic storage capacity has difficulties when compared with human memory which, in spite of its severe limitations, has an amazing capacity for filtering and sorting information, so that we remember what is important, forget what is insignificant, reconstruct the past in the light of the present and give each data item the value it deserves, while digital memories remember everything, but without the ability to reinterpret or evaluate. . . Algorithms are neither sentient nor moral; they have no awareness of pain, pleasure, remorse or empathy; they do not have values nor are they capable of making an exception to a rule. They cannot reflect on the type of life they want to lead, or the type of society they want to live in and act accordingly” (Argandoña 2019b). Consequently, ethics applies to people, not to machines or software. A robot may be an accountable agent if it is able to account for its decisions. However, in order to be morally responsible, it “must relate itself to its actions in some more profound way, involving meaning, wishing or wanting to act in a certain way, and being epistemically aware of its behaviour” (Floridi and Sanders 2004, p. 365). One corollary of this is that financial decisions must always be subject to human control: machines and programs only facilitate and complement human decisions; they cannot replace them because they cannot comprehend these decisions’ ethical content. As the European Union’s General Data Protection Regulation (GDPR) explains, “the data subject shall have the right not to be subject to a decision based solely on automated processing, including profiling, which produces legal effects concerning him or her or similarly significantly affects him or her” (Regulation (EU) 2016/679 of the European Parliament and the Council of 27 April 2016, Art. 22.1); if a nonhuman agent takes this decision, the data subject is entitled to have a human agent intervene to express his or her opinion and confirm or not confirm the decision. In other words, algorithms should have some kind of rollback or override. An algorithm is a mathematical construct with “a finite, abstract, effective, compound

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control structure, imperatively given, accomplishing a given purpose under given provisions” (Hill 2015, p. 47). The popular concept refers not to this technical definition but to the “implementation and interaction of one or more algorithms in a particular program, software or information system” (Mittelstadt et al. 2016, p. 2). Furthermore, while ethics must inspire law and regulation, it actually goes much further. Law is reactive, it considers general cases, and it normally uses a single analytic framework and cannot examine the specific details of each situation. Ethics, on the other hand, is proactive, it considers not only the general arguments but also the specific arguments, and it delves into the details of the circumstances. For example, the regulation may accept a person’s consent to use her personal data if certain objective conditions are met. However, ethics may say that this purported consent is invalid if, after considering the person’s situation, there are serious reasons for thinking that it was not truly informed and freely given (Bogroff and Guégan 2019). In the rest of this chapter, we will discuss, first, the ethical problems involved in data processing and in the algorithms that use the data, which is probably where the fintechs’ most pressing moral problems are to be found. We will then review the ethical problems found in a broad sample of financial operations, in which the digital technologies play a significant role; this is followed by an explanation of the problems and opportunities in applying ethics in fintechs, closing with the conclusions.

Big Data and Algorithm Ethics The Data Data ethics can be defined as the branch of ethics that studies and evaluates moral problems related to data (including generation, recording, curation, processing, dissemination, sharing and use), algorithms (including artificial intelligence, artificial agents, machine learning and robots) and corresponding practices (including responsible innovation, programming, hacking and professional codes), in order to formulate and support morally good solutions. (Floridi and Taddeo 2016, p. 3)

A large proportion of fintech innovations rely on the use of big data. A large number of studies have been published on big data, its potential and the problems it raises; cfr., for example, Boyd and Crawford (2012), Ekbia et al. (2015), Noto La Diega (2018), and Sloan and Warner (2019). People and organizations generate large quantities of data that are collected by human recording, sensors, or systems; and then they are stored, processed, and added to other data; examined, analyzed, and transformed for use in training and in operating algorithms; or, if so decided, shared in new datasets. “Thanks to Big Data techniques and technologies, we can now make more accurate predictions and potentially better decisions in dealing with health epidemics, natural disasters, or social unrest. At the same time, however, one cannot fail to notice the imperious opacity of data-driven approaches to science, social

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policy, cultural development, financial forecasting, advertising, and marketing” (Ekbia et al. 2015, p. 1539; cfr. Hagerty and Rubinov 2019). Personal data are related with individual dignity and the right to privacy (Roessler 2005). Their ethical importance is often overlooked, perhaps because it is thought that it is impossible to prevent personal information from multiplying and being disseminated without check, or because the cost of protecting these rights is perceived as hampering technological development, governments’ interest in accumulating detailed information about their citizens, or companies’ interest in providing better services to their customers. However, nowadays it is generally accepted that “there are good moral reasons to protect individuals from Big Brother, data-greedy companies, and snooping fellow citizens” (van den Hoven 2008, p. 303). The moral reasons for limiting the use of these data are, primarily, to avoid harm (unnecessary data gathering, data theft, identity fraud, and the possibility of unfairly profiling people), prevent informational inequality and unfairness (including access to the goods that information provides), and foster moral autonomy (“the capacity to shape our own moral biographies, to present ourselves as we think fit and appropriate, to reflect on our moral careers, and to evaluate and identify with our moral choices, without the critical gaze and interference of others and without a pressure to conform to the ‘normal’ or socially desired identities”) (van den Hoven 2008, pp. 315–316). The ethical problems related with personal data can be identified from the viewpoint of those who generate them or from that of the organizations that use them. When viewed from the viewpoint of those who generate them, three rights are apparent: ownership, privacy, and safety. (For a presentation of the impact of fintechs on consumers, cfr. Consumers International (2019) and Zamora (2019).) 1. Ownership of the information: this is attributed to the person, who can demand that it be kept intact in a secure place (Mason 1986). This also applies to cloud computing, which is on-demand availability of resources such as data storage and computing capacity (Timmermans et al. 2010), because those who store their data in the cloud can lose control of them. 2. Privacy: limitation on the use of data by third parties through informed consent, which includes the right to authorize or refuse use of these data, impose conditions on their storage and use, and recover full control of the data whenever the person wishes (Burr et al. 2019). This are the “rights of information, access to and rectification or erasure of personal data, the right to data portability, the right to object, decisions based on profiling, as well as the communication of a personal data breach to a data subject” in the European Union’s General Data Protection Regulation, n. 73. “Such data are generated silently and often put to unforeseen uses after they have been collected by known and unknown others, implicating privacy but also leading to second-order harms, such as ‘profiling, tracking, discrimination, exclusion, government surveillance and loss of control’” (Ekbia et al. 2015, p. 1536). (The citation is from Tene and Polonetsky (2012), p. 63). One related problem is that of “group privacy,” when a group’s data, even when each of its participant’s identity is protected, can give rise to group discrimination problems on the grounds of age, race, gender, etc.; cfr. Floridi (2014).

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These rights held by the information’s owner become obligations for the financial or technological organization that controls the data (Turilli and Floridi 2009), including compliance with the conditions for transferring or including the information in other databases; limiting access to the data only with the customer’s prior consent, and in accordance with the conditions specified by the customer; the prohibition to use the data for illegal or immoral purposes; prevention and correction of errors and misinformation; not gathering data that are not necessary; honesty in requesting and accepting informed consent (e.g., when it is a necessary condition for gaining access to certain services); etc. 3. Safety or security: this is the right to protection from errors in data handling, destruction, theft, misrepresentation, leakage or unauthorized publication, or identity theft, due to negligence, malicious interventions, or cyberattacks, including the robustness of the password protection and user authentication system, discovering phishing and spam attempts, etc.4

From Data to Algorithm Financial institutions and technology companies use large datasets to find information (hidden patterns, market trends, customer preferences), linking events and yielding predictions through machine learning models, with the purpose of predicting behaviors and, by this means, making informed business decisions (e.g., credit assignment) and suggesting recommendations (for marketing actions or investment advice). The ethics of algorithms is developed mainly on three levels: data (which we have already talked about), software development, and application. From the customer’s viewpoint, this produces three main types of problems related with the rights to transparency, fairness, and autonomy; from the organization’s perspective, we must also add the question of accountability (cfr. Wing 2018). 1. An algorithm is transparent, explainable, traceable, or interpretable when the sequence of steps that leads to the decision can be known and explained clearly and comprehensibly: for example, when the bank can justify the reasons why the algorithm turned down a loan (an opaque algorithm can be false, misleading, partial, or inappropriate.) This can be very difficult, first, from the data’s viewpoint, because in many cases they are not original and have already been manipulated; they have undergone cleaning processes to correct errors; the attributes and variables to be identified have been chosen subjectively; the data are usually neither random nor representative; they are subject to privacy or copyright restrictions and are usually kept out of context – this is important, for example, when trying to apply the analysis of a large number of cases to a specific person, which can be unfair (cfr. Boyd and Crawford 2012; Turilli 2007). Second, transparency can be an unattainable desideratum because of the high level of complexity of the algorithms used; they are usually the product of work

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done by many experts, often with no direct contact between them; not just technical but also commercial criteria are applied in their development; they are usually reworks, corrections, and combinations of other programs, whose content may be a black box, even for experts; they can be self-supporting algorithms, which formulate themselves the questions that it is wished to answer and the information they will use; software can be probabilistic, which makes the decision opaque, etc. (Floridi and Sanders 2004). And, furthermore, companies view their algorithms as trade secrets, and do not allow their public scrutiny. In short, “the information disclosed, when implementing information transparency, is supposed to consist of meaningful, veridical, comprehensible, accessible and useful data (. . .). The problem is that the elaboration processes that have produced such information usually remain opaque (. . .) [because] the management of information is increasingly outsourced to autonomous computational artefacts” (Turilli and Floridi 2009, pp. 108–110). The duty of transparency cannot be confined to giving generic explanations about the algorithm used, or handing the customer an incomprehensible technical report. “The trust in artificial intelligence and algorithms derives from the belief that non-human agents are unbiased, and their decisions are not affected by passions and ideologies. In fact, algorithms are as biased as the people who [designed and] trained them, but in a less transparent and accountable way. The more important algorithms will become, the more we will want them to embed our values (and, therefore, our ideologies and biases)” (Noto La Diega 2018, p. 33). 2. The fairness requirement, in a broad sense, requires that algorithms respect customers’ rights and facilitate the execution of the contract (whether explicit or not) agreed with them. This condition is not fulfilled when the decision made by the algorithm is subject to biases that lead to unequal or discriminatory treatment (Barocas and Selbst 2016; Hacker 2018), particularly in predictive systems that ascribe (not always fairly) a particular conduct to the customer (the biases mentioned here are not statistical but may include unfair inclinations or prejudices against a person or a group.) These biases, which may or may not be inadvertent, may affect the data or the algorithms. There are several reasons for data bias: sampling bias (when, e.g., part of the population is misrepresented in the sample), historical bias (the data used to train the algorithm are contaminated by the characteristics of the age), or unequal ground truth (when, e.g., missing data are replaced with proxies). In addition, data are usually not contextualized, that is, customers are treated as groups, and any consideration of their particular circumstances is omitted: for example, it may be unfair to refuse a loan to a person who shares certain features with a population group that turned out to be insolvent in the past but who may be an exception to that group’s behavior (Sloan and Warner 2019). There are also several reasons for algorithmic bias: “design choices make the decision-making process or the factors it considers too opaque; . . . the output of the system may be affected by biases in data collection; . . . unlike human beings, algorithms cannot balance biases in interpretation of data by a conscious attention to the redress of the bias; . . . there are biases in the ways that learning algorithms

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are tuned based on the testing users’ behaviour . . .” (Noto La Diega 2018, pp. 8–9). And also in data selection, cleaning, and structuring (Sloan and Warner 2019, p. 14); for example, a credit scoring program may identify a relationship between loans that defaulted in the past and the borrower’s race (even when this information is not included in the database but can be inferred from other data) and discriminate against new applications on the grounds of race. There are many examples of evidence of racial, location, or other types of bias in facial recognition, loan allocation, hiring, profiling, or sentence guidance programs, among others. The possible existence of bias, even undetected, requires designers to make special effort to understand where they can appear and how to correct them. Some of the means for doing this include greater transparency in data construction and testing, a reflection on the use of artificial intelligence models (e.g., to identify in what contexts bias can be corrected and in what other contexts it can be exacerbated), introducing impact assessment measures and audits to check for fairness before the systems are deployed, abide by the law and pertinent codes of good practices, etc. (Silberg and Manyika 2019). And, as a premise of the above, it is also to give priority to the person, considering the positive or negative consequences that this may have for all stakeholders. Although here we have concentrated on the potential discriminatory use of algorithms, the concept of fairness, justice, or loyalty is broader, because in the relationship between customer and financial institution, this principle must always take precedence, including fulfilment of all of the contract’s provisions, proportionality between the benefit gained by the institution from the customer’s information and the service it renders, and the fulfilment of other conditions, such as objectiveness, impartiality, integrity, veracity, honesty, diligence, etc. 3. The principle of autonomy or self-determination requires that people do not become mere constellations of data, without any consideration of their social context and their life experience, because the very “concept of ‘data’ presumes the possibility that human behavior can be traced, isolated, collected as data points, and measured (. . .). The basic premise is that knowledge derived from data analytics is true (or has strong truth value) because of the objective qualities of data, their means of collection and analysis, and the sheer size of the data set” (Markham et al. 2018, p. 4), and this can easily lead to arbitrary decisions, which may violate the individual’s freedom. The principle of autonomy also demands observance of the data holder’s agency, which can be defined as “an individual’s ability to make informed decisions about matters affecting her life and to govern herself according to those decisions” (Pham and Castro 2019, p. 119). 4. The principle of accountability encompasses many of the actions performed by algorithm designers. It is important to define the level of responsibility held by each stakeholder and how account should be given of it, including, if applicable, the recognition of the harm done and its compensation and the undertaking to avoid and correct the errors or biases found. In principle, the information given must be objective, complete, precise, impartial, punctual, and relevant, and it must be expressed in language that can be understood by the person receiving it.

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In short, ethics demands that those who handle artificial intelligence, machine learning, and algorithms be qualified, informed professionals who are objective, impartial, independent, truthful, honest, upright, responsible, law-abiding, prudent, etc. At this point, the principles put the spotlight on the virtues that must govern these professionals’ activity. “Algorithms are inescapably value-laden” (Mittelstadt et al. 2016, p. 1) (and will reflect the values of their designers, verifiers, and appliers and their organizations) – and the values of their users. We will come back to this later on. Having explained the main ethical problems of data and algorithms, we can now turn to other problems related with financial innovations.

Ethics in Fintechs The financial system consists of organizations (commercial banks, financial companies, investment banks, insurance companies, pension and mutual funds, and many others), markets (equity, bonds, derivatives, commodities, forex, platforms, etc.), ancillary actors (regulators, supervisors, rating agencies, etc.), and products and services (currency, deposits, bonds, equity, credits, loans, funds, and many others). Digital technologies impact on the entire range of activities, goods, and services. And ethics is present in all of them.

Payment Systems: Platforms, Digital Currencies, Blockchain One of the most significant transformations that digital technologies have brought to fintechs is to be found in the payment systems and new currencies, often developed outside of the banks by digital platforms that offer users the ability to connect with service providers through mobile channels or online. There are different types of platforms: technology platforms, which offer access to secure infrastructures (e.g., in the cloud); business process platforms, which enable users to optimize value across business; and market platforms, which facilitate exchanges between multiple parties on a global scale and which are the most important for financial businesses (Diamond et al. 2019). The economic logic underlying platforms is that they are able to develop and optimize links between different activities. Platforms are uniquely suited to this role because they are able to exploit the key input to those activities: data. Data recorded and shared on a platform can be used to make recommendations to users, to construct reputation systems, or to efficiently match users to each other, among other possibilities. (Brunnermeier et al. 2019, p. 13)

The social and business platforms usually offer digital or virtual wallets, peer-topeer (P2P) transactions, and other devices that enable payments to be made instantly without having to use coins or banknotes, bank accounts, or credit cards. These activities bring together mobile application providers, third-party application

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service providers, intermediate payment facilitators, and other possible partners. With the data generated by the platform, it is possible to offer interesting services to the customers, who must adopt the platform’s payment system if they want to have access to these services. These platforms are transforming the business model used by financial institutions, from product orientation to consumer orientation, contributing to creating an ecosystem that consumers do not need to leave in order to use the services offered to them. A platform economy improves productivity, reduces costs and risks (e.g., risks for credit card security), and creates new markets. However, it can also create moral hazard problems, discrimination against marginalized customers, precarious employment, changes in users’ habits, or abuse of market power (Clements 2019). “The platform may underprice risk or approve or facilitate loans to overly risky borrowers, collecting the origination fee while shifting the default risk entirely onto investors” (Competition Bureau of Canada 2017, p. 47). The currencies created on the platforms “will no longer simply grant payment services –they also grant access to interactions with other platform users. Hence, a digital currency is inseparable from the characteristics of the platform on which it is exchanged” (Brunnermeier et al. 2019, p. 14). This in turn can generate a degree of user dependence that offsets the advantages brought by membership of the platform. “The diversity of services offered by platforms leads them to develop as closed ecosystems. Consumers would like to be able to use a platform’s currency in order to purchase a wide range of the goods and services they need in everyday life . . . The company sees itself more as a ‘lifestyle platform’ on which people conduct most of their life’s transactions. From ordering food, to buying movie tickets, to paying utility bills. The idea is that people are living their lives through this platform” (Ibid., p. 17). One of the consequences of the development of digital platforms for traditional banks is that, unless they create a platform themselves or associate with one, they may find themselves excluded from the payment services for their customers and deprived of important information about customer tastes and preferences that can be useful for granting loans, financial advice, or portfolio management. One consequence of the above is that “money will no longer be as simple as it was in the past: each digital currency will come bundled with an array of data services and be associated with a collection of economic activities occurring across borders. The traditional system of intermediation may be turned on its head” (Brunnermeier et al. 2019, p. 23). This may have ethical implications, derived, for example, from users’ possible loss of freedom to operate in other spheres or from the implementation of aggressive strategies by these platforms, which may have harmful consequences in the long run for their customers’ interests. And, of course, the problems derived from the data that are generated and used and which we discussed earlier are ownership and control of personal data, privacy, loss or theft of information (particularly by the use of mobile wallets in unsecured networks), etc. (Selvadurai 2013). Marketplace lending are online platforms that enable investors to lend to households, retail, and commercial borrowers without the involvement of intermediaries, sometimes for very small amounts (peer-to-peer transactions, P2P). They perform commercial banks’ functions and compete with them, but they are not financed with

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deposits, they do not take on any risks in their loans, nor do they monitor their borrowers. The P2P lending process works like this: the potential borrower submits an application for a loan; the platform performs a prior analysis and assigns a loan grade that rates the credit risk; the potential investors offer their loans, proposing the amount and the interest rate; and the platform combines the offers into a single loan (Thakor 2019, p. 12). The ethical problems raised are the typical problems associated with applying for, granting, and repaying a loan (Argandoña 1995), such as asymmetric information on the part of the borrower, mislabelling the loans sold to investors, creating a moral risk for banks due to the competition from market lending, as well as the problems related with online transactions: ownership of the data, security, privacy, etc. Crowdfunding, crowdsourcing, or alternative finance is a variant of market lending, in which an activity is financed by many contributions of small quantities over the Internet. Three types of player are usually involved in a transaction: the project initiator, the people who fund her project, and the moderating platform which puts the two sides into contact. It is used for very different initiatives: provide capital for a company (equity crowdfunding) and finance artistic and creative projects, medical expenses, travel, litigation, research, and also community-oriented social projects (donation-based crowdfunding). The ethical problems arising from crowdfunding include protection of the intellectual property rights on the projects whose details are being disclosed; the intermediary’s reputation risk, if it does not achieve its target; donor exhaustion, when too many requests reach a limited number of investors; the morality of the funded activity (the fact that it is a social or philanthropic activity does not automatically confer moral value on funding it); the information asymmetry that may arise if the information is not sufficient, secure, and reliable; the lack of due diligence before the investment and monitoring until full repayment; the organizers’ accountability; etc. Digital currency and electronic money are terms given to a type of currency that does not circulate physically but is a digital computer code stored in an electronic wallet in cyberspace; this enables it to circulate quickly, with very low transaction costs. It may be valid generally or limited to a particular community, and it may be centralized or not, depending on whether or not there is a central control authority (a commercial bank or a central bank). If it does not perform all the functions of money (unit of account, store of value, and medium of exchange), it is called virtual money. A digital wallet is a contactless payment system, often using a smartphone, that enables a payment to be made faster and more securely, without disclosing credit card information. It often integrates other services: international remittances, P2P payments, tickets, boarding passes, car keys, and even passports or driver’s licenses. The main ethical problems related with digital wallets are the security both of the data and of the payment itself. Cryptocurrencies are digital assets that use decentralized forms of control; their ownership, security, and verification are based on a cryptography-based digital ledger that replaces banks and central banks; transactions are stored digitally on a public ledger known as blockchain (cfr. Thakor 2019, p. 13). A distributed ledger

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spreads information among all peers in the network, which gives confidence in the transactions and renders control by a government or central bank unnecessary (Thakor 2019, p. 13). To a greater or less extent, they share the features of money: medium of exchange, store of value, and unit of account, and they compete with other payment and investment media. The best-known cryptocurrency is Bitcoin, created in 2009, but there are many more. On the ethics of cryptocurrencies, cfr. Dierksmeier and Seele (2018). Blockchain technology has fuelled many innovations; it offers “the possibility of having reliable and verifiable shared digital records of any data, be it ownership rights, transaction records, supply chain data or contractual rights” (Tinn 2019, p. 15). Blocks on the blockchain are transactions (verified or “mined,” authenticated through cryptography, and linked to the previous block) added in chronological order, which, once proven, are provided to each node as an “indelible” (permanent) digital transaction record. Cryptocurrencies are also a means for financing projects “through a mechanism called an initial coin offering (ICO). An ICO is basically a cryptocurrency version of crowdfunding. It enables cryptocurrency developers to raise funding for the development by selling tokens to investors, who therefore essentially become part of the project themselves” (Thakor 2019, p. 14). A token allows identifying sensitive data by another nonsensitive one, so that potential attackers cannot reach the information that is wished to protect. “These tokens can offer a share of the future revenues or profit the firm generates, a right to access the platform, or any other rights that can be described by a computer code that is stored on a distributed digital ledger in a similar way as the ownership rights of a bitcoin” (Tinn 2019, p. 16) and can be traded on an exchange. Digital currencies have advantages such as low transaction costs, transaction speed, and ease of use via computers or mobile phones. They allow unbanked people to gain access to payment means and bank services while at the same time preventing corrupt governments from controlling their currency. And, in the case of cryptocurrencies, its advantage is the availability of fast, transparent, cooperative mechanisms with low transaction costs that provide a means for verifying operations and offering guarantees to the transaction’s parties. Among the drawbacks of some forms of digital currency, there is the possibility of using these funds, which are opaque, for illegal operations (drug traffic, money laundering, or financing terrorism); the possibility of market manipulation and the risk of hacking attacks, theft, and other security problems; the risk associated with its high price volatility compared with other currencies; the lack of protection provided by a deposit insurance; and, in currencies such as the Bitcoin, complexity and high mining costs, which is one of the downsides of its anonymity; according to Foley et al. (2019), 46% of Bitcoin transactions are illegal. Another impact of blockchain technology is the creation of smart contracts, “based on decentralized consensus as well as tamper-proof algorithmic executions” (Thakor 2019, p. 34). This innovation allows agents between whom there are no prior ties of trust to conclude secure contracts without any need for a central authority. This drastically reduces costs and risks and expedites the settlement of

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trades, although it increases the risk of collusion, due to information asymmetries. This can have a significant impact, for example, in the insurance industry: “with a smart contract, the car insurance can be embedded in the car itself and that data generated by the driver’s use of the car can be fed continuously to the insurance contract, so it adjusts the terms of the contract based on this data” (Thakor 2019, p. 35; italics in the original). In the near future, there will be centralized digital currencies issued by central banks with a high level of security and confidence that, partly or completely, will displace money as we know it today (Bank for International Settlements 2018b; Dierksmeier and Seele 2018). The ethical problems that this will raise for central banks, such as loss or instability of the value of money, will be similar to those they have now.

Customer Relations: Mobile Banking, Electronic Trading Platforms, Robo-Advisors, Credit Scoring Digital technologies facilitate relations between financial institutions and their customers. Access for actual or prospective customers is often provided by chatbots or the automated management of customer services. These are pieces of software that conduct a conversation, using voice or written text; access is provided by a virtual assistant, via messaging apps or via the apps and websites offered by the organizations themselves, to provide information (about the customer’s account and operations or other aspects about the organization) or carry out certain operations (transferring funds, opening an account, paying bills, and making P2P payments), etc. Their main advantages are less costs, service personalization, speed, 24/7 availability, the ability to attract new customers and lock in existing customers, etc. The ethical problems are mainly those related with the data provided by the customer to the bank (vulnerability, privacy), the quality of the information provided, etc. Related with these and other services are the consumer identification and authentication measures (e.g., by biometric measures, voice and text recognition, etc.), where the problems are mainly discrimination, security, and inappropriate handling. Mobile banking is a service provided by a financial or technological institution that enables customers to perform financial transactions remotely, through the use of a smartphone or computer; normally, they do not include cash transactions. The advantages are those that have already been explained earlier: personalized attention, 24/7 service, low transaction costs, etc.; the most frequent ethical problems are those related with transaction and account security (hacking, interference, etc.). The commercial banks offer liquidity management services (regular payments, check collection, transfers, etc.) at very low costs when they are carried out using online procedures; they also allow “consolidation in one place of a user’s account balances, card transaction histories, credit scores and other key financial data from across providers. They add value through analytics and data visualisation to provide the user with a picture of their current financial health, forecasts on how this will change in the future and suggestions on how to improve” (Consumers International 2017, p. 9).

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Algorithmic or automated trading is a software for carrying out commercial transactions with financial assets; the customer decides when, where, and how the order is issued on the basis of pre-specified rules and market conditions, with a speed and frequency that is not possible without the technology’s help. Transactions can be executed either through an intermediary or directly between buyers and sellers who are members of the platform, overcoming the limitations of having to use an organized market or request the services of a broker or dealer. Transactions can be performed instantly from anywhere, at the best price available, with a low risk of human errors, and it is also possible to back-test the trading with historic or real-time data. Their problems are those that have already been mentioned for platforms and, in particular, data control and security. High-frequency trading (HFT) allows a large number of orders to be processed at high speed (in milli- and even micro-seconds) and in multiple markets, with different decision criteria based on pre-programmed instructions (Aldridge 2019). “These are sophisticated programs that carry out operations in a fraction of second and do it thousands of times a day by holding numerous positions open for very short periods of time. By locating the intermediaries’ computers very close to the markets’ computers, they receive orders a few milliseconds before slow traders; if, for example, a buying order arrives, they can place another order before the selling order arrives from a slower trader, obtaining a minimal profit per unit but multiplied by a very large number of operations. In addition, they anticipate market movements, placing many orders that forestall the actions of slow traders, running ahead of them to get a profit” (Argandoña 2018, p. 352). HFT facilitates the creation of market liquidity, allows a large number of transactions to be performed without noticeably affecting the price, and reduces transaction costs for retail investors. However, they are a rent-capturing procedure at the expense of slower traders, and its social benefits (liquidity creation and reduced transaction costs) are insignificant. “Furthermore, stuffing the market with fictitious orders can be a type of deception: for example, a trader can launch a large number of fictitious purchase orders to create the false impression that he is trying to make that purchase and cause sales orders from other traders, although the released orders will be canceled immediately. And these practices heighten operations’ endogeneity, giving markets a life of their own, disconnected from the agents’ financial needs, and may have destabilizing effects, triggering a chain reaction processed by computers, without human intervention – but with human responsibility – in response to an erratic market movement” (Ibid., p. 352). One of the most interesting uses of big data, artificial intelligence, and machine learning is in the assessment of investment opportunities, portfolio optimization, and risk mitigation, giving rise to robo-advisor services. These are programs used to offer investment recommendations and portfolio management services, using questionnaires that elicit the customer’s idiosyncrasies and preferences, in addition to many other data, following passive fund strategies (Iannarone 2018). These services may be rendered remotely, with low costs and minimal or even nonexistent human involvement, which also excludes possible advisor or customer biases, conflicts of interest, and opaque decisions (D’Acunto et al. 2019, p. 3). They combine the advice

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problems (loyalty to the customer, possible conflict of interest) with the previously mentioned data handling problems. Social, copy, and mirror trading are cooperative forms of portfolio management and consist primarily of observing and following other investors’ strategies, either free or in exchange for a fee; they are widely used in forex trading. Easy to run, they enable people without any financial knowledge to manage their portfolios; they shorten the learning curve for novices; they are transparent and they generate trust; they have a low cost; and they are cooperative, encouraging information sharing. Among their drawbacks are the possibility of speculation and manipulation by the leader and the possibility of the leader using strategies that are aimed more at boosting his image than his followers’ results, among others. Credit scoring is one of the first applications of predictive analytics in banking business, exploiting the information available about the customer’s and other customers’ history to assess creditworthiness quickly and cheaply, reducing the loan’s or a credit card’s risk, and enabling the terms of the contract to be personalized to each customer. (Another traditional use of predictive analytics is to use the customer’s data to personalize advertising and offers of new products and services (e.g., suggesting to the customer that it is a good time to apply for an instant loan to cover a planned purchase or trip); cfr. Pham and Castro (2019).) The associated ethical problems are those that have already been mentioned for data processing: possible privacy and security conflicts; possible discrimination against certain groups, as general profiles are applied to specific individuals; use of mainly negative information, which gives an unfair view of the customer; etc.

Other Products and Services Digital technologies are present in financial institutions’ and markets’ operating and strategic functioning. We have already mentioned some aspects of this less visible but no less important role: big data analysis, artificial intelligence, machine learning, distributed ledger technology, customer identification and authentication, etc. Risk management also plays an important role. “Fintech creates new types of risks. When banks internally adopt fintech innovations into their existing processes and services there is cyber-risk and customer data vulnerability through new interface technologies, and risk to the stability of the financial system if riskier borrowers are quickly approved for credit using algorithmic processes. Banks partnering with technology companies must also monitor and manage third parties. This requires heightened due diligence and ongoing monitoring costs” (Clements 2019). Many types of risk are created by digital technologies (Bogroff and Guégan 2019): data risk (poor quality, representativity), algorithm risk (model selection, training, parameterization), risk of the subject (covariance shift, unpredictability), risk of the process (operational, cyber, conduct, IT risks), and compliance risk (data protection, consumer protection), in addition to the intrinsic risks of financial activity – market risks, market manipulations, systemic, liquidity, money laundering and terrorism financing, etc. (Bank for International Settlements 2018a). These risks

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have a clear ethical significance, insofar as they affect the welfare of people and financial institutions, other agents, and society in general. Connected devices (smartphones, computers, watches, etc.) contain large quantities of information about people, their homes, vehicles, and the instruments they use. Insurance companies may use this information to generate precise, constantly updated risk calculations that can be factored into insurance contracts, giving rise to insurtech (Thakor 2019, p. 15). As a result, personalized policies can be offered, eliminating the need to share among all customers certain risk profiles that are predictable, heterogeneous, and ex ante indistinguishable. This may create a possible discrimination against high-risk customers, whose risk until now was shared with other customers. This problem arises, for example, when a medical insurance company refuses to cover the risk of a person who has a high probability of developing a chronic illness that is expensive to treat. However, strictly speaking, this is not a matter of personal ethics but of social ethics: society must decide whether certain risks should be subsidized for certain people. Peer-to-peer insurance models have also been developed, in which a platform groups policyholders in small groups who share the same risks with low costs.

Putting Ethics into Practice in Fintechs “Technology is neither good nor bad; nor is it neutral . . . technology’s interaction with the social ecology is such that technical developments frequently have environmental, social, and human consequences that go far beyond the immediate purposes of the technical devices and practices themselves” (Kranzberg 1986, p. 545). The temptation among those who work in the fintech industry may be to give greater importance to certain positive impacts (efficiency and cost reduction, inclusion opportunities, increased standard of living, freedom, and initiative) than to the negative impacts (exclusion of certain population groups, increased inequality, imbalances in power relationships, employment disruption). However, we should not forget that digital technologies not only have functional dimensions but also “mediating” and, to some extent, “co-deciding” functions with the human agent: “ethics, after all, is about the question of how to act, and technologies appear to give material answers to this question” (Verbeek 2006, p. 369). The ethical dimension of the design of digital technologies, viewed from a negative perspective, is to “assess possible undesired forms of mediation” and, viewed from a positive perspective, to “explicitly moralize technologies” (Ibid., p. 370). This task also applies to users: “technologies have to be interpreted and appropriated by their users to be more than just objects lying around. Only when human beings use them, artefacts become artefacts for doing something. And this ‘for doing something’ is determined not entirely by the properties of the artefact itself but also by the ways users deal with them” (Ibid., p. 371), for example, through assessment feedback processes during the technology’s design, testing, and debugging phases. Faced with the growth of digital technologies, a number of ethical codes have been developed by interdisciplinary experts (Argandoña 2019b); Morley et al.

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(2019) cite 70 lists of principles, protocols, or codes promoted by governments, companies, and academics that have been published to date. They are based on abstract principles, aimed mostly at designers, who are expected to integrate them in their programs. There is no consensus as to how many and what these principles should be (cfr. Anderson and Anderson 2007). Codes seek to formalize certain values that it is hoped that designers and their organizations will take up and use to guide their work and reflect in their programs (Etzioni and Etzioni 2016, 2017). This is a form of “ethics by design” or “by default,” in which ethics is present from the early stages of development of the software or program; for example, “privacy by design” seeks to convert the principle of privacy into something that is proactive, and not just reactive (cfr. d’Acquisto et al. 2015); the same can be said about “security by design,” “autonomy by design,” “responsibility by design,” etc. Ann Cavoukian (2009) articulated the seven principles of “privacy by design”: (1) proactive, not reactive and preventive, not remedial; (2) privacy as the default setting; (3) privacy embedded into design; (4) full functionality (positive sum, not zero sum); (5) end-to-end security and full lifecycle protection; (6) visibility and transparency, keep it open; and (7) respect for user privacy: keep it user-centric, because the notice and consent mechanisms are not sufficient. The aim is to get the designer to go beyond being a mere technician to become a “decision-maker,” with a broad vision of problems that also encompasses his organization’s and local community’s culture, the regulatory framework, markets, business models, governance structures, the situations and events in which he performs his work, and, above all, the possible uses of the program he is developing. The intention is that he become capable of seeing into the user’s mind, insofar as this possible, and comprehend not just the technical issues but also the ethical problems that the user will encounter. This will be possible if design is a shared, multidisciplinary task in which different viewpoints converge and which is open to discussion by those who have been involved in its development or who will apply it and subject to decision transparency processes and external auditing. When viewed from within the organization, it is understood that the ethics of digital technologies is not something separate from business ethics, communication ethics, or strategy ethics, as all must form a coherent whole. However, this entails advancing beyond “ethics by design” toward a “proethical design” that nudges agents to behave ethically while giving them freedom to decide otherwise, if there are reasons for doing so (Morley et al. 2019). Speed bumps on roads are examples of ethics by design, which force drivers to brake to avoid damaging their vehicle; speed cameras are a form of proethical design, which encourages drivers to slow down but leaves open the possibility of not following the speed limit, not to flout the regulation but because the regulation cannot take into account all possible driving situations. “Ethics that matter are not applied, but produced. It is within our choices at various junctures that our decisions create actions, which in turn have consequence” (Markham et al. 2018, p. 3). “Proethical design” implies a broad vision of ethics that includes the three dimensions posited by Polo (1995): it must be an ethics of goods, norms, and virtues.

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• Human decisions pursue a real or imagined good, such as improving efficiency, reducing costs, anticipating risks, personalizing service, or coordinating decisions better with other agents (Daugherty and Wilson 2018). Personalization is “the ability to provide contents and services tailored to individuals based on knowledge about their needs, expectations, preferences, constraints, and behaviours” (Valleé et al. 2016, p. 186). The technology designer must identify the goods (and evils) that can be created from the early stages of the project. • Ethics is often present in the form of principles or norms that decision-makers must obey and which, somehow, must also be present in machines and programs. Principles are abstract, which makes it easier to agree on their validity but harder to apply, because “it is impossible to standardize or universalize what constitutes the ethically correct actions in technology design and research contexts, not least because we cannot predict what will happen as a result of our choices” (Markham et al. 2018, p. 3); this arises, for example, when there is a conflict between principles (e.g., between privacy and public security). • And, lastly, ethics is present in the agent’s virtues: fairness, integrity, honesty, truthfulness, practical wisdom, etc. A virtuous agent “perceives a situation rightly –that is, notices and takes appropriate account of the salient features of a situation” (Hartman 2008, p. 322); she develops appropriate emotions, because virtues are “dispositions not only to act in particular ways but also to feel in particular ways” (MacIntyre 1984, p. 149), so that she will be motivated to act by appropriate motives, not for fear of reprisals or unpleasant consequences, or for convenience, and, ultimately, she will perform the chosen actions, because virtues “will sustain us in the relevant quest for the good, by enabling us to overcome the harms, dangers, temptations and distractions which we encounter, and which will furnish us with increasing self-knowledge and increasing knowledge of the good” (MacIntyre 1984, p. 219); cfr. Argandoña (2019a).

Conclusions Ethics is “the discipline concerned with what is morally good and bad, right and wrong” (https://www.britannica.com/topic/ethics-philosophy). Its purpose is to contribute to the development of better people, organizations, and communities, with the help of technologies and physical, human, and social sciences. The chief reason why the designer or user of a software must be ethical is because it is a necessary condition for becoming a good designer or a good user, beyond financial profit or any other benefit. There are many arguments for putting ethics aside and using technologies to achieve other objectives, to the detriment of persons. However, these arguments cease to hold water when we consider that we learn from our actions and from other people’s actions. When we make an immoral decision or allow others to make immoral decisions, we are developing capabilities that work against our human dimension and make it more difficult to achieve the goals of a good society. Digital technologies are changing people’s lives and how organizations behave, for the better, in many cases, but also for the worse. Laws and regulations try to

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prevent some of this harm, but they will invariably fall short if human agents do not accept their ethical obligations and make decisions guided by what is good, and not just by what is useful, profitable, socially prized, or pleasant. The thesis of this chapter is that the ethics of the fintechs is not “another” ethics; in fact, it is the same ethics of traditional finance. The person’s dignity, fairness in dealings with customers, equity in offering products or services to users, and respect for persons’ autonomy are duties that all must obey. Thanks to the digital technologies, it is possible to process much greater amounts of information, at greater speed, combining many more variables and relating with more people; the agents’ duties do not change. But the characteristics of fintechs – abundance of data, complexity, relations, speed, etc. – create new demands.

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Ethics for Automated Financial Markets Ricky Cooper, Michael Davis, Andrew Kumiega, and Ben Van Vliet

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective Markets as the Goal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Professional, Organizational, and Industry-Wide Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Professional Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Organizational Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Industry-Wide Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Innovation and Manipulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . What Is a Prudent Automated Trading System? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . What Is an Ethical Automated Trading System? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Quality Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Future of Ethics in Automated Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Artificial Intelligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative Data Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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R. Cooper · A. Kumiega Stuart School of Business, Illinois Institute of Technology, Chicago, IL, USA e-mail: [email protected]; [email protected] M. Davis Center for the Study of Ethics in the Professions, Lewis College of Human Sciences, Illinois Institute of Technology, Chicago, IL, USA e-mail: [email protected] B. Van Vliet (*) Center for Strategic Finance, Stuart School of Business, Illinois Institute of Technology, Chicago, IL, USA e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_18

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Abstract

Financial markets are now ecologies of trading algorithms. In this chapter, we propose market effectiveness as the ethical goal of automated markets and review the professional, organizational, and industry-wide ethics in this domain. We present criteria for what counts as both a prudent and ethical automated trading system. We argue that an ecology of such systems unfettered by excessive regulation will evolve to promote the effectiveness goal. Largely, this is already occurring. Then, we look to the future, investigating new issues that are arising around the use of artificial intelligence and alternative data sources and possible courses of action. However markets evolve, as long as their effectiveness as we define it increases, the outcome ought to benefit society. Keywords

High-frequency trading · Algorithmic trading · Finance ethics

Introduction Today, automated trading systems drive almost all activity in financial markets. One industry executive suggests that “fundamental discretionary traders [now] account for only about 10 percent of trading volume in stocks (Cheng 2017).” Markets are now ecologies, or even sociologies, of algorithms (see, e.g., MacKenzie 2016). “There is clearly an ethical imperative implicit in the growing influence of automation in market behavior. The ethical dimension of market automation is therefore worthy of serious study (Hurlburt et al. 2009).” Because automation enables virtually instantaneous trading across both asset classes and continents, such study ought to take on a global perspective. By “automated trading systems,” we mean to include high-frequency trading (HFT) systems such as those that implement market-making and various short-term arbitrage strategies, as well as longer-term trading strategies, such as statistical arbitrage and order execution systems. We also include many long-term investment strategies, such as index funds. Exchange-traded funds (ETFs), for example, often make use of automated portfolio rebalancing. The advantage over human trading is that within a few millionths of a second, a computer can receive market data, perform complex calculations, make strategic decisions, and execute trades across hundreds of financial instruments, all with (virtually) no mistakes. This is not a values-neutral endeavor, however. These firms implicitly take a stand on ethical issues when engaging in this activity. While “automated trading systems lack human judgment, their consequences can nevertheless be unethical (Davis et al. 2013).” In this chapter, we discuss the new ethics in electronic or automated trading, not the ethics of automated trading, since we think automated trading is not inherently unethical. We “cannot categorically denounce the practice [of automated trading] as unfair (Angel and McCabe 2013).” What we mean by ethics are those special,

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morally permissible standards of conduct that apply to people engaged in the design, development, operation, and control of what Moor (2006) calls implicit ethical agents (computers). As such they ought to be “programmed to behave ethically, or at least avoid unethical behavior (Anderson and Anderson 2007).” Intentionally or unintentionally, people “bake ethics in” to their algorithms and enabling technologies. Our goal is to present a set of standards for evaluating ethics in automated trading and to consider the future of this subject.

Effective Markets as the Goal Society should be concerned, not with whether any particular market participant – automated or nonautomated, high frequency or low frequency – is happy with their profitability or the structure of the markets, but rather with whether prices in markets are being set as quickly as possible so that the socially beneficial outcomes of markets can occur: efficient capital formation, risk transfer, price discovery, and resource allocation. In Cooper et al. (2016), we argued that the ethical goal, or telos, of automated markets is to generate these outcomes effectively. Specifically, an effective financial market is one that exhibits four characteristics: 1. Voluntariness. Participation in a market is free, not the result of coercion, compulsion, or trickery. 2. Transparency. Data regarding trades and quotes are disseminated in real time so that all traders can make informed decisions (see Bloomfield and O’Hara 1999). 3. Informational efficiency. Observed prices incorporate all relevant information (Roll 1984). 4. Reliability. There is a high probability that the market will adequately perform its purpose in all environments. There is, in particular, a low probability of failure. Market effectiveness is a more robust concept than mere weak or semi-strong form efficiency posited by Fama (1970). The efficiency of a market may vary over time (see, e.g., Lo 2004). It could be efficient at one time and become inefficient at the next. This may happen, for example, when there suddenly are no offers to trades (i.e., a liquidity crisis). Often researchers attempt to measure a market’s average, or interval, efficiency over a period of time. But, instantaneous efficiency is of greater interest. By including reliability as a characteristic of effectiveness, we imply that an effective market is consistently, or “almost always,” instantaneously efficient and technologically stable. This notion is similar to capability as a measure of algorithmic trading system performance which we developed in Kumiega et al. (2014) and further defined in Cooper et al. (2015). A capable algorithmic strategy is one that delivers profits “almost always.” We discuss capability in greater detail in section “What Is a Prudent Automated Trading System.” A market that is reliable can be counted on to perform its function over time. Technological instability, for example, can threaten reliability. This is important because financial markets no longer consist of groups of people convening on a

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trading floor, but rather of the technological networks designed to facilitate the interaction of automated agents. Latent hazards may be embedded in this design, and design flaws may trigger cascading failures. Some failures may propagate across the market network, as in the case of the flash crash of May 6, 2010, while others may cause a firm to fail, as in the case of Knight Capital. Poor market reliability may be reflected in prices, higher bid-ask spreads, lowered informational efficiency, or higher implied volatilities (see Kumiega et al. 2016). Highly reliable system designs minimize distortions. Some issues to consider when evaluating system design are: What are the critical performance variables in this new perspective? Efficiency still matters, but technological failure rates do, too. What counts as “almost always”? In quality management’s Six Sigma methodology, the threshold is one error in 3.40  10 6. Is this an appropriate standard for automated financial markets? Should it be higher or lower? Efficient prices certainly ought to be unencumbered by price and risk distortions arising from design flaws. Then prices will correctly reflect the sum total of information through the competition of algorithmic strategies. As a threshold for “almost always,” a natural candidate is that efficiency ought to hold for almost any demand on liquidity (i.e., order flow in one or the other direction). This would also be true if we said “almost always” with respect to points in time. But, critically, this misses order flow as an important parameter. Order flow is what determines the rate of information input into the market, and we might assume that hazards are more likely triggered during extreme liquidity or information events. Put the other way around, an effective market is one where there is “almost never” an information event (i.e., order flow event) that pushes changes in prices to be serially correlated, a measure of inefficiency. What counts then as “almost never”? Is this the Six Sigma threshold, or is it a probability – 90% of the time, 95%, 99%? The level of market effectiveness can be measured using such a threshold, and this ought to matter in finance ethics. Providing correct or fair prices at every instant is the unique purpose of continuous, automated financial markets. Things that make such markets more effective ought to be thought of as “economically ethical activities.” All else equal, such things should be allowed. This is true of HFT. The academic literature often evaluates HFT in terms of its impact on liquidity, volatility, and size of the bid-ask spread. The preponderance of the evidence supports the claims that HFT increases liquidity, decreases volatility, and decreases the size of the bid-ask spread (see, e.g., Hasbrouck and Saar (2009), Brogaard (2010), Hendershott et al. (2011), and Hendershott and Riordan (2013) among others). Orders that demand liquidity have less short-term price impact on highly liquid markets (see, e.g., Chordia et al. (2002, 2005)). Li et al. (2018) find that the activity of HFT traders lowers the effective spread paid by lower-frequency traders. Blocher et al. (2016) find that HFT’s intense jockeying for queue position at the correct price causes lower bid-ask spreads. Thus, fewer trades occur at temporarily inefficient prices. Further, lower trading costs by way of smaller spreads facilitate the flow of information which increases efficiency. The longer it takes for information to be incorporated into the price, the more trades will execute at the stale, or wrong, price (although that wrong price will be favorable for one side of the

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trade). All of this supports the argument that HFT enhances market effectiveness (as we have defined it), because it increases the ability of the market to provide for transactions at the correct price reliably, or “almost always,” as long as these systems are able to control any latent hazard before it propagates across the market network. As an evolving ecosystem of algorithmic trading strategies (see Farmer and Lo 1999; Farmer and Skouras 2013), the presence of more such strategies in the marketplace makes the ecology better at processing information and more resilient to external shocks. Instabilities can develop when there is a lack of diversity. The ability of a financial market to perform its function reliably (i.e., “almost always”) depends upon sufficient diversity to ensure the appropriate supply of efficiency services at all times so that information processing occurs continuously. An effective market is one that is informationally efficient, where in all market contexts, trading strategies continuously supply the level of information processing necessary. Much like any other industry, the market will determine correctly the appropriate supply of efficiency services and diversity of trading strategies, unless external forces or barriers prevent it from doing so. Regulators, for example, may prefer fewer trading strategies, not more. Regulation is fundamentally a reduction of variety. This is antithetical to information transmission, which is the purpose of markets. Society ought to desire effective financial markets because they promote socially beneficial outcomes, which in turn promote economic growth and attract participation. What we are primarily concerned with, however, are the duties of people engaged in the design, operation, and maintenance of automated trading in such markets insofar as their activities impact effectiveness.

Professional, Organizational, and Industry-Wide Ethics Trading no longer consists of the individuals that classic financial economic theory contemplates. Rather, automated trading is done by teams that trade-off cost, time, and performance heuristically. It is an organizational endeavor. Success is determined not by the acumen of (microlevel) individual traders (or for that matter, portfolio managers), ethical or otherwise, but rather by the quality of the computerized systems built by (meso-level) interdisciplinary teams. The goal of such teams is to become the high-quality, low-cost supplier of information processing and/or liquidity services to the financial markets. To accomplish this, traders (or portfolio managers), programmers, mathematicians (known as quants), and network engineers work together to design, build, operate, and improve these systems, so that no one person is responsible for their performance. It may be unclear who is responsible if a latent hazard is realized. “This kind of blamelessness provides insufficient protection for those who might be harmed (Allen et al. 2006).” Harm in this case comes both directly, in the form of financial loss to the firm itself or external market participants, and indirectly, in the form of society’s loss of confidence in financial markets, which could reduce economic growth. In the next section, we review our discussion of professional, organizational, and industry-wide ethics in automated trading in Davis et al. (2013).

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Professional Ethics Professional ethics are those morally permissible standards of conduct everyone in that profession (at their rational best) wants everyone else in the profession to follow even if following them would mean having to do the same (Davis 2002). While ethics of one’s profession should guide behavior of a professional, in financial markets fear and greed are thought to get in the way of rational thinking and tend to encourage ethical violations (see Sims 1992). But, fear and greed are at most only part of the problem. In addition, each of the professions represented on the automated trading team has its own ethics, and this affects how members of those professions understand their respective roles and how they work with members of other professions. For example, traders, quants, and computer engineers each perceive risk in ways the others do not. While all these professions are represented in any important decision concerning trading systems, as automated trading has matured as a discipline, increasingly a single person may perform more than one role or at least bridge roles. Traders. Traders focus on profit opportunities. In the past, traders met on trading floors to transact face-to-face and foster orderly markets. But, automated trading creates an anonymous environment. Traditionally, the work climate among traders has been instrumental and independent, meaning, essentially, that they are egotistical and, in the sense of Adam Smith, ignore the interests of others. In free market economies, society is thought to benefit from their collective self-interested competition (when regulated enough to prevent market failure). Quants. Quants focus on mathematical constructs, logical algorithms, and data. Ethics in this sphere is largely superseded by adherence to mathematical truth, but also a law and order climate where exchange rules and governmental regulation define boundaries. In practice, however, quants may cross an ethical divide when converting “positive” research (i.e., research where the goal is truth whatever the consequences) into normative business logic and algorithms (where the goal is profit). Theoretical assumptions can have harmful implications if they do not hold in the real world. Hurlburt et al. (2009) note that “when quants create and implement a model by focusing exclusively on short-term. . .value, the social and economic consequences of the trades themselves might be completely ignored [allowing for great harm to be done to society as well as market participants].” Programmers and network engineers. Programmers and network engineers focus on low-latency implementation of the support infrastructure and the business logic and algorithms developed by traders and quants. Ethics are embedded in the rules of software and hardware design and testing. Software quality and fail-safe design are part of both academic computer science and professional software and computer engineering. Automation can enable unethical behavior and obscure its source (Ramaswamy and Joshi 2009). Teams of professionals, each bound (in theory) to a different ethical climate, create plausible deniability. For example, traders may care only about profitable trading, not mathematical truth or the appropriateness of theoretical assumptions. Likewise, quants may be uninterested in fail-safe code and control

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mechanisms. Programmers cannot foresee all possible reactions that the quantdesigned algorithms they encode may have in operation. The programmer should not be held accountable to the quants’ or traders’ ethical climate if harm arises as a secondary effect of the system interacting with external market participants (see Allen et al. 2006). So, whose responsibility is it to ensure that automated trading systems are ethically designed, developed, operated, and controlled? Monitoring of market performance of working systems allows people to adjust parameters in real time and make on/off decisions. Might these decisions also be ethics-laden? All these responsibilities rest at least in part with the organization (the automated trading firm).

Organizational Ethics An organization’s ethical climate is its “shared set of understandings about what is correct behavior and how ethical issues will be handled (Sims 1992).” Within an automated trading firm, the ethics of its professions may even conflict, and it may be unclear which perspective should become the shared set of understandings (or whether some compromise or new perspective should). Different firms may arrive at different conclusions about what is ethical, based upon internal politics and compromise. During the flash crash, for example, some trading firms shut down their systems because profiting from what they saw as an operational failure of the market (i.e., propagation of a latent hazard) would be unethical. This reasoning seems to derive from the fail-safe ethics of computer engineers. Other firms chose to continue trading because they believed that providing liquidity (at prices safe for the firm) during extreme market volatility was an ethical duty. Their reasoning seems to derive from the traders’ ethics and their role in fostering orderly markets. This illustrates the lack of industry-wide agreement as to what ethics should prevail in subsequent similar situations. Over the ensuing years, some of these issues have been worked out – as we will explain later.

Industry-Wide Ethics An industry-wide ethical climate can determine how individual organizations and professionals perceive problems, obligations to external stakeholders, and formal standards. In financial markets, the industry-wide climate has been one of “law and order,” driven by exchange rules, government oversight, and penalties designed to reduce differences in the way firms operate. Nevertheless, methodological plurality is an important component of competitive price discovery, and organizational independence is rightly a widely held ideal. Maximizing diversity optimally prepares the market for any contingency, thereby enhancing effectiveness (see Ashby 1991). By culture, we simply mean a particular way of doing certain things that a group shares. This definition applies not just to nations, geographic regions, and professional groups within organizations but also to individual markets.

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The culture of one market may conflict with that of other markets. For example, equity markets have an uptick rule for short selling, where futures markets have no such rule. Even within equity markets, there is ethical conflict. The Investors’ Exchange (IEX) brands itself as “fairer” than other stock markets due to its unique matching rules. Likewise, what is ethical (or even now legal) in one country or geographic region may be unethical in another. Europe has different ethical ideas than the USA. Because automated trading systems trade across markets and across geographical jurisdictions, discussions in the industry have moved toward regulatory harmonization and a shared ethics. In the aftermath of the flash crash, some stock exchanges sought to rectify (what they considered) unfair trades that occurred during the event by “busting trades.” However, some automated traders had made those trades in good faith and had immediately taken other positions in other markets to reduce risk. Busting the initial trades after the fact left some firms’ with unhedged positions, leading to potentially large losses. Going forward, those automated traders have a disincentive to continue providing liquidity during similar events. This incentive would certainly reduce market effectiveness precisely at a time when it is most needed. Yet, there is no industry-wide agreement concerning what standard should prevail next time.

Innovation and Manipulation One of the problems facing markets today is the rapid pace of innovation. The raw materials of automated trading – math, data, and technology – are never stable. They change rapidly as firms search for competitive advantage. The inventions of new technologies, new execution venues, new strategies, new data sets, and new mathematical techniques (such as machine learning) are continuous. Regulation cannot keep up, nor is there much time for ethical reflection. However, as long as innovations promote market effectiveness, bad effects ought to lessen. Nevertheless, other things remaining equal, regulators ought to (and now do) attempt to prevent intentional or reckless defrauding by manipulation of market participants. In Davis et al. (2013), we divide intentional and reckless manipulation into strategies and technology, resulting in four categories – A through D – as in Fig. 1. In box A of Fig. 1, a firm intentionally develops a manipulative automated trading system. In box B, a firm deploys an automated trading system with a reckless strategy (i.e., one not allowing enough time for testing), even though its technology Root Cause Strategy Technology

Manipulative Outcome Intentional A C

Fig. 1 Breakdown of market manipulation

Reckless B D

Prudence Q

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is high quality. Traders and quants design a business logic that is poorly thought out and may behave in unexpected ways. We assume the programmers of the system are aware (at least in some way) of the potential adverse impact of such conscious negligence. In box C, the strategy may be prudently researched and tested, but malicious technological implementation introduces manipulation. For example, programmers could remove pre-trade controls to decrease latency. In box D, reckless coding could introduce bugs that cause unexpected performance. Whatever the source of a manipulative outcome, the ethical failing was not in the real-time conscience of a trader but rather in the weeks or even months of conscious, teambased research and development of a complex system. No surprise, then, that what counts as manipulation in automated trading has been much debated and is still unclear. In their prosecutions of algorithmic traders, regulators often use the general prohibition of market manipulation and its central concept of “artificiality.” Certain algorithms may create artificial prices, it is argued, and the creation of artificial prices counts as box A manipulation. However, this line of reasoning has met with varying degrees of success. Spoofing is the primary example. It occurs when one algorithmic system is designed to place limit orders not with the intent of taking a position but rather with the deceptive intent to trick other competitors’ algorithms into placing disadvantageous trades (see Angel and McCabe 2013). This deception, some argue, leads to artificial prices. This line of reasoning has led to some convictions but also some acquittals. However, in the absence of a guilty plea, prosecutors typically depend on arbitrary thresholds and circumstantial evidence as proxies for intent. In Cooper et al. (2016), we present several arguments against this characterization of algorithmic deception as manipulation. In another example, US CFTC v. Donald R. Wilson and DRW Investments LLC (2018), regulators argued that the trading firm electronically placed orders with the intent to move prices in their favor. Thus, “intent is [as the plaintiff argued] the transformative element for market manipulation.” The court declined to accept this “intent-based approach to assessing [artificiality].” Mere intent does not prove artificiality. In a harshly worded judgment in favor of the defendant, the judge wrote that the regulator’s theory “has no basis in law or logic” and felt it necessary to explain to the regulators “what markets are for.” The ruling averred that any artificial prices in free markets will naturally be subject to market discipline. This is “how markets work.” This ruling supports the idea of quality arbitrage, which we will discuss in section “Quality Arbitrage.” Regulators are better off avoiding such micro-oversight of individual strategies, allowing the competitive ecology of algorithms to evolve unfettered. Regulators would do better to tolerate an otherwise unsavory practice (or merely discourage it through quote-to-fill ratios) rather than prohibit it outright, if such prohibition would discourage the evolution of trading strategies. Regulation ought to encourage firms to develop systems that promote market effectiveness. Such systems fit in box Q in Fig. 1 and represent prudent automated trading. Prudence, or the Prudent Man Rule, has long been an ethical standard in finance. But, what specifically constitutes prudence in automated trading? This is where innovation-lagging regulation ends,

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and the new ethical territory begins. We note that the obligation now is on requiring trading firms to prove prudence in their research, development, operations, and control processes.

What Is a Prudent Automated Trading System? Traditionally, the concept of prudence applies to intermediaries and fiduciaries, agents to whom others entrust their money. “Prudence demands adherence to processes that reliably produce strategies with desirable characteristics, including monitoring results in light of the strategy’s purpose, managing risk, and minimizing the possibility of large losses (Cooper et al. (2016) summarizing Longstreth (1986)).” Organizations that trade for themselves (rather than acting as fiduciaries) typically want to be prudent with their own capital. That is, they want to act as they would act when at their rational best, whatever anyone else does. Prudence is an organizational virtue even for firms that are not fiduciaries. As we have argued, the interfaces between professional ethics can cause varying and potentially inappropriate or imprudent organizational decisions. Management may be forced to make trade-offs between competing ethical perspectives and the sources of competitive advantage. Such trade-offs are fertile ground for cognitive biases and scenarios of blamelessness. A rigorous and interdisciplinary approach by management across the trading system life-cycle can prevent ethics lapses. For example, a robust regime of software and strategy testing (almost inevitably) avoids performance in boxes B and D. For this reason, we have proposed in Cooper et al. (2016) that the concept of capability developed in Kumiega et al. (2014) and Cooper et al. (2015) can serve as a proxy for prudence (i.e., box Q). Capability requires satisfying three criteria. An automated trading system must: 1. Operate in statistical control at all times with respect to its critical performance measures and have in place real-time monitoring to ensure containment in the event it operates outside of control. Satisfying this criterion should prevent boxes B and D manipulation from occurring. 2. Have acceptable probability and severity of loss (i.e., reasonable risk). This should keep boxes A and C manipulation within acceptable limits. 3. Be able to reliably, or “almost always,” generate revenue in excess of its costs over a period acceptable to its investors. If these criteria are met, then the automated trading system is unlikely to harm the firm or external market participants, and it possesses favorable risk-return characteristics relative to its operating costs. We believe that this framework should satisfy any reasonable definition of prudence. Further, a financial market consisting of such automated trading systems is essential for market effectiveness. A market

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ecology of capable trading systems would continuously evolve to eliminate informational inefficiencies without the fear of out-of-control systems, market mishaps, or improper risks. However, just because an automated trading system is prudent does not mean it is necessarily ethical.

What Is an Ethical Automated Trading System? In Cooper et al. (2016), we also present three criteria for any automated trading system to be ethical (i.e., such that every participant, at their rational best, would want every other participant to act even if that meant having to do the same.) We believe these criteria are individually necessary and jointly sufficient for an automated trading system to be ethical: 1. The trading system should be prudent as defined in section “What Is a Prudent Automated Trading System.” 2. The trading system should not block price discovery. We express this in the negative since we cannot say that a trading system must have good intentions or even that it sends orders that add good information. Rather, if an order can be responded to, then the market will process the information that system adds. That is to say, the regulator’s position should not be to decide which information is fit for market consumption. That is the job of the market. The market will discipline bad intentions and bad information. Effective markets only require that one market participant not interfere with the ability of other market participants to add to their own information. For example, quote stuffing (see Angel and McCabe 2013), where one trader attempts to flood the market with order messages so as to block competitors’ messages, clearly violates this ethical criterion (not block price discovery) and should be prohibited. Likewise, wash trading, where a firm trades with itself to create the illusion of activity, is unethical and rightly prohibited because the prices at which these trades occur are not part of competitive price discovery. 3. The trading system should not circumvent transparent price discovery. Thus, the use of dark pools or hidden orders cannot be part of an effective financial market. Such mechanisms hide information, create prices that do not reflect all available information, and may discourage participation by those left in the dark. If all three of these criteria are met, then the automated trading system is unlikely to impair the transparency of the market, hinder the attempts of other market participants to add their own information, or otherwise prevent the market from achieving effectiveness in the most expeditious and cost-effective manner technologically possible. Because the markets and technology are so dynamic, markets ought to continuously evolve toward increasing effectiveness. New strategies and technologies are applied; old ones are discarded. Some succeed; some fail. We call this process quality arbitrage.

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Quality Arbitrage There has been much discussion of the ability of automated trading systems to “game” the market. “One smart computer may attempt to take advantage of the order placement strategy of another not-so-smart computer with the possible effect that prices are driven away from equilibrium (Stoll 2006).” The idea of using computers was first put forward as a way to increase the quality and fairness of the markets, since humans could and did obtain unfair advantages in the trading pits (see, e.g., Markham (1989) for an in-depth discussion). Good traders have always made money off bad traders, both in the pits and on screens. This is not a bad thing. Using speed to construct a Dutch book, for example, is not unethical. Other firms have equal opportunity to construct similar books, if only they choose to invest in the infrastructure to capably compete. Today, quality arbitrage occurs when better (or higher-quality) trading systems gain at the expense of worse (or lower-quality) ones. Good systems survive; bad systems die. Over time, competition should increase both the quality and the diversity of trading systems in the market ecology, which should promote effectiveness and mitigate systemic risk. As for any disequilibria created, other systems should arise (relatively quickly) to take advantage of such systematic opportunities and push prices back in line. Those trading systems that are unable to profitably supply information processing and/or liquidity to the market reliably, or “almost always,” should eventually die and be replaced by those that can. This is not to say that quality arbitrage cannot at times be rather unsavory. But quality arbitrage results in markets that should be increasingly effective. Since we first published these ideas, time has largely shown this claim to be correct. As the high-frequency trading industry (in particular) has matured, there has been significant consolidation. Much like any other industry, the low-quality and high-cost firms have died or been consumed by more fit competitors. Further, lower-frequency trading firms have purchased higher-frequency ones for their superior technologies and products. What we see today is an industry evolving toward firms of higher quality and lower costs. The extent of this evolution toward increasing effectiveness can be measured. In Kumiega et al. (2016), for example, we present data that shows market reliability has been improving. A “quality revolution” in financial markets is well underway and has been since roughly 2010. As an example, consider this back-of-the-napkin calculation regarding market hazards, or mishaps, that is, unplanned events resulting in market disruption. Assume that a large exchange handles over 300 million incoming order messages per trading day, mostly from automated traders. If there are (say) five such exchanges in the world, the total number of messages a year would be something around 3.8 trillion. From a scan of news reports from 8/1/2011 to 7/31/2012, we count 31 mishaps worldwide. If a single mishap contains 10,000 bad messages, then the total number of errors is about 300,000 messages a year. The error rate then is 300,000 / 3.8 trillion = 8.20  10 7. If we compare this rate against the Six Sigma threshold discussed earlier, automated markets exceeded this threshold by an order of magnitude even 7 years ago. In the time since, far fewer such mishaps have occurred, and the number of zero-mishap months has been

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increasing. We believe this demonstrates that the ethical climate in the financial industry is improving. Financial markets are getting more reliable and, therefore, more effective. Yet regulators still feel it necessary to intervene in the quality arbitrage process in the form of “speed bumps” or transaction taxes which, all else equal, only serve to protect poorer-quality systems and hinder the evolution toward increasingly effective markets.

The Future of Ethics in Automated Trading Automated trading is here to stay, though its practice is constantly evolving. New instruments, such as cryptocurrencies, come (and maybe go). New exchanges are being created and old ones are dying. New regulations are being enacted. This evolution is especially apparent with the new, alternative data sources that are now available and the greater autonomy that new techniques, such as machine learning, grant implicit ethical agents.

Artificial Intelligence In financial markets, the fear is that an otherwise ethical trading system could “learn” its way across some boundary. A trading system could learn to spoof or engage in wash trades or attempt to cause a flash crash. In a well-known study, Facebook and Carnegie Mellon scientists developed a poker bot that learned to bluff, with very profitable results against some of the world’s top players (see Vincent 2019). As one of the developers of the “poker bot” said, “the AI doesn’t see bluffing as deceptive. It just sees the decision that will make it the most money in that particular situation.” It’s reasonable to think that this kind of thing could happen in automated trading. The poker analogy is hard to dismiss by those who lack an understanding of the game-theoretic logic used by most trading algorithms (see Dalko and Wang (2018) as one example). Both in theory and application, the analogy holds. Even a cursory investigation into the very foundations of financial economics itself shows that the theory of expected utility arises from the attempt to describe people’s preferences regarding gambles. In a rare peek at industry practice, Moffitt (2017) discloses that many researchers in the industry that design trading systems view them as complex games of chance. But, there are behavioral aspects to both gambling and trading, and an AI-driven trading algorithm may learn to exploit these just as in the poker bot did. AI-driven trading algorithms will, all else equal, learn to bluff or spoof. Identifying this type of behavior in actual trading is already difficult and will likely get more so. What should the firm’s obligations be to prevent spoofing and to respond should it happen? What type of controls ought to be in place around AI systems that learn every minute of the day? How would the firm continuously test the system to ensure that it does not cross some boundary? Would such AI inventions count as market manipulation? Further, in a market ecology of AI algorithms, what if systems learn to bluff each other? Might there be coordinated behavior, or positive feedback

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loops, that lead to loss of liquidity (i.e., liquidity evacuation) or flash crashes? The academy can contribute to the resolution of these questions, but we believe ignoring the gambling approach of both economic theory and industry practice is inconsistent with the goal of increasing market effectiveness.

Alternative Data Sources As technological speed has waned as the source of competitive advantage, the additional costs of squeezing out even more nanoseconds can no longer be justified, and firms have refocused on the search for informational inefficiencies. However, the gains from the mathematical low-hanging fruit have largely been arbitraged out of the market. Automated trading is now very much about data – who has it and who doesn’t – and the use of machine learning to extract signals from it. It’s not just the usual financial data like past prices or corporate 10-Qs. Alternative data, those data coming from nontraditional sources, are becoming increasingly important. Some such data is structured data captured from transactions, mobile devices, and sensors, but much of it is unstructured, like news, Facebook pictures, satellite images, Twitter feeds, online reviews, and the vast amounts of data on companies, industries, and economies accessible over the Internet. Sentiment is often embedded in these data. This is where competitive advantage now lies, and this is where new ethical questions also lie. For example, does the use of certain private data sets, either bought or gleaned from sources available only to the firm, constitute trading skill or an unfair advantage? This question is complicated by the fact that what counts as public data in one country may not be considered public in another.

Example Scenario 1 All market participants have access to all the data. Some is freely available, such as corporate financial statements, some is available for a (sometimes high) price, and some may available only to firms with specific competencies. If the use of expensive or hard-to-get data is defined as skill, then using such data is arguably ethical. However, if it is thought of as being unfair, it could be unethical. Could it be, though, that the truth lies somewhere in the gray area in between? Here is an example. Using machine learning techniques, skilled data scientists attempt to predict corporate fundamentals (sales, earnings, etc.) and may embed these predictions in their automated strategies. It is not the mathematics of a predictive algorithm that gives rise to an ethical dilemma. The algorithm may be widely known. Rather, the accessibility of the data used to create these predictions is somewhere in the gray area. The data may even be superior to the data available to the corporation itself. The data may be better than what we traditionally think of as insider information. Should it be deemed public information because it was derived from publically available data? How is such a scenario possible? More than 10 years ago, a corporation’s knowledge of its product sales or their production costs was superior to publicly available information. This is why insider trading was prohibited. Today, however,

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it is altogether possible that some trading firms have more data on a corporation’s sales and costs than the corporation itself – and before the corporation has its own less-complete data for the same period. These data may be collected directly from customers, the government, or Internet sources. Car sales, for example, are reported in real time to the government, and this data is for sale on the Internet. The same is true of house purchases. When it comes to international trade, the location of ships is known and published in real time on the Internet. It’s altogether possible that some trading firms have developed expertise in using such publicly available data to predict, for example, oil prices, inventories, and other factors that drive stock prices. The average investor has no such expertise. So, is trading on this information just good trading or taking an unfair advantage?

Example Scenario 2 Some firms gather data on all sorts of business activity. Amazon has data on product sales. Google has data on Internet searches. Data vendors have data on who is buying what data. Twitter has data on all the tweets about various products and stocks. Some of this data may be relevant to predicting stock prices. May Amazon use its internal sales data to place trades on companies whose products are selling well? May Amazon sell this data? May Google use its data on the number of searches for “IBM” to predict the price of IBM? May Twitter extract the sentiment from all tweets on Apple to predict the price of Apple? If a firm can collect information on (say) 50% of a firm’s sales due to the email traffic running through its servers, this can be a highly predictive number. What about Web page traffic? Yahoo! has data on how many people pull up price charts on stocks. May vendor firms that sell historical price data also sell their data on how many of their customers have accessed the price of some call option? They have the data. Should they trade on this data? Should it be unethical for them to do so? If this data is thought to be material and nonpublic, then it should count as insider data. Who decides what the standard is? Should the standard consider the necessity to combine various data together and use machine learning to extract the “nonpublic information”? These are already live ethical questions, and the amount of data is only going to increase in the future. Possible Courses of Action The accessibility of new data sources along with the learning ability of machines to process data quickly to make predictions and automated trading decisions is a gray area. These information “insiders” have an advantage over the general investing public. Does the playing field need to be levelled here? If so, how? Regulators, at least, are attempting to address the issue. The European Union has enacted the General Data Protection Regulation (GDPR), which aims to give individuals control over their own private data. This is a first step to ensure that people are not (unwittingly) giving away their data on purchases and web site visits for free when that data can be used to trade against them in financial markets. Another potential step, we believe, is to create a register for commercial data, through a regulator such as the SEC or CFTC. Every firm that uses public information gathered on the Internet or government sources ought to be obligated to disclose those sources being

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used in their trading systems. This level of transparency ought to create a more level playing field and enhance market effectiveness. These are regulatory remedies, however, not ethics. Regulations cannot keep pace with innovation in financial markets. New ethical guidelines, such as those proposed in this chapter, ought to guide the behavior of firms engaging in automated trading. In principle, promoting market effectiveness is a coherent framework. However, the specifics of permissible machine learning and alternative sources of data remain open questions. We suggest that defining the rules about transparency of privately acquired data is important. The algorithms used to analyze the data are widely known and taught in universities. The technologies for low latency (quick response) are increasingly commodities. Firms that voluntarily pay for data scientists and technological infrastructure earn better returns. That is good trading. But, the data itself is often opaque, inaccessible, or prohibitively expensive. In the future, only a few trading firms may have all the data. Such concentration of expertise reduces variety and does not support the goal of market effectiveness.

Conclusion Financial markets constantly evolve. In this paper, we present a framework for ethics in automated trading. Using the concept of market effectiveness as the goal, we investigate what should be the professional, organizational, and industry-wide standards in modern financial markets. By and large, regulation runs the risk of preventing quality arbitrage, where the best innovations survive and the weak die. Excessive regulation prevents the market from evolving in the direction of increasing effectiveness. Our framework provides criteria for prudence and ethicalness in the design and operation of automated, especially high-frequency trading systems. We believe it is reasonable to assume that a market consisting of such systems will reliably generate the highest level of market effectiveness given dynamic and complex technological and economic environments. The most pressing ethical questions concern access to various nontraditional data sets. If one very small group of market participants has access to data that other groups do not, at any price, then the transparency, and therefore the effectiveness, of automated markets may decline. This sort of market concentration, we argue, should be unethical.

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Ethics in Education for Sustainable Finance Challenges Toward Long-Termism in Japan and Europe Jutaro Kaneko

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current Practices in Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Approaches by the National Authorities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Approaches by the Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current Practices in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Central Council for Financial Services Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Official Moral Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Challenges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . European Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Japanese Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common Challenges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

In order to achieve the UN’s SDGs which was adopted in 2015, demand for affluent private investments compatible with ESG factors is growing in international communities. Given the lack of evidence on higher performance and cheaper cost of green financial products than conventional products, to change peoples’ mind-set toward long-termism is a prerequisite for developing sustainable finance, so that they consider benefits of future generation and the people outside their own communities with a mind of altruism, when making financial decisions. In this respect, ethics can play key roles. Financial education needs to be upgraded to incorporate it. “Financial education for sustainability” is a very J. Kaneko (*) Japan Center for International Finance, Tokyo, Japan Institute for International Trade and Investment, Tokyo, Japan e-mail: [email protected]; [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_13

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new concept. However, there are early attempts to link financial education with sustainable finance in Europe, while lack of active involvement of EU institutions is an obstacle for such activities to spread. On the other hand, Japan has a centralized platform for financial education and formalized ethics classes at schools, although relatively low level of the financial literacy among the citizens needs to be overcome. This chapter explores to clarify the standpoints of the two jurisdictions for achieving this new social challenge. Academic literature directly related is limited in this area. That said, valuable insights and implications can be derived from classic and contemporary work on ethics in finance, in the sense that they touch upon importance of moral education. How to incorporate altruism in traditional financial education is an imperative to establish a firm basis for developing sustainable finance on it. Keywords

Financial education · Ethics · Long-termism · Sustainable finance · Altruism · ESG · SDGs · Moral education

Introduction Concern on environmental, social, and corporate governance issues, known as “ESG” collectively, has been growing rapidly all over the world since the signing of COP’s Paris Agreement which stipulated targets such as keeping rise of average global temperature well below 2  C in comparison with preindustry revolution era and adoption of UN’s sustainable development goals (SDGs) both in 2015. It leads to developments, including increasing issuances of financial products such as green bonds and divestment from coal-related enterprises through a new financial behavior mindful of ESG factors. (A green bond is a designated bond intended to encourage sustainability and to support climate-related or other types of special environmental projects.) The EU committed to reduce the emission of carbon/greenhouse gas by 40% in comparison with the level of 1990 by 2030 in the community in alignment with the Paris Agreement. (At the time of this writing, Ursura von der Leyen, President-elect of the European Commission, is committed to even more ambitious target of 50% emission reduction.) In order to achieve this, the EU decided to utilize as much private capital as possible for projects to develop environment-friendly technologies and infrastructures along with public funds, based on its estimation that additional investment of around 200 billion euro is necessary annually. This is the mother of demand for a new concept of “sustainable finance.” (The United Nations launched a project of Principles of Responsible Investment in 2006 based on the similar perception, which resulted in six high-level guidelines to accommodate ESG factors in investment decision-making.) The European Commission initiated its investigation on potential roles which financial services could play with establishing a high-level expert group (HLEG)

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(The group was consisted of 20 experts from different industries and academia.) on sustainable finance in 2016. HLEG published a final report titled “Financing a Sustainable European Economy” in January 2018. The HLEG’s final report shows a vision that the EU should aim to be a global leader in the area of financial services to support sustainable economy and recommended to the European Commission eight priority work areas, including development of a classification system of economic activities in accordance with ESG factors (taxonomy), enhancement of corporate disclosure requirements, and review of prudential regulations. The HLEG’s final report clarifies that long-termism which prioritizes long-term interests over short-term interests is indispensable to realize a sustainable economy. Based on this conviction, it repeatedly emphasizes importance of enhancing financial education for all social constituents, so that private capital will be invested in sustainable manners (HLEG 2018). The definition on long-termism is not necessarily clear, but it may be interpreted as a long-term value which can accommodate other elements than financial return. As such, the author finds “mental satisfaction” pertinent. In March 2018, the European Commission published an action plan on sustainable finance which lays out concrete policy areas to be completed within a couple of years, based on the recommendations by HLEG. The action plan shows three goals: (1) to direct capital flow to investments in alignment with ESG factors, (2) to manage financial risk which arises from such challenges as climate change and depletion of natural resources, and (3) to promote transparency and long-termism in financial and economic activities. For these purposes, the action plan presents 27 work items under 10 policy areas, including establishing an EU taxonomy, creating standards and labels for green financial products, and developing sustainability benchmarks (European Commission 2018). In October 2019, the European Commission announced that it launched an international platform to promote sustainable finance together with several other financial regulators in the world. The European Commission’s action plan doesn’t explicitly incorporate work related to financial education. Although the reason is not explained, it is rational to interpret that the European Commission regards financial education as a matter of the member states’ discretion in the light of “Principle of Subsidiarity” which is stipulated in the Treaty of the European Union (TEU). (Based on article 5 (3) of the TEU, in areas in which the European Union does not have exclusive competence, the principle of subsidiarity defines the circumstances in which it is preferable for action to be taken by the Union, rather than the Member States.) The fourth goal of UN SDGs is to ensure inclusive and equitable quality education and promote lifelong learning opportunities for all. So far, usefulness of financial education has been evaluated mainly in the context of consumer/investor protection and financial inclusion all over the world. Basic literacy on finance is a prerequisite also for promoting sustainable finance. That said, financial education for sustainability is an academic frontier, and methodologies for it are yet to be established. Also in Japan, the discussion has not formally begun. Yet, the Japanese approach on financial education as an entirety is different from that of the EU. This chapter explores to clarify the standpoints of Europe and Japan for

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achieving this new social challenge and to present a possible way forward through comparison of the current practices and approaches of financial education in the two jurisdictions.

Current Practices in Europe At the time of this writing, the European Commission is still in the process of proceeding with its action plan on sustainable finance. Of the 27 work items, the one on developing a taxonomy is regarded as the cornerstone for the entire action plan. It will also be a foundation for financial education for sustainability. Other work items such as introduction of EU standards and labels for green bonds as well as enhanced disclosure will be beneficial for this purpose in the sense to ensure access by the citizens to information necessary to make decisions in accordance with their orientations to ESG factors. Notwithstanding lack of the taxonomy, European countries are increasing issuances of green bonds to raise fund to finance projects which have positive impact on the climate and/or environment (e.g., development of renewable energy, reduction of CO2 emission). As of June 2019, France has issued the world’s largest amount of green bonds, 13.4 billion euro, since the start of the year, overtaking the USA of which issuance was the largest in 2018. Among the top 15 countries are the Netherlands (3rd), Germany (5th), Sweden (6th), Spain (8th), Italy (9th), Poland (11th), Denmark (12th), and Finland (14th), too (Climate Bond Initiative 2019a). In order for sustainable finance to be truly rooted in societies, every citizen needs to be more than aware of the significance of it. Moreover, it is essential for them to be empowered to change their societies. European system of financial education has not initiated with designated program for this purpose. But, in general, it is well sophisticated and already has a good basis for the new challenge. The approaches ongoing in Europe can be classified in two types, namely, those taken by the national authorities of individual member states and those taken by the financial industries across the region.

Approaches by the National Authorities OECD/INFE regularly conducts surveys on financial literacy of 48,000 students of 15 years old in 15 countries or areas of the world as a part of its Programme for International Student Assessment (PISA). The latest result of the survey which was published in 2016 highly evaluated Flanders region of Belgium and the Netherlands far above the OECD’s average (see Fig. 1 for the international comparison of the result) (OECD/INFE 2016). The Standard & Poor’s, a US rating agency, investigates financial literacy of adults of different countries, in cooperation with the World Bank. According to their latest survey result as of 2015, European countries, especially Scandinavian countries such as Norway, Denmark, and Sweden, are the top rankers among 144

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580 560 540 520 500 480 460 440 China

Belgium

Canada

Russia Netherlands Australia

OECD Average

Fig. 1 Financial literacy among students. Note: The score is average of each country-15 OECD member states excluding Japan participated in the survey- Only region/s participated with China, Belgium and Canada. (Source: OECD PISA 2015)

72 70 68 66 64 62 60 nd Fi n

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m en D

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Fig. 2 Financial literacy among adults. Note: The figures are ratio of those who have certain literacy of the total tested. (Source: Standard & Poor’s 2015)

countries tested (see Fig. 2 for the international comparison of the result) (Standard & Poor’s 2015). OECD published a report concerning approaches for financial education in different countries in 2015. As is pointed out in it, approaches by European countries are divert in terms of authorities’ involvement, etc. (OECD/INFE 2015). In Flanders region of Belgium, for example, financial education is accommodated in school curriculum. The Financial Services and Markets Authority (FSMA) analyzes its

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domestic situation as that the citizens in the region are mindful of environmental problems, partly due to aging nuclear reactors they have, while most of them do not know what to do concretely to address those issues. (Yet, Belgium is known for some activists like Adélaïde Charlier, a student in Walloon region and an initiator of a student movement named “Youth for Climate” which is regarded as a Belgian Greta Thunberg, a Swedish student known for her movement “Fridays for Future.”) FSMA prioritizes education and enlightenment for young generations from the viewpoint of efficiency. (According to Bruegel, a think tank based in Brussels, integrating financial education into early schooling builds numeracy skills more effectively and raises financial awareness (Batsaikhan and Demertzis: 2018).) It plans to establish Financial Education Centre (FEC) around 2019. In the Netherlands, the central bank has the first chairperson of a global network on green finance among central banks and financial supervisors named Network for Greening the Financial System (NGFS). (The network was established in end 2017. Its secretariat is in the Bank of France (Banque de France 2018).) The country launched a national strategy named “Money Wise Action Plan” in 2008 where the private sector and the public sector, including Ministry of Finance, collaborate to enhance financial literacy among the citizens. They annually organize an event for families titled “National Money Week” in elementary schools and an event for employers and employees of small- and middle-sized enterprises titled “Pension3Day,” respectively. The UK launched a public agency specialized for financial education named Money Advice Service (MAS) in 2011 which is in charge of developing strategies for improving financial literacy of the citizens. (The UK notified its intention of withdrawal from the EU, so-called Brexit, in 2017. However, due to repeated failures to adopt the UK-EU agreement on terms of Brexit in the UK parliament, it remains in the EU at the time of this writing.); (Its predecessor was the Consumer Financial Education Body (CFEB) which had been established in 2010.) In 2014, MAS conducted a nationwide enlightenment campaign for the adults on the public pension scheme. The financial industry finances administrative expenses of MAS, and the government extends financial supports for sending lecturers to the schools. In Denmark, financial education is taught as a formal subject like mathematics in the middle schools which is also subject to examinations. The assigned teachers are, thus, obliged to take special training to obtain necessary skills.

Approaches by the Industry Nine industrial associations active in the entire EU launched a common fora “European Platform for Financial Education” (EPFE) in February 2017, aiming at enhancing financial literacy among European citizens, especially the youth and entrepreneurs. The original members of EPFE were BetterFinance, CFA Institute, EUROCHAMBRES, European Banking Federation (EBF), European Banking & Financial Services Training Association, European Fund and Asset Management Association, European Microfinance Network, Insurance Europe, and JA Europe (EBF 2017).

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EBF, a core constituent of EPFE, initiated an annual event named European Money Week for the youth, in collaboration with bankers’ associations in individual European countries in 2015. Over 30 countries participated in the latest and fourth event in March 2018 where lectures at schools, seminars, and conferences were held. EBF hosts a competition named European Money Quiz, as a part of European Money Week, which questions understanding on financial activities of the participants of 13–15 years old. Around 50 pupils who survived the preliminary selections are invited to a final tournament in Brussels. EBF is considering adding questions regarding ESG and SDGs. EUROSIF is an industry organization for improving sustainability of European financial markets. It is engaged in educating their member institutions which are mainly asset managers, so that they increase purchase of ESG-compatible financial products. Behind the European activities regarding financial education, there is a policy intention to improve public image of financial institutions which was severely impaired by the previous financial crisis where massive amount of taxpayers’ money was used to save them. Based on a reflection that the financial crisis was triggered by excessive risk-taking attitude which was rooted in short-termism, the European industry associations are trying to change their mind-sets and educate their clients to take ESG factors into consideration when deciding their financial actions (e.g., investment and saving) from a longer perspective.

Current Practices in Japan A nationwide online survey was conducted by a Japanese public-private organization for financial education in 2016, covering 25,000 individuals aged 18–79 based on INFE toolkit and FINRA survey to the extent possible. The result shows that the Japanese financial literacy is not necessarily high, compared with some European countries, both in terms of knowledge and behavior (see Table 1 for the details) (The survey concludes that the percentages of correct answers of Japan were lower than those of Germany and the UK by 7–9% points, based on comparison with the OECD survey.). In the light of the Standard & Poor’s survey mentioned in section “Approaches by the National Authorities” of this chapter, Japan is ranked at 38th position. On the other hand, Japan’s scores on mathematical literacy have been at the top or close to the top level, according to PISA surveys. Given the close relationship between financial literacy and mathematical literacy, this is somewhat mysterious. One possible explanation for it is that to speak much about money is regarded somewhat unsophisticated in Japanese societies. Another reason may be the general mind-set of the Japanese financial consumers: risk aversion. A strong correlation is indicated in the abovementioned nationwide survey between the share of those who invested in safe assets and the number of incorrect answers to the survey questions. Notwithstanding the relatively modest performance in the international assessment on financial literacy, there are a few advantages unique to Japan for promoting

61

75

Q21-1

Q21-3

Q21-4

(3) Definition of inflation

(4) Risk and return

(5) Diversified investment 60

79

87

47

64

55

77

94

37

61

65

U.K.

Q1-7

Keeping watch on financial affairs

Q1-5

Q1-6

Prioritizing future savings over consumption Avoiding living for today

Attitude (average for five questions)

Q1-4

Q1-2

Q1-1

Settings long-term financial goals

Paying bills on time

when purchasing something

Considering affordability

Behavior (average for five questions)

55

36

45

58

47

85

70

65

Japan

65

49

57

87

61

96

82

82

Germany

Those who chose desirable behavior/attitude

Source: The Central Council for Financial Services Information (CCFSI) “Financial Literacy Survey 2016”

46

43

Q19

(2) Compound interest

66

Q18

67

58

(1) Interest rate

Knowledge (average for five questions)

Germany

Japan

(%)

Correct answers given to questions on financial knowledge

Table 1 Results of the Japanese nation-wide survey in 2016

50

35

43

80

43

89

77

72

U.K.

(%)

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sustainable finance. These are strong initiative in financial education by the authorities and moral education at schools.

Central Council for Financial Services Information In Japan, financial education is a joint task between authorities and industries. Japan has a hub for financial education named the Central Council for Financial Services Information (CCFSI) which was established in 2001 (Its predecessor was the Central Council for Savings Promotion which had been established in 1952.). CCFSI consists of various stakeholders, including government agencies, representatives from the financial industry, consumer fora, and academia. The central bank serves as the secretariat. That Japan has a platform to connect authorities and industries makes a sharp contrast with the situation in Europe. The origin of financial education in Japan can be traced back to the nineteenth century, i.e., in the Meiji era (1868–1912). Eiichi Shibusawa and Yukichi Fukuzawa, prominent figures among founders of modern Japan, both said that financial literacy is essential to an independent and complete life. (Shibusawa, known as the “father of Japanese capitalism,” developed a set of ideas that he called the “unity of morality and economy,” attempting to reconcile Confucian ethics with market capitalism (Sagers 2014: 30).) This is a strong message for promoting financial education. One of the remarkable developments in the period between the Meiji era and the Second World War was that the government took the primary initiative to achieve national goals. In order to catch up with advanced western countries, the government implemented measures to support savings which were regarded as a fundamental funding source for new industries. After the Second World War, the government fostered savings for the purpose of rehabilitating the Japanese economy and putting down vicious inflation (Yoshikuni 2018: 30). In 1952, the Central Council for Savings Promotion (CCSP) was established as the hub to promote savings movement. The CCSP dramatically changed the movement’s nature which could be characterized as being more or less officially sponsored. With the foundation of the CCSP, it came under private control. The CCSP successfully supported the nationwide movement by closely collaborating with local financial services (or savings) information committees (local committees hereinafter). At first, savings were encouraged to promote capital accumulation to strengthen Japan’s economy which was mainly driven by exports. Then, as the economy entered a high-growth period and living standards rose, the CCSP gradually shifted to place more emphasis on the provision of information necessary and useful for a healthy and independent economy not only for individual households but also for the country as an entirety. Lastly, consumer education regarding financial and economic matters related to daily life became the central agenda for the CCSP. To reflect the evolution of its mandate, the CCSP changed its name to the Central Council for Savings Information in April 1988 and further to the CCFSI in April 2001. With the primary aim to enlighten the public concerning the importance of basic financial and economic knowledge pertinent to daily life, the council has been

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engaged in nationwide public relations activities since 1983. These activities have three purposes: The first aim is to disseminate financial and economic information via various channels such as the Internet and newspapers and, by doing so, to help acquire basic financial knowledge related to daily life to foster a healthy household economy. In recent years, many developments have taken place in the financial area, including internationalization. Thus, the general citizens have an ever-greater need of accurate financial and economic knowledge. The second aim is to help draft life plans. Since Japanese society is aging rapidly, it has become an imperative that each member of the society develops a life plan, which contributes to maintenance and improvement of living conditions. From this perspective, the council organizes different events to inculcate the importance of life planning, as well as providing consulting services in this respect. The third aim is to provide pecuniary education. It is essential to teach children the value of money for the sake of keeping a healthy family budget and, as the collective result, ensuring the sound economy of the country. Against the backdrop, the council and local committees have held activities for the young generation, together with schools, families, and communities, in close cooperation with the Ministry of Education, Culture, Sports, Science and Technology (MEXT) in the previous years (CCFSI 2019).

Official Moral Education Japan has developed unique senses or concepts of ethics based on indigenous religion named Shinto which has its roots in Buddhism and Confucianism. “Mottainai” which was introduced by Wangari Muta Maathai, a Kenyan environmental activist who won a Nobel Peace Prize in 2004, to international societies is one of the best-known examples as such. (The term expresses a feeling of regret at wasting the intrinsic value of a resource or object and can be translated as both “what a waste” and “don’t be wasteful.” It has come to be thought of as an allencompassing Japanese term for the four Rs: reduce, reuse, recycle, and respect (Taylor 2015).) Ethics has been built in the Japanese education system in Edo era (A.C. 1603–1868) at latest. Basic knowledge and skills regarding money and finance, such as the calculation of compound interest rates, were also taught in primary schools, which might reflect the legacy of high literacy rates in Edo era, preceding Meiji, when a lot of children from ordinary families went to Terakoya (primary schools run by temples). The Japanese school system has had a weekly class specialized in ethics since the 1950s. “The General Course of Study” in 1951 showed the direction of moral education not as a teaching subject in school but as teaching by whole school education. However, “Report of the Curriculum Council: Establishment of Special Time of Moral Education,” in 1958, pointed out that the whole-school approach did not produce effective education and suggested that a period for moral education should be established formally. The principle was that moral education should be

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closely aligned with other subject lessons, which will supplement, enrich, and integrate its own instruction. This became the prototype of the present formal moral education in Japan. A main underlying element of introduction of the mandatory moral class was a bullying problem in the Japanese schools. According to a UNICEF’s survey “Child well-being in rich countries” in 2013, Japan ranks at 12th position among 30 advanced economies investigated, in terms of ratio of children aged 11, 13, and 15 who reported “being bullied at school at least once in the past couple of months” (UNICEF 2013). The figure may not look necessarily high in the international comparison. Yet, some bullied children committed suicide, and then to address this issue became an utmost important social agenda. The statistics show that the annual suicide rate per 100,000 population of Japan was the ninth largest in the world after Lithuania, Hungary, Slovenia, and Latvia from the EU (The Japanese data is as of 2004.) (World Health Organization 2019). In Japan, suicide borders on a crisis level, although the government has been actively intervening to decrease the suicides among the vulnerable (see Fig. 3 for the development of the number). It is the leading cause of death in men among the ages of 20–44 and for women among the ages of 15–34 (World Population Review 2018). Japanese pupils and students committed the largest numbers of suicide in the world. There were four pillars of moral education practice and contents in formal school education: (1) basic lifestyle and behavior, (2) moral mentality and judgment, (3)

180 160 140 120 100 80 60 40 20 0 1999

2000

2001

2002

2003

2004

elementary school pupils

junior high-school students

high-school students

total

2005

Fig. 3 Suicide numbers of Japanese pupils and students. (Source: Ministry of Education, Culture, Sports, Science and Technology)

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expansion of personality and creative lifestyle, and (4) ethical attitude and practical motivation as member of the nation and society. In 2008, the Central Council for Education, the ad hoc advisory committee for MEXT, concluded that Japanese children have a poor mind-set in terms of respect for life and self-esteem and their normative consciousness is becoming lower and their inadequate social skills prevent them from forming good human relationships and participating in group activities. The present official curriculum guidelines, specifying the minimum contents of the national curriculum, have been designed to enrich and improve moral education for elementary schools since 2008 and secondary schools since 2009 (NIER 2013). Regarding elementary school, moral education aims at cultivating morality as a foundation for helping Japanese citizens develop a proactive attitude which would support a spirit of respect for human dignity and reverence for life at home, school, and other social situations, have a generous spirit, respect traditions and culture, love one’s country and hometown, make an effort to develop the democratic society and state, respect other countries, contribute to world peace and the development of the international community and the preservation of the environment, and have interest in exploring possibilities for the future. With regard to middle school, the objective is to combine regional environmental problems and conservation efforts to trends in industry and regional development, as well as to people’s everyday lives, in order to reflect on the importance of regional environmental conservation efforts in the building of sustainable societies. Concerning high school, moral education is expected to establish a broad perspective on the creation of sustainable societies that can be asserted and shared by peoples of the world, by having students define appropriate topics on the characteristics and issues of the contemporary world, investigate the use of materials from a historical standpoint, and defend and debate their findings (MEXT 2009b). In 2018, the class was upgraded at elementary school, and it was done so at middle school in 2019. Through the upgrade, the teachers are being specially trained, and designated textbooks are introduced to the class. The Ministry of Education stipulates in its teaching guide for elementary schools that the ethics class aims to nourish sociability which is a prerequisite to reflect one’s lifestyle, behave actively, and live in harmony with the others as an independent individual. The longtime experience in educating ethics will facilitate understanding of the importance of sustainable finance once the people gets equipped with enough literacy. An underlying principle of the ethics class is to teach importance of altruism and philanthropy which are to consider interests of others (e.g., people living in remote countries and future generations) like those of themselves. For instance, a textbook for first and second grades of elementary school which is published by Tokyo Metropolitan Board of Education contains a chapter entitled “Let’s deliver warm hearts” which aims to teach that to be nice to the others makes ourselves feel happy (TMBE 2014: 92–93). Likewise, a textbook for fourth grade of elementary school which is published by public fund includes a chapter entitled “Pupils in other countries” which aims to broaden the children’s view to help strengthen their imagination on the existence of the people with whom they don’t have direct contacts in their daily lives (Tokyo Shoseki 2018: 126–129).

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The Japanese ethics class is designed to educate youngsters to be good components of the society, and not designed to contribute to sustainable finance specifically. But the author believes that it is useful also for promoting sustainable finance. As for practice of sustainable finance, Japan is not a most major player in the market yet. As of June 2019, the accumulated issuance of its green bonds from the beginning of the year corresponds to tenth position in value in the world (Climate Bond Initiative 2019b). But, Japan’s Government Pension Investment Fund (GPIF), the world’s largest retirement scheme with 159 trillion yen in assets, has become a vocal proponent of responsible investing in recent years, helping to fuel the 307% growth in sustainable assets in Japan from 2016 to 2018 (Riding 2019).

Challenges In a nutshell, discussions over environmental factors of ESG are more developed in Europe, while discussions over social factors (e.g., violation of human rights, inequality, and disrespect of human dignity) have been the main concerns of the societies in Japan. As for corporate governance factors (e.g., juvenile workforce), some important rules developed by international standard setters, including OECD and BCBS, are already in place, and both jurisdictions are adopting the international standards in their respective legal and regulatory regimes, although education on corporate governance is still seldom discussed in either of them.

European Perspective Roughly summarizing, the European education and training system has three institutional insufficiencies from a viewpoint of promoting sustainable finance. These are public-private cooperation, education on ethics, and great divergence of financial literacy across the union. First, public sector and private sector are basically coping with financial education independently of each other in the EU countries with some exceptions like the Netherlands. The author often hears voices from the financial industries requesting for stronger support of the competent authorities. Civil projects can be surely upgraded by public involvement to reach out to wider range of stakeholders (e.g., social academia, environment protectionists, specialists on corporate governance), which is a must in the case of financial education for sustainability. Education is an issue of competence shared between the member states and the EU. The content and design of curricula remain the competence of EU member states. The European Commission offers only project and mobility funding through the Erasmus+ Programme, but does not interact with member states on curricula at primary, secondary, or tertiary level. In that respect, we are quite different from a ministry of education. The European Commission includes some crosscutting priorities in our Erasmus+ Programme, such as refugee integration or climate action. However, it is up to the applying institutions to define how this will be done (e.g.,

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through moral education, but it could be something else). In this regard, the Erasmus + Programme is very bottom-up. Notwithstanding the limitation, there are remarkable signs that the European institutions are beginning to expand its scope of activities through upgrading program for education, training, youth, and sports. In November 2018, the General Secretariat of the Council of the European Union (EU Council) submitted to the EU Council a proposal (13943/18) to repeal existing relevant EU Regulation (No 1288/ 2013). The aim is to allow the Erasmus+ Programme to contribute to mainstream climate action in the EU’s policies and to the achievement of an overall target of 25% of the EU’s budget expenditures supporting climate objectives (EU Council 2018). In September 2019, Ursula von der Leyen, the then President-elect of the European Commission, expressed her view that education will be key to the ability to lead in the transition to a climate-neutral economy in her mission letter to Mariya Gabriel, the then Commissioner-designate for Innovation and Youth, and expects her to triple the Erasmus+ Programme as a part of next EU budget (MFF), while respecting the principles of proportionality and subsidiarity (von der Leyen 2019). In addition, it is worth while noting that an EU directive on mortgage loan (Mortgage Credit Directive) which was adopted in 2014 requires the member states to promote measures support financial education on borrowing and debt management and the European Commission to assess their practices in the article 6 (European Commission 2014). For this purpose, it is an idea to set up a platform or an intermediate body where authorities and associations in financial sectors can exchange views and share information, in addition to further strengthening collaboration among financial associations. The platform can be expected to facilitate development of publicprivate joint projects. With the financial crisis, the authorities felt betrayed by the banks which used to enjoy various discretion (e.g., internal models for risk measurement) based on a belief in market mechanism and then started tightening regulations and supervision over financial institutions. Against the backdrop, the financial industries are inclined to stay away from the competent authorities, and trust between them has been mutually weakened. Second, ethics is not formally installed in school curriculum as an independent subject in general, although teachers can teach it as a voluntary subject based on their discretion if they find it useful, and the elements related to ethics are accommodated in social studies in some countries. Financial literacy is useful for citizens to protect themselves against financial fraud and financial exclusion. Well-managed households can contribute to stable development of the society through avoidance of excess domestic debt problems. Nonetheless, financial literacy doesn’t deal with protecting rights and interests of the others. The essence of sustainable finance is long-termism based on the sense of social responsibility and altruism. Traditionally, it had been perceived that ethics was something to be taught in church. Given the European society of today where the number of those who regularly go to church is decreasing, school is increasing its importance of enhancing ethical spirit of the citizens. (According to a survey conducted by a US research institute, non-practicing Christians make up the biggest share of the population

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across Western Europe (Pew Research Center 2018).) Yet, Finland is known for its education program named “KiVA” which aims to share the pain of classmates who are bullied in elementary schools. Such attempt can be regarded as an effort to educate moral sentiment of pupils. Moreover, there are valuable green shoots in the European industry that some financial institutions like Banca Etica in Italy have ethical business models and are making profit out of their provision of services which aim to support socially useful activities in their communities. Third, the degree of financial literacy is divergent among the European countries. It can be attributed largely to that each EU member state has unique education system. Of the member states, northern countries generally reveal a higher ratio of those who are with enough literacy than some other countries such as Romania (22%) and Portugal (26%) where the ratio is around one-third of those of the northern countries. The divergence may affect uniform progress of the European Commission’s action plan on sustainable finance going forward.

Japanese Perspective Japan is the country which has the largest number of institutions supporting the recommendations by Task Force on Climate-related Financial Disclosures (TCFD) of the Basel-based global standard setter, Financial Stability Board, which was published in June 2017. The recommendations are designed to help investors, lenders, and insurance underwriters identify the information needed and assess climate-related risks and opportunities appropriately. As of August 2019, it amounts to 188 which comprises 23% of all the institutions in the world, with the UK in the second position (117 institutions) and France in the fifth position (38 institutions) (METI 2019). The Japanese integrated financial regulator, Financial Services Agency (FSA), takes a lead of the initiatives on disclosure and created a position of chief sustainable finance officer in March 2019. GPIF has announced in September 2019 that it will accelerate investments in green bonds. The GPIF which holds assets of 1.5 trillion USD can be a game changer for green bond markets both in Japan and in the world. As an entirety, however, discussions on how to address issues arising from ESG factors have been less active among the Japanese market participants than among those in Europe. According to Climate Bond Initiative, total amount of the green bonds issued in the world in 2018 is 167.6 billion USD, of which the Japanese issuance is below 5 billion USD. There exists neither index nor benchmark related to green bonds in Japan at the time of this writing. What leaves to be desired from Japan is to locate ethical education systematically in the context of the policy agenda for promoting sustainable finance. To connect them is key for future enhancement of Japanese position in sustainable finance. Besides, an impending necessity of the Japanese education system is to improve financial literacy in general. This is a cornerstone of not only for financial inclusion and investor protection but also for sustainable finance. An analysis on the Japan’s nationwide survey indicates that the level of financial literacy is significantly and

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positively correlated with having received financial education. It implies that policy measures to increase financial education can improve financial literacy (Yoshino et al. 2017: 24). In the first place, public spending on education needs to be expanded. According to OECD, Japan’s official financial support to education as a percentage of GDP was the lowest among OECD’s 35 member countries. The report says spending on education by Japan’s national and local governments accounted for 2.9% of the country’s GDP. The figure is well below the OECD average of 4%. Norway tops the list at 6.3%, followed by Finland at 5.4% and Belgium at 5.3%. On the other hand, Japan’s families cover 22% of education expenses, which is remarkably higher than the other OECD members. For advanced education, households bear 53% of the cost (OECD 2019). Although the author points out the mandatory moral class as a potential advantage of the Japanese financial education, it leaves some questions to be examined. These include if the form of mandatory class is really an optimal alternative to educate moral sentiment among the pupils and students and if it arises any side effects due to its uniformity designed by the government which means less flexibility to address indigenous problems in each region, community, and school. Arbitrary interference in contents of textbooks authorized by the government might lead to totalitarianism and, thus, need to be avoided.

Common Challenges Today, profitability analysis on financial activities to support ESG factors and SDGs are very active against the background of growing concerns over global warming in the international communities. However, there has not been a firm evidence that fund raising through ESG-compatible financial products is cheaper than conventional debt instruments. (IMF shows its assessment that there is little evidence that issuers achieve lower costs through green bonds than conventional bonds, likely reflecting the identical credit risk profile (IMF 2019: 85).) This is also the case with investment. There lacks evidence at least in a short term that ESG investment outperforms average performance of investment fund managed passively) and, more profoundly and controversially, that global warming is indeed attributed to increase of CO2 emission. We can only empirically say that a company or a project managed poorly is not likely to be sustainable. Yet, it may be explained by the methodological limitation that profitability is assessed by a relatively short-term performance, due to the lack of enough historical data. European institutions envisage the usage of regulatory tools such as “green supporting factor” which allows reduction of capital requirements for banks’ exposure compliant with EU’s green standards to be introduced. (Contrary to it, a concept called “brown penalizing factor” which imposes punitive capital charge on nongreen/brown exposures is also theoretically conceivable.) Based on the Economic Partnership Agreement and the Strategic Partnership Agreement both signed in July 2018, the EU and Japan declared that they share

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values and principles of democracy, the rule of law, human rights, respect for human dignity, freedom, and democracy. The two major and developed jurisdictions have some social challenges for conventional financial education in common. These are aging problem and rapid development of technology. They pose risks to consumer/ investor protection and financial inclusion/exclusion. As for the former issue, Japan and the EU are among the fastest aging societies in the world. In particular, the ratio of over or equal to 65-year-old people in the whole population is the highest in Japan among 201 countries in the world, with Italy in the second position, according to an estimate by Japan’s government as of 15 September 2019. The Japanese figure is 28.4% and the Italian figure is 23.0%. All the top 10 countries except Japan are European countries or territories, including Martinique, a Caribbean island, which belongs to France (Statistics Bureau of Japan 2019). (After Italy are Portugal, Finland, Greece, Germany, Bulgaria, Martinique (France), Croatia, and Malta, in order. The data on Europe is as of 1 July 2019.) The necessity to protect elder people from financial fraud and other types of crimes is increasing. Regarding the latter, there are both positive aspects and negative aspects. IT development, including fintech, contributes to financial inclusion. It makes different financial services accessible for everybody and our day-to-day lives much easier. At the same time, however, we can also easily lose money just by clicking a wrong button, as financial transaction became so smooth. Besides, blind use of artificial intelligence in financial services potentially poses risks of unethical biases which can cause discrimination and unfairness in terms of gender, race, religion, etc. Combining ethics and financial education is a common challenge for the both jurisdictions. Europe has room for upgrading ethics as an independent subject, while Japan should improve the level of national literacy on finance in general. Financial education without ethics is not effective to illuminate people on altruism. For this purpose, education may need to be redefined. A realistic understanding of human rationalism might perhaps return business education to a traditional, broader focus that includes moral development (Boatright 2010). Financial education for promoting sustainable finance can have specificities to be considered in designing the designated methodology, since financial education for sustainability is somewhat different from traditional financial education which mainly aims at consumer protection and financial inclusion. The most remarkable characteristic is that financial education for sustainability requires drastic change of people’s mind-set at a global level. In a word, people need to respect their external world, environment, societies, and firms, and make actions to improve it. Therefore, literacy per se is not enough to support sustainable financial. A critical prerequisite to promote financial education for sustainability is ethic. Why? In general, authorities rely on regulation and taxation to induce the citizens, including market players, into a certain behavior. Yet, the two policy tools could have unintended consequences while they are very effective and efficient. They sometimes cause wrong incentives and distort market structures. The citizens might try to avoid application of the regulation (regulatory arbitrage) and levy and, contrary to that, take advantage of the regulatory and tax benefit (market abuse). (Jean Tirole indicates that an economic policy loses sight of the true purpose far too

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often and regulation or prohibition of the market is a response to a straightforward market failure (Tirole 2017).) As such, green support factor or brown penalizing factor can bring about a wrong incentive for market participants to invest in assets which are green but take on high credit risk. Moreover, non-concerted introduction of the regulatory treatment in a jurisdiction can undermine level playing field of financial institutions across jurisdictions. Voluntary actions by the citizens themselves provide solution without such side effects, unlike forced measures. Therefore, educating and enlightening citizens, specifically ultimate investors and depositors, so that they pay more attention to sustainability of their economy and society, is especially important. Based on the bottom-up approach, financial education needs to accommodate ethical elements to change mind-set and proposition of the social constituencies. If compared with environmental issues, social issues such as juvenile workers as well as gender and racial inequality have unique difficulties in a sense that they don’t directly affect everyone on the planet. On the other hand, some can disregard climate change as a serious global problem which is not for their own generation but for future generations. To embrace sense of ownership which make every citizen feel like addressing those issues right away, instead of passing them to somebody else, is essential. Great old scholars such as Jeremy Bentham, Adam Smith, and Max Weber pointed out the necessity to relate ethics with economics. Nonetheless, we tend to be egoistic, going for short-term profit taking, rather than long-term profit making. This is a profound problem. It may take long until people’s mind-set changes. There should be attempts to tackle it from different channels. Adam Smith defines sympathy as to denote our fellow feeling with any passion whatever in his work titled “The Theory of Moral Sentiments.” He also points out that it is by the imagination only that we can build any conception of other’s sensations. By placing ourselves in his/her situation, we conceive ourselves enduring the same torments, we enter as it were into his/her body, and we become in some measure the same person with him/her (Smith 1749: 1–2). Sympathy is exactly what financial education for sustainability is to develop in the society. Jeremy Bentham, a British economist later in the eighteenth century who founded modern utilitarianism, maintains that there may be called the pleasures of goodwill, the pleasures of sympathy, or the pleasures of the benevolent or social affections and the quantity and quality of moral, religious, sympathetic sensibility belong to intellectual part of education in his work titled “An introduction to the Principles of Morals and Legislation” (Bentham 1789). Here, he hints the connection between ethics and education. Similarly, Max Weber, a German political economist in the early twentieth century, writes that a well-developed sense of responsibility (. . .) is not something which occurs naturally and has to be the product of a long, slow “process of education” in his famous work “The Protestant Ethic and the Spirit of Capitalism” (Weber 1905: 17–18). According to Weber, the feeling of responsibility preserves possessions undiminished to God’s glory and to increase them through tireless labor

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(Weber 1905: 115). This eloquently indicates that capitalism in his concept is nothing just to produce “moneymaking machine” and entails sense of ethics. Also in the contemporary world, Amartya Sen, the first Asian winner of Nobel Prize in economics, emphasizes the importance to cultivate ethical spirits like sympathy and “commitment.” According to him, the definition of commitment includes cases in which the person’s choice, while maximizing anticipated personal welfare, would be unaffected under at least one counterfactual condition in which the act chosen would cease to maximize personal welfare (Sen 1977: 327). In order to overcome today’s excessive or wrong utilitarianism and capitalism, development of firm and attractive logics, beyond moral suasion, to convince people that ESG-compatible financial behavior provides higher satisfaction in a long run is an absolute must. Development of a reliable taxonomy of economic activities is a prerequisite for promoting financial education for sustainability. But for it, greenwashing products which are in disguise of sustainable character can hardly be eliminated. Unless consumers and investors have faith in ESG-related products, sustainable finance will never flourish. As of when the author writes this chapter, the legislative proposal on the EU regulation concerning taxonomy is still under discussion among the EU Council, the European Parliament, and the European Commission. It is expected that the EU will start introducing different financial infrastructures such as standards, labels, and indices which are related to environmental factor, once the legislative proposal is adopted in the trialogue.

Conclusion Sustainable finance is a new policy area. Therefore, financial education for sustainability is left unaddressed or underdeveloped probably in any country yet. Academic literature is seemingly not sufficient either. That said, valuable insights which are related to this new academic domain can be found in classics and contemporary work on ethics in economics. They touch upon importance of moral education. How to incorporate altruism in traditional financial education will be a remaining challenge to establish a firm basis for developing sustainable finance on it. In Europe, the necessity of financial education for sustainability is being brought to attention among authorities and industries. But the development is hindered by the lack of EU-level initiatives. (There are a few exceptions, including FinLiCO, a financial education programme for adults conducted in eight EU member states (e.g., the UK) in 2010–2012, where the European Commission provided financial support.) In Japan, there is potentiality for improving financial literacy among the nations. In this regard, the author believes that literacy is not enough to achieve the goal and ethics plays critical role, since it is necessary to use literacy appropriately. It would be highly desirable that discussion on this issue prevails at a global level soon. The EU has already clarified importance of financial education in the context of sustainable finance. However, its system of financial education has room for further

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strengthening. First, firm trust between the authorities and industries needs to be restored, so that the communication and collaboration toward joint projects on financial education for sustainability can be enhanced. Second, ethical sentiment should be built in the education system as a driver of the long-termism which is a prerequisite of successful sustainable finance. On the other hand, Japan is behind the EU in terms of awareness of the roles that education can play for sustainable finance. Yet, it has two strong points in the education system. First, Japan’s financial education is based on public-private partnership. Second, Japanese education system includes ethics classes as a mandatory subject. One-size-fits-all approach is not adequate, since each jurisdiction has unique backgrounds both historically and culturally, but the EU and Japan share fundamental goals. The two jurisdictions can learn from each other. It is desirable for them to exchange information on respective experiences and projects across the sectors. Discussion on sustainable finance will expand to cover not only environmental factors but also social factors sooner or later. Human rights, equality, and human dignity can only be ensured by empowered citizens. The call for financial education for sustainability is to grow. It is extremely meaningful for Europe and Japan to closely collaborate in today’s world where the USA notified the UN of its intent to withdraw from the Paris Agreement in November 2019.

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Readiness to the FinTech Industry in Developing Countries An Overview of Prospective Factors Impacts Chemseddine Tidjani

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Background and Literature on FinTech . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Definitions and Crucial Facts of the FinTech Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concept Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outlooks and Facts on the FinTech Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Potentials and Challenges of FinTech Adoption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FinTech Adoption in Developing Countries: Readiness Indicators and Prospective Factors . . . Experiences and Ascertainment from Selected Developing Countries . . . . . . . . . . . . . . . . . . . . . Conclusions/Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

Financial Technology (FinTech) is one of the revolutionary ideas that the financial industry sector is facing today. Financial innovations convey high evolution in technology and financing alternatives. Thus, this revolution has entered a new evolvement with impact dimensions for developed countries that are similar to those for developing countries. These latter are influenced in their financial and economic activity by different aspects of FinTech impacts. Based on recent research reports, surveys, papers, and statistics collected from secondary and tertiary published literature, this chapter tries to analyse and extract the basic points and facts related to the FinTech industry in general, and most particularly in developing countries. Hence, the main objective of this chapter may allow some answers to the core expected factors that may influence FinTech adoption in some selected developing countries. The key findings, across investigations

C. Tidjani (*) Division of Firms and Industrial Economics, Research Center in Applied Economics for Development (CREAD), Algiers, Algeria e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_28

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covering three main regions, Latin America, Africa, and Asia, concluded there is high potential capacity to invest in this sector because of the development of mobile money in those countries most studied. In contrast, FinTech might also present some risks and limits for other developing countries. Keywords

FinTech industry · Technology readiness · FinTech adoption · FinTech startups · Developing countries JEL Codes

G2 · M13 · M15 · O3 · Z23

Introduction The integration of new technological solutions usually modernises the work environment, techniques, and skills in different ways, in particular, in the ways computers can be used for organisations. Those technologies have transformed work platforms to fully automated for tasks most frequently performed, such as those with enormous bulk, through computerised systems (Bredmar 2017). Through the latest global actions and changes, the technological revolution is affecting almost all the financial systems in the world. Thus, the appearance of the blockchain and artificial intelligence revolution started pushing the governments of developed countries to take into consideration the potential risks and benefits. At the same time, this revolution can bring major new problems or improvements, or both, to political and economic systems. In other words, the world now is facing new interactions and challenges by this revolution in which the blockchain system may change the global financial system wherein all the currencies, transactions, commercial contracts, and global investments can be entirely changed. This revolution leads to the development of other related sectors, ecosystems, and tools with new mechanisms and architecture, particularly, in finance, by what we call “financial technology” or “FinTech.” This latter means the use of software and digital platforms that distribute financial services to consumers. Therefore, the creation of new and efficient means by which to provide services might lead those digital tools to disrupt recognised business models. In recent years, the investment capacity in financial technology (FinTech) has been well recorded with a growth rate near to 201% globally, whereas the total of venture capital (VC) investments has only grown by 63% in the same time period (Lynn et al. 2019). According to Ernst and Young (2019), a global survey that interviewed more than 27,000 consumers in 27 world different markets also interviewed 1,000 organisations (SMEs) in five markets. The results revealed that 64% and 25% of FinTech is adopted successively from the consumers and the SMEs, respectively, whereas China and India were the first and quickest to adopt FinTech.

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Moreover, based on the KPMG report (2019) an increasing rate of total investment activity in FinTech was shown, from US$ 46 billion in 2014 to US$ 120 billion in 2018, with a considerable decrease in the first quarter of 2019. This revolution is beginning to arise globally; however, it has arisen mainly in some developed countries but is not yet established in developing countries. From this point, this chapter attempts to present and to understand the main concepts, definitions, and crucial issues related to FinTech, the reality and facts about this revolution; it then also tries to delineate the main questions, reasons, and challenges behind the adoption of this technology. Similarly, it is extracting the expected main factors that may impact the adoption of FinTech methods in some developing countries. This chapter focuses around these principal questions: • Are developing countries ready to be involved in the new financial changes? • Do developing countries really understand the FinTech challenges and its impacts? • Do these countries sufficiently trust those new technologies? • What expected changes could the FinTech industry cause for developing countries? This research is based on different recent reports with wide results and statistics that are collected from other most recent published literature closest to the subject. In this context, we tried to provide an overview with comparison and analysis to what has already been published about FinTech adoption in developing countries. Also, we have selected some of these as cross-country evidence as to what has already been done through initiatives, achievements, or experience in some kinds of financial innovation products and services. Those data are extracted essentially from such sources as the Global Competitiveness Index (GCI) ranking, Global Findex database (WB), Global FinTech Report, and the Global FinTech Adoption index. In fact, the main objective of this research may provide some answers to an overall issue: What are the main expected factors that may influence FinTech adoption in some selected developing countries? Toward this consideration, we structured this chapter in four sections: “Background and Literature on FinTech,” “Definitions and Crucial Facts of the FinTech Industry,” “Potentials and Challenges of FinTech Adoption,” and “FinTech Adoption in Developing Countries: Readiness Indicators and Prospective Factors.”

Background and Literature on FinTech From a chronological aspect, financial and banking sector activities have known a real technological transformation in the past decade because of the intensive integration of information technology (IT) at all different processing levels of financial products. Accordingly, multiple innovative solutions and applications affected and

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have deeply changed the possibilities, the tools, and the way that consumers work with these methods. One of the recent types of those changes is “FinTech.” Indeed, the term FinTech is a compound noun from a combination of “finance” and “technology.” According to Alt et al. (2018), that concept is not considered as a new financial activity or service phenomenon; in fact, it is more like an evolution rather than a revolution. In another way, financial technology (FinTech) basically refers to the use of software, applications, and digital platforms to offer and deliver multiple financial services to consumers (Badruddin 2017). Even though FinTech, as a concept, has only come to prominence during the past 5 years, the finance–technology relationship has a long history. The three foremost evolutionary trends are the result of the current FinTech outlook that affects traditional financial services in global markets, developing countries, and FinTech startups (Arner et al. 2017). The financial sector, related to the first element of the FinTech term, has grown over the past centuries from the traditional banking goods and services (loans, bonds, etc.), then through a wide range of developed services (securitisation, financial derivatives, etc.), until the development of e-payments with full-access mobile banking services (ATM, 24 h online banking, online financing, etc.). Relating to the second element of the FinTech term, technologies have developed to be the main core operative in the treatment of financial processes. Bouwman et al. (2005) defined that “a technology is a manner of organising things, coordinating processes, and performing tasks more easily” (Alt et al. 2018). Further, technologies have recently known new smart developments that bring all-new practices and processes into financial sector services. The Ernst & Young (EY) agency has launched a series of reports related to the measurement of FinTech activity, named the “FinTech Adoption Index.” The first global report by EYabout the FinTech Adoption Index appeared in 2015; the FinTech phenomenon was moderate in its beginning. In 2017, it was found that one in seven digitally active consumers were already FinTech users (EY 2017). The FinTech industry had recognised rapid growth and had also attained initial mass adoption. The current report (2019) showed that FinTech nowadays is becoming a host of multiple companies that offer and operate a wide range of financial services globally. In the same context, in a global survey Ernst and Young (2019) interviewed more than 27,000 consumers in 27 world different markets and also interviewed 1,000 organisations (SMEs) in 5 markets. The results revealed that 64% and 25% of FinTech is adopted successively from consumers and SMEs, respectively; China and India were the first and fastest adopters of FinTech. The last CGAP (CGAP: Consultative Group to Assist the Poor (https://www. cgap.org)) report (May 2019) found primary evidence that the FinTech industry has the potential to disturb financial inclusion; nonetheless, further deep research on this result is likely needed. Going forward, CGAP will work to support the global development sector, policymakers, and the impact of investing industry that has the potential to increase financial inclusion through enabling a shared understanding of emerging business models in FinTech (Murthy et al. 2019).

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Most of the recent research is focusing on what is related to FinTech and its impacts in developed countries. Nevertheless, some other studies focused on cases from developing countries. In that way, this chapter tries to shed light as an overview of different studies that concerning those countries.

Definitions and Crucial Facts of the FinTech Industry Concept Definitions Regarding its concept , the FinTech phenomenon has low theoretical insights and has no known unique definition, although many authors and practitioners have given some definitions. We might get slightly around the history of this concept where the origin of the term is a compound noun of finance and technology, then being briefly known as “Fin-Tech” or “FinTech.” The emergence of FinTech is remarkable, but this phenomenon has not come suddenly; it was not invented or created as a whole new generation in the finance sector. Its origin is related to the long background history of finance evolution, and particularly, it supports financial technology. In other words, FinTech might be considered as a revolution or rather as an evolution! By the late 1980s, the financial services industry had become widely developed and digitalised, thus emphasising the real importance of global electronic transactions that occur among the financial institutions, financial market actors, and also customers around the world. Hence, the progress in that era is sometimes called “E-Finance” (Alt et al. 2018; Gimpel et al. 2018). In the early 1990s, the term FinTech was used for the first time for promotion of technological collaboration assessed by a project of Citigroup precursors. Since 2014, FinTech has known a considerable importance in these contexts, such as innovative business models (Gimpel et al. 2018). The same authors refer to the term FinTech when it integrates the usefulness of different digital technologies such as the Internet, mobile computing, mobile applications, and data analytics with the objective, therefore, to qualify, innovate, or disrupt financial services. In this latter process, the whole financial transformation can be either supported or reconsidered as a crucial force for FinTech as well as technological innovation. In other expressions, FinTech is considered as a concept composed of finance and technology. This concept is used for technology startups or firms that adopt new technological applications and platforms that lead them to offer new financial services as well as the traditional ones. Henceforth, FinTech firms can bring other competitive advantages into financial markets to either banking sector products or services. Further, this may also influence consumer behaviour. According to the International Organisation of Securities Commissions (IOSCO) (2017, p. 4): “The term Financial Technologies or “FinTech” is used to describe a variety of innovative business models and emerging technologies that have the potential to transform the financial services industry.”

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The Financial Stability Board “FSB” (2017, p. 7) defined FinTech as “technology-enabled innovation in financial services that could result in new business models, applications, processes or products with an associated material effect on the provision of financial services. While the broad term “FinTech” can be useful to describe a wide range of innovations, further specificity is needed for individual innovations.” Accordingly, FinTech innovations are already denoted to disturb many other different ranges of financial services in the coming years. Ernst and Young (2017, p. 5) refer to FinTech as “an industry that includes not only early-stage start-ups and new entrants, but also scale-ups, maturing firms and even non-financial services firms.” Gimpel et al. (2018) introduced a proposed definition to the term: “characterises the usage of digital technologies such as the Internet, mobile computing, and data analytics to enable, innovate, or disrupt financial services.” In fact, the FinTech phenomenon is a new form of financial products and services that are delivered through the marriage of different technological platforms and such innovative business models. Nevertheless, this combination leads to emerge, transform, or even to disrupt the traditional financial services. However, FinTech is widely distributed and has expanded to spread to New York, London, Singapore, Hong Kong, and most global cities. Other related definitions to FinTech have interrelated around that concept. We might mention some briefly: FinTech innovation, FinTech startup, FinTech disruption. As an example of description and understanding, Murthy et al. (2019) mentions the term “FinTech innovation” as the entire activities by a wide range of actors, necessarily involving the financial and other institutions. Actually, most of all matured and also recognised financial institutions (e.g., banks, credit card companies) around the world are basically still using different innovative technologies, therefore, to enhance the quality and the performance of their services at multilevel and on different categories toward the customers’ needs and engagements. Additionally, Gimpel et al. (2018) define “FinTech startup” as “newly established businesses that offer financial services based on FinTech.” In general, digitalisation processing is increased and sometimes other new products and services are introduced by other several incumbents (e.g., advanced online banking, customer applications, video conferencing, crypto-assets). Regarding the “FinTech disruption,” currently it is interesting that the arrival of a new generation of FinTech is designed on near-ubiquitous access to the Internet via mobile and cloud computing, machine learning, artificial intelligence, and blockchain. Those technologies are subsequently able to cause substantial disruptive changes to the financial services sector, either from the openness of the sector for another level of competition or by empowerment of customers in ways inconceivable a decade ago (Lynn et al. 2019). Finally, the FinTech concept does not fit a unique or universal definition. Among others, practitioners and some professional financial institutions and companies tried to adopt an executive definition based on what they understood or explained. Nonetheless, regarding the background of the term, it appears that it is not a novel

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one as it was developed by the 1980s. Meanwhile, the new characteristic of FinTech, as a term, is the combination of the two existing parts that brought together all modern views of business models and traditional processing of the financial services, transactions, banking systems, payments, and market effective vitality. However, we can say simply that FinTech is a composed concept wherein it gathers all the traditional and enhanced finance sector products and services from one side with the innovative technology tools from the other side.

Outlooks and Facts on the FinTech Industry In the past 10 years, the FinTech industry has reached a really mature level and has grown rapidly. This status followed the fast progress and increases in both sectors: finance and technology. The traditional finance sector is increasing significantly, from banking and stock market financing (loans, bonds, credits, assets, etc.) to other new forms of financing (venture capital, crowdfunding, micro-finance, business angels, etc.) on the one side even though the rapid development of technology also increases extraordinarily the level, speed, and quality of methods and tools applied in different payments and transactions on the other side. Consequently, the industry is marked by very important investments from several global companies and financial institutions. According to the KPMG (2019) report, the global FinTech investment accounted for US$ 37.9 billion dollars up to Q1 2019 over a volume of 962 deals (Figs. 1and 2).

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$64

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Fig. 1 Global investment outlook in the FinTech sector (VC, PE, M&A) (2014–H1 2019). VC venture capital, PE private equity, M&A mergers and acquisitions. (Source: By author, based on KPMG 2019 report)

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Fig. 2 Global venture activity investment in FinTech companies (2010–2019). (Source: Established by the author based on data retrieved from STATISTA. https://www.statista.com/ statistics/412642/value-of-global-vc-investment-in-fintech/, 2020)

Figures 1 and 2 show that the FinTech industry has had an increasing impact from the year 2014 to Q2 of 2018: it has registered the highest deal values across US$120 billion with 2590 deal counts. However, the H1 2019 recorded a slump in some kinds of VC and PE, which may suggest that the industry, in total, may be navigating across a typical settling period wherein several mature M&A dominate investment activity even as the venture pipeline fills up. However, from another vantage, the FinTech industry has a huge investment in capital and human capabilities throughout the world. According to FinTech Control Tower BCG (2019), up to H2 of 2019, there are around 18,400 FinTech startups globally, attracting more than US$228 billion as cumulative funding, whereas Gupta and Tham (2019, p. 21) confirm that there were close to 12,000 such with more than US$130 billion between 2016 and 2017. This unpredictable situation has expanded to overall global markets with a high rate of transactions (see Figs. 3 and 4). This situation gives the opportunity for those startups to “attack” or attract the possibility to invest their technological potentials as a partnership or as a service offer with the incumbent banks. Meanwhile, according to Galvin et al. (2018), many financial institutions are engaging with many other FinTech startups in different working contracts: as investors, financing and sponsoring their innovative ideas, or by adoption or acquisition of some selected brilliant startups, either done through strategic partnerships. Actually, nearly 80% of financial institutions have come into FinTech partnerships.

Readiness to the FinTech Industry in Developing Countries Fig. 3 Total number and distribution of FinTech startups in the world (February 2019). (Source: By author based on data retrieved from https:// FinTechcontroltower.bcg. com/#/home)

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APAC (Asia Pacific) EMEA (Europe Middle East & Africa) AMERICAS (north, central & south America)

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Fig. 4 FinTech adoption level compared in six markets from 2015 to 2019. (Source: Established by the author based on data available from Ernst and Young (2019, p. 8))

Additionally, some other banks have created innovation laboratories in which they attract, adopt, support, and also incubate the startup’s initiatives. This kind of motivational investment could afford those banks another new competitive market position among the other institutions. Subsequently, this opportunity could support each part (banks/startups) to work beneficially together. Another perspective from Latin America, as an example, demonstrates how the FinTech industry has been driving new startups growth during the past 5 years up to 2018 (Fig. 5).

Fig. 5 International development of FinTech startups in Latin America (2018). (Source: Finnovista 2018)

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In 2017, a first report was published by Finnovista and therefore the InterAmerican Development Bank (IDB) in which they conducted a survey demonstrating a total of 703 FinTech startups in 15 countries of Latin America and the Caribbean (IDB and Finnovista 2017). According to this information, it was found that more than half of the surveyed startups were already launched between 2014 and 2016. However, a recent report released in 2018 by these same companies showed a significant accelerating of around 66% of FinTech created in 18 countries at the same region by the end of 2018 (IDB and Finnovista, 2018). In 2018, however, more than US$186 M in venture capital funding was established in this sector, and one third of that was passed to startups. It appears that Latin America countries are at the forefront of a FinTech revolution, going along with recent advances in internet access and technology driving this prosperity (Lustig 2019). Consequently, the fact that new challenges are facing those FinTech startups leads us to understand that there are some important market opportunities to follow after that wherein they make a great contribution to the capital markets infrastructure (Fig. 6). Figure 6 shows an increased cumulative number of capital market infrastructures with more than 277% from before 2010 up to 2016. Compared to that, the number of FinTech startups was increased intensively with more than 186 FinTechs in corporate banking from 2010 to 2016, with more than 184 payments operated by those startups at the same period. Therefore, those results add to what was shown for FinTech global activity already mentioned.

Potentials and Challenges of FinTech Adoption The financial technology revolution can threat the behaviour and decisions for both consumers and SMEs toward themselves in bilateral or multilateral transactions and contracting. A strong atmosphere of rules, mechanisms, and ethics is needed that could conserve the rights of each component. Accordingly, at the early stage, the relationship between FinTechs and traditional financial institutions has morphed from competition to collaboration, but this potential of collaboration is just the start. This collaboration will drive both traditional financial institutions and FinTechs to increase their profit and benefits in which they try to strengthen and find the right integrity potentials and the most appropriate market positions. From Fig. 7, it appears that the FinTech activity sector raises new challenges and has evolved new investment opportunities with different products and services such as payments, real estate, capital markets, and insurance. Therefore, this challenge will support the creation of an ecosystem that work out, in fact, with a new diversity and changes of market structure. Furthermore, the range of those activities acts to inspire and draw up a typology of FinTech startups/firms where it might simplify and illustrate the core of different activities (Fig. 8). Figure 8 groups the FinTech firms into three main types:

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a. Cumulative number of (CMI) related to FinTechs 377

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Fig. 6 FinTech activity within capital markets infrastructure (CMI). (Source: Established by the author based on data available from McKinsey & Company (2018, p. 7))

(i) enabler firms providing technology support; (ii) firms providing customer services; and (iii) firms providing value-added services. Figure 8 could show three kinds of transactions or services offered. Essentially, FinTech firms provide new technology management support for traditional banks and

Fig. 7 An overview of global financial technology investment trends (Q2, 2019). (Source: CB Insights, 2019, p. 8)

Readiness to the FinTech Industry in Developing Countries 281

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Enable firms providing technology support

Firms providings customers services

• FinTech firms that provide technologybased offrings to traditional firms or other FinTech firms. E;g., Fiirms that provide data mining services.

• FinTech firms that provide financial services to customers or help in distributing financial services offerings. E.g., Neo-Banks or Challenger banks.

Firms providing ValueAdded services • Firms providings valueadded services to customers such as comparison of financial products. E.g., Online portals to compare insurance products.

Fig. 8 Types of FinTech firms. (Source: Established by the author; inspired from Capegemini 2018, p. 16)

financial institutions through data analysis, secure online transactions, quick funding treatments, and other methods. Further, the FinTech firms can also provide financial services solutions to customers through means of communication and plans for payments, loans, etc. Furthermore, the FinTech firms can also provide value-added services to customers in which they could make, for example, a comparison or benchmarking of different financial products and online services offered by other firms. Also, some other interested people working in FinTech activities suggest another categorisation of FinTech industry forms: as payment, capital raising, deposits and lending, enterprise financial software, investment management, market provision, international money transfers, personal finance, equity financing, and insurance. From another aspect, according to Pereira da Silva (2018), the FinTech industry also is conducted under regulation standards. Therefore, most central banks are confronted by numerous challenges across the implementation and design of regulations because of the prominent growth led by FinTech. In the main, we distinguish among two methods to regulate FinTech firms: (i) risk-based regulation (RBR) and (ii) size-based regulation (SBR). Indeed, the RBR is established on the slogan of “same risk, same regulation,” in that FinTech companies have to be regulated on the basis of the threats they face, whereas the identification and classification of those risks are also admitted as challenging. However, the SBR, in contrast, is based on the hypothesis of small FinTech firms that are unlikely be offended by systemic risks. For instance, Brazil has established a framework for cyber risk regulation that was launched in July 2018 for all firms that use cybertechnologies.

FinTech Adoption in Developing Countries: Readiness Indicators and Prospective Factors Thus far, developing economies are considered as a more stimulating environment. In these economies, customers still reach financial services in greatly different ways, although these differences necessarily need to be adopted or endowed by FinTech startups to prosper in new markets (Buckley and Webster 2016).

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In recent times, the FinTech phenomenon was generally limited, in particular, to developed markets. Nowadays, FinTech is starting to disrupt almost all the financial ecosystem in emerging markets and developing economies (EMDEs) as well, whereas most given solutions globally by different financial institutions are still focusing on wealthy customers who are well served by financial services, rather than other FinTechs, which are innovating and creating new services specifically intended for underserved and unbanked low-income customers (Murthy et al. 2019, p. 5). Financial literacy is also particularly low in developing countries. Nonetheless, some other actualities disclose that there is real potential that may lead FinTech firms to conduct financial inclusion in developing economies. Hence, FinTech developers in emerging economies are confronting a challenge wherein they work individually to develop financial solutions; with less or limited understanding of basic financial concepts and practices, and also with short formal experience. Inherently, FinTech products and services must be developed in ways in which they seek a new level of convenience and ease of use (Buckley and Webster 2016). Inversely, FinTech learning has been fascinating and rapidly enhancing as well in those countries regarding the availability of hundreds of online materials as courses, webinars, online workshops, and Massive Open Online Courses (MOOCs). Nonetheless, some FinTech solutions are based on blockchain technology that will have a positive emotional impact on developing countries. The use of this technology can help reduce fraud and corruption gaps and, therefore, advance legal property titles. Thus, it would provide entrepreneurial initiatives to the low-income world. Further, it can also help financial transactions be performed more quickly and ensure that support is spreading so less theft and fraud is possible (Kshetri and Voas 2018, p. 13). Otherwise, in addition to blockchain, the FinTech practices also based on artificial intelligence technology will effectively have a significant impact on developing countries and in different levels: economic and business training, handling intelligent systems, auto-financing operations systems, etc. On the other hand, most venture capital and equity investments in the FinTech sector are basically realised in the United States, Europe, and China, and to a lesser extent in some other developed markets. Further, as FinTechs arise in the financial services markets as well in Latin America, Africa, and South Asia, they attract the attention of private investments, accelerators, and incubators. Unusually, some firms considered as startups not long ago, such as PayTM (India), Cellulant (Kenya/ Nigeria), and Mercado Libre (Argentina), have beneficially received important investments. As a consequence, the increase of FinTech applications such as PayTM, Zoona, Jumo, and Cellulant in EMDEs markets had inspired CGAP to focus on them to comprehend their potential influence on financial inclusion (Murthy et al. 2019). However, given the financial and technological infrastructure indicators, the emerging and developing countries are still appending the last ranks categories in kind of financial access affordability, in financial access affordability and technology adoption readiness. The financial technology can give those countries another penetration level to swift growth with a quick rate, which can provide an effective jump for new advances in their financial environment.

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Country ranking in 2007

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Fig. 9 Technological readiness ranking in 2007 and 2017 (for selected countries). (Source: By the author, based on World Bank data (2018) (Global Competitiveness Index GCI))

Figure 9 presents such comparison of global ranking overviews for some selected developing countries in 2007 and 2017. The World Bank data show that there is a considerable new country order in terms of technological readiness. In 2007, the following countries have been ranked consecutively from a global of 130: UAE (33), Uruguay (67), Chile (42), Colombia (76), Kenya (92), and Argentina (78), whereas in 2017, those countries have known a high ranking against their position in 2007, as follows: UAE (18), Uruguay (36), Chile (39), Colombia (64), Kenya (89), and Argentina (69). On the other hand, the eighth pillar of Global Competitiveness Index 2018 that concerns financial market development can be measured through multiple subindicators: access to loans, affordability of financial services, financial services meeting business needs, soundness of banks, venture capital availability, local

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equity market financing, regulation of securities exchanges, and legal rights index. This pillar could present a general view about the evolutionary ranking of each country in some kinds of financial environment development. Figure 10 presents the key differences for 10 years in comparison to the same selection of countries in 2007 and 2017. In summary, both Figs. 9 and 10 have presented an entire overview for the evolution of technology readiness levels as well the financial readiness and development level compared between the years 2007 and 2017. It was remarkably shown that there was a very considerable change between country ranking registered with an important leap of some countries from the bottom positions to the top ones, notably UAE, Uruguay, Chile, Kenya, Argentina, Cameroon, and Colombia. Further, these findings confirm the fact that those countries are taking off as well where they are becoming more inclined. Thus, the business and financial environment would be more affordable to help FinTech startups grow. From another perspective, many different innovations have arisen and been furthered in several developing countries, for instance, Colombia, Kenya, Mongolia, Bangladesh, Chile, and Peru, rather than in affluent developed countries. Therefore, an increasing number of theoretically available cases of FinTech that supported financial services are yet ongoing (UN Environment Inquiry 2017, p. 15).

Experiences and Ascertainment from Selected Developing Countries According to the World Bank (WB), about 55% of the adult population in emerging and developing economies is unbanked – without an account – because of high financial costs, lack of necessary documents, and also by living a long distance from banks and financial institutions. On the other hand, some developed countries, for instance, the United Kingdom, United States, and China, have established an online lending platform. This latter has supported the increment of the SME lending rate. Nevertheless, several other countries in Sub-Saharan Africa and South Asia have been successful in encouraging mobile money savings and payments, which has, as a result, significantly enhanced financial inclusion (Berkmen et al. 2019). Thus far, the Global Findex Database (2017) report has found that around 1.7 billion adults remain without banking access at financial institutions or even through a mobile money provider. Adults in high-income economies are almost all bank account holders; practically all those unbanked adults live in the developing world. Indeed, about half of them live strictly in seven developing economies, such as Bangladesh, China, India, Indonesia, Mexico, Nigeria, and Pakistan (DemirgucKunt et al. 2018). This part attempts to give an overview on what was explored, what was invested, what was really realised during the past decade, and what would be expected in the coming years in the FinTech industry. This part, also, tries to summarise the industry situation and its evolution among a selection of developing countries, from different continents that have succeeded or failed in facing the industry revolution challenges.

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Fig. 10 Rankings of some selected developing countries in 2007–2017 (eighth pillar: financial market development). (Source: Established by the author based on World Bank data (2018) (Global Competitiveness Index GCI))

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FinTech Adoption in Latin America Lately, the FinTech industry has known great importance, depending on the increased or decreased level of economic development and market structure, which differs widely across countries and regions. In particular, in Latin America and the Caribbean (LAC) countries, FinTech has experienced rapid evolution after a dull start and, actually, is on the agenda of many policy makers as a stimulating future activity (Buckley and Webster 2016). Up to 2016, no more than 50% of the population of Latin America (LA) had access to become bank account or even debit card holders and only a few of them had access to get credit. Therefore, LA countries had considered attaining significant levels in financial inclusion integration, FinTech evolution startups, and high rates of economic development owing to a dynamic private sector that compounded with 99% of micro, small, and medium enterprises (MSMEs). Moreover, the LA countries had a strong profitable banking system compared to other world regions. Thus, it could support those SMEs and could stimulate the financial environment to create new innovative services. Throughout the 2008 recession, LA economies were unexpectedly robust, and realised an economic growth rate around 3.8% in 2010, after only 2% of contraction in 2009 (Frank et al. 2016; Lustig 2019; Oxford Analytica 2010). On what concerns the FinTech startups development, and according to IDB Invest, (IADB/ IDB: Inter-American Development Bank) Finnovista (2018) based on a survey conducted in 2018, a total of 1166 startups (compared to 703 in 2017) were found to be functioning across 18 countries in the LAC region. Consequently, Brazil ranked as the top booster in numbers of startups, about 33% from most types, then Mexico with 23%, and in addition Colombia represented 13%. In fact, they are leading other LAC countries (Fig. 11). Moreover, the total of emerging startups (1166) surveyed in 2018 is mainly distributed throughout 11 segments of FinTech activities. Three major segments entirely represented a little more than half of the total startups identified, significantly representing the foremost activities in the FinTech sector, notably payments and remittances, lending, and enterprise financial management (IDB and Finnovista 2018, pp. 14–15). More specifically, in Brazil, an estimate by Goldman Sachs for the next 10 years projected that Brazil’s FinTech companies would generate revenues of around US$24 billion. According to the EY insights (2018), Brazil’s FinTech users are considered among the world’s most active adopters of FinTech applications. Also, these applications helped them to perform different services such as payments, savings, money transfers, financial planning, borrowing, and investments. As an example, such popular FinTech companies that include about 2 million users are providing innovative services definitely newer than the old offerings largely used with the traditional financial services. On the other hand, internal groups intended to create and set up a system that promotes innovation have been established by the Brazilian Central Bank and the securities regulator Comissão de Valores Mobiliários (CVM). Therefore, the Central Bank engaged to assist with the implementation of the partnership framework concerning banks and FinTech companies to make

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available such digital and technological services as securitised loans, and also P2P lending that connects both individual investors and borrowers (EY Insights 2018). For Mexico, payments in FinTechs also are still increasing. Thus, Mexican FinTech startups such as Sen˜ or Pago, Billpocket, and Clip have established mobile point of sale (MPOS) technologies that are acquiring important traction in Mexico. As an example, Kueski is a Mexican startup intended to deliver small loans to middle-class individuals. Further, the country counted 273 FinTech startups, where some examples of popular and notable ones include ComproPago, Bitso, Conekta, and Kiwi (Berkmen et al. 2019; Frank et al. 2016; Lustig 2019). In Colombia, there were 148 FinTech startups by 2018. However, in 2017, the country suffered some startup failures and a rate of 14% was recorded. This result expresses the level of competition in the financial sector that is related to the introduction of innovative and technological solutions to the market (IDB and Finnovista 2018). Nonetheless, the regulatory aspects that differ extensively across economies, while depending on the structure and size of their financial and FinTech markets and also the flexibility and usefulness of the existing regulatory and legal frameworks, are concerns. Therefore, Brazil and Mexico have been the most driven in refitting regulatory frameworks. Despite this, Mexico has in particular introduced new and broad FinTech specific legislation. Meanwhile Brazil has integrated FinTech-related content into the existing regulatory and legal framework (Berkmen et al. 2019). Meanwhile, the FinTech startups in LAC countries are similarly attracting investments and funding sources possibilities. Some traditional banks are supporting and financing the creation of such startups in which they could introduce new market products and services with different financial solutions, such as trading and capital markets, wealth management, insurance, digital banks, scoring, identity, and fraud. Nevertheless, according to the report of IDB and Finnovista (2018) that includes perspectives on LAC countries, no clear strategy for open collaborative initiatives can yet be determined among the majority of the traditional financial institutions in these countries. Although some banks have already created laboratories of innovation and shown interest, this interest has yet to materialise in concrete results. Finally, this state might conclude with the main idea that there are still important differences among LAC countries; for example, Chile and Costa Rica are more technologically developed and have the human talent necessary for these types of startups. These factors in other countries are more challenging. Nevertheless, the lack of human capacity in this area is prevalent throughout Latin America.

FinTech Adoption in Africa Established research by the World Bank found that more than 66% of Sub-Saharan African people are listed as “unbanked” (Sesinye 2018). Further, African countries, among other less developed countries, have similarly come across other barriers to the development of their financial services, notably weak bank systems automation, regulations that are not adapted to the high world technological financing systems, or bureaucracy procedures in different bank operations.

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From another aspect, the financial services sector has been disrupted by cryptocurrencies technologies, while this alteration can, therefore, incite other opportunities for the financial inclusion and economic incentive for low-income people. Also, other new money technologies have succeeded in functioning as well, such as “M-Pesa,” and some other blockchain innovations are introducing and even disrupting other new potentials toward the evolution of financial inclusion among several operating in informal economies (Sesinye 2018). Thus, the M-Pesa is considered as a perfect example of the role that regulations have played in financial inclusion. This company has become one of the most successful FinTech startups in financial inclusion, and its success can be partially attributed to an open regulatory body (Central Bank of Kenya), which worked together with the company and allowed it to scale up and grow quickly without imposing restrictions (Soriano 2017; UN Environment Inquiry 2017). Another example is “BitPesa”; it is a digital payment platform that enables businesses to make payments to, from, and within Africa, providing an inexpensive alternative to conventional bank transfers. Similarly, “Musoni” is a cloud-based banking system that aimed at microfinance institutions. Across some African organisations, Musoni has led the way to establish a new technology in the microfinance sector and currently is incorporated with various mobile money transfer services. Moreover, “BitLand” is a land registration pilot project in Ghana, where vast tracts of land are not registered, even though BitLand uses decentralised and trustless models such as Bitcoin’s blockchain to link the gap between the government and the undocumented areas (Bitland 2019; BitPesa 2019; Musoni 2019; UN Environment Inquiry 2017). However, currently Sub-Saharan Africa is considered as the global leader in mobile money usefulness, where, in fact, 21% of adults in the region already have a mobile money account, particularly in Côte d’Ivoire, Tanzania, Burkina Faso, Gabon, Senegal, Kenya, Uganda, and Zimbabwe (Demirguc-Kunt et al. 2018; Felsenthal and Hahn 2019). Among those countries, it is found that approximately 50% stated having only a mobile money account, whereas others stated having a financial institution account as well (Demirguc-Kunt et al. 2018). In the past 3 years, many African startups have focused on the financial technology activity sector and have been the tech rave of the moment. Therefore, those startups have received, in that sector, more investment than other sectors (Yomi 2019). However, thousands of FinTech startups have declined into the gap of unbanked and underbanked citizens and SMEs, whereas they are looking to grow products and market share in digital finance, even though, in 2018, the continent exceeded US $1 billion in kinds of venture capital of startups. Besides, according to research done by Partech and WeeTracker, FinTech is the focus of the bulk of capital and deal flow (Bright 2019) (Partech is a global investment platform for tech and digital companies, led by ex-entrepreneurs and operators of the industry spread across offices in San Francisco, Paris, Berlin and Dakar. WeeTracker is a Global tech media, which aims to connect the startup ecosystems across the globe and be the medium for knowledge sharing. With their mainland being Africa, they aspire to be the bridge for connecting it to the rest of the world.).

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Another successful example among the first startups resulted in a mobile infrastructure in which it could connect the whole population of Africa: this was “Flutterwave,” a Nigerian startup created to combine Africa’s fragmented system through a single application programming interface (API). This startup has released their first product, Moneywave, which is a solution providing local merchants the ability to send money anywhere in Africa to any bank account or digital wallet instantly, which previously would have required days (Ashlene n.d.). In fact, the central banks and regulators could acquire benefits in considering FinTechs as a leap-frogging opportunity to step into economic growth and development regarding weaknesses concerning bank competition, financial inclusion, and also macrofinancial linkages in Sub-Saharan Africa compared to other African regions. Nevertheless, FinTech may present a new risk that must be driven, at the same time, with the most suitable and appropriate regulatory frameworks (Sy et al. 2019). The distribution of financial services in Sub-Saharan Africa has been significantly reinforced by radical change with the technology of mobile money. Consequently, nearly 40 of 45 Sub-Saharan African countries are currently using this new financial technology (FinTech); this region has, in fact, become the global leader of mobile money innovation, adoption, and usage (Sy et al. 2019). Although South Africa is considered as a leading example in carrying out development and innovation with the latest trends, which supported the adoption of technological financial services (product portfolios, service delivery), such as the full execution of cryptocurrency, this latter is legally restricted in some other African countries. This technology also leads to a thorough application of blockchain in their infrastructure (Mazambani and Mutambara 2019). From a forthcoming point of view, the FinTech industry is projected to have a major impact particularly on Sub-Saharan Africa, without the north African region (Algeria, Egypt, Morocco, and Tunisia), but also including most African countries. Thus, by 2022, according to a recent report by Financial Sector Deepening Africa (FSDA), the FinTech industry is estimated to surge its economic productivity from at least US $40 billion annually to US$150 billion (FSDA: Established in 2012 and supported by UK aid, FSD Africa is a specialist development agency working to build and strengthen financial markets across Sub-Saharan Africa.). The FSDA development report also disclosed that around 3 million people work, either directly or indirectly, in the FinTech industry (Clyde 2019).

FinTech Adoption in Asia A research report published by Ortiz Vidal-Abarca et al. (2017) showed that, whether it is promptly broadening to secure funding with more companies, ASEAN digital banking systems are still in the budding stage of evolution. Thus, parabolic growth in both mobile and internet banking platforms in ASEAN countries is impeded by the lack of trust in sharing information online. According to recent research by CBinsight (2019), Southeast Asia FinTech startups are attracting important funding and foreign investments. Therefore, historically Southeast Asia was considered an underbanked region. Until 2018, only 47%

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of adults in the region were banked, and only one third of Southeast Asian SMEs could obtain loans or credit. Recently, many Southeast Asian companies have initiated access and integrated through emerging financial ecosystems across the region that are aimed to build a favourable environment with capacities to afford payments platforms, loans, and many other services to the mostly underbanked populations. Also, the year 2019 recorded a modest FinTech investment in Asia Pacific, because a shattering level of investment was recorded in 2018, whereas both merge and acquisition and venture capital investment activity in the region were also breaking down considerably during the first semester of 2019 (Rubaiyat 2020). In summary, in East Asia and the Pacific, despite account ownership (banked people) stagnating, the use of digital financial transactions is still increasing. In the present day, near 71% of adults are banked, just slightly changed from 2014. Nonetheless, for example, Indonesia made an exception, where the percentage of account holders rose from 13% to 49% in 2017 (see Fig. 12) (Felsenthal and Hahn 2019). At the country level, FinTech companies in Singapore continue to dominate the ASEAN FinTech landscape, followed by Thailand and Indonesia (Ortiz VidalAbarca et al. 2017). While in China, digital ecosystem platforms realised size and success, India currently holds Asia’s FinTech hub crest. Furthermore, based on the first recent report published by Findexable in 2019 concerning a global FinTech Index ranking of 7000 FinTech companies, for more than 230 cities, in 65 countries worldwide, 11 Indian cities hold FinTech ecosystem platforms compared with 6 cities in China (Findexable 2019). China has succeeded in driving the financial and digital inclusion instantaneously. Also, the country is now home to 4 of the world’s 20 largest internet companies, and has also generated a set of new financial services companies with high transaction capacities. In 2017, mobile payments in China reached the value of topping US$13 trillion, compared to the USA, which has reached US$49.3 billion (Gupta and Tham 2019). In the Philippines, FinTech would have an important challenging role as a disruptive factor in the finance sector, whereby the industry has registered US$11.2 million in investments as new FinTech firms that have progressively increased, reaching US$96.6 million in 2018. In the meanwhile, several startups and FinTech incubators have started in the country, but they are facing difficulty in hiring and retaining FinTech talents. Therefore, they are limited to focus on payment systems and alternative finance and are not yet ready to provide other financial services such as blockchain and cryptocurrencies. Further, in 2018, the Philippine startups only received funds of about US$50 million in venture capital, an extremely low amount compared to the total of investments in the region, which ranged to US$3.6 billion that year (Gan 2019). However, since 2017, Pakistan has been a cash-based economy; it has nearly 100 million (50% of the population) unbanked people, with 85% of its population being financially excluded, one reason being the high banking infrastructure costs considered as an obstacle to the diffusion of financial services outside a small segment of the population. Currently, there are only a few FinTech companies

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a. Density & distribution of ASEAN FinTech by countries Philippines 14% Malaysia 11%

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Fig. 12 Density and dominant distribution of ASEAN FinTech industry by categories and countries (2017). (Source: Established by the author based on Ortiz Vidal-Abarca et al. 2017, pp. 15–16)

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operating in the country, where those companies are mostly concentrated in the industralised cities such as Lahore, Karachi, and Islamabad. Further, the FinTech ecosystem is confronted by threats to data security and intellectual property policies, and also with trouble in attracting the right talent and customer base, as well as uncertainty in future regulation. Therefore, these factors discourage entrepreneurs from venturing into the FinTech environment (Kumail Abbas Rizvi et al. 2018). Nevertheless, Southeast Asia is additionally seeing an upsurge of new mobile wallet services. In Indonesia, this includes Go-Jek, established since 2010, then Go-Pay, launched in 2018. Other services such as Razer Pay were also launched in July 2018 in Malaysia (Tegos 2018; Gupta and Tham 2019; Mulia 2020). Therefore, Indonesia considered as a fertile land for FinTech evolution, especially markets for cards, lending, and payments. Also, the country counts more than 150 FinTech startups, with a growth of 78% since 2015. Further, some of the talented FinTech startups constitute Jurnal, Cashlez, TunaiKita, Payfazz, and KoinWorks, wherein 44% of the total FinTech companies are activating as payment service providers (Cekindo.com 2018). Both payments and wallets are much more involved for Malaysian FinTech companies. Thus, in 2018, payments represented 19% of the market whereas wallets represented 17% of the market transactions, compared to 2017 with 18% and 12%, respectively (Fong 2018). In Bangladesh, although only 47% of the population are financially included, mobile financial services (MFS) have made the most significant enhancement over the years. Subsequently, the application of technology in businesses is considered as a key element of the “Digital Bangladesh Vision.” Consequently, this means that 47% of the population has access to affordable and convenient financial products and services through payments, transactions, savings, credit, and also insurance, which are delivered in formal and sustainable ways. In contrast, Bangladesh’s micro finance institutions (MFI) covered around 32 million people where they give out credit of more than USD$7.2 billion annually. Thus, the mechanism has supported many people to become more financially secure (LightCastle Analytics Wing 2019). In general, according to LightCastle Analytics Wing (2019), in Asia there are, in close to 90% of the 180 million poor households, a shortage of institutional financial services as most formal financial institutions are refusing to serve those poorest people because of the perceived high risks. The high costs are generally implicated to small transactions, while the poor are unable to afford marketable collateral for loans. Accordingly, MFIs could be considered as the main way whereby those categories of people can be financially included. Finally, a recent research report by Soriano et al. (2019) produced by the Cambridge Centre for Alternative Finance (CCAF), Asian Development Bank Institute (ADBI), and FinTechSpace company states some noteworthy findings and facts on FinTech industry environment evolution in the ASEAN region, summarised as follows: • Financial inclusion is a key issue in the region, where in many countries a high percentage of the population is without access to financial products and services. Across the complete data set, 17% of customers served by FinTech firms were categorised as unbanked and 28% were underbanked.

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• Another important factor is having a good digital infrastructure in the country. FinTech firms based in Singapore, for example, have been the most active in expanding to other countries, specifically targeting Indonesia and Malaysia. • Regulatory harmonisation is significant in terms of FinTech development in the region, and efforts are underway to encourage and further facilitate this, specifically involving cross-border initiatives. Regarding Soriano et al. (2019), the same report revealed another circumstance concerning the FinTech startups and firms that operate in the ASEAN region, noticeably that those firms in the ASEAN region are shifting their customer focus from serving individuals to SMEs and large corporations across the digital lending, artificial intelligence/machine learning/big data, and enterprise technology for financial institutions. Moreover, the study also revealed that the predictive analytics (68% of respondents) and machine learning (40% of respondents) are the most commonly used technologies for all FinTech firms in the region, with blockchain/distributed ledger technology (DLT) gaining momentum in digital payments, enterprise technology for financial institutions, capital raising, and crowdfunding business models.

Conclusions/Summary This chapter aimed to give some answers and analyses concerning the overall issues and main factors that may be expected to influence FinTech adoption in some selected developing countries. Based on research work, reports, studies, and statistics, the main goal of this contribution was to present a focused overview and to shed light, as a situation statement and real facts, about the positive and negative influence of the FinTech industry as a new challenge for most developing countries and its revolutionising impacts on those economies. This chapter has tried to analyse and extract the essential points and facts related to the FinTech industry in general, and most particularly in developing countries. Thus, a quick review on the background and basic concepts and definitions of FinTech was followed by an outlook of the facts of the industry, then a brief intense presentation on the future potentials and challenges of FinTech. Finally, an exposition of FinTech industry in developing countries was focused on three main regions: Latin America, Africa, and Asia. According to Buckley and Webster (2016), developed countries have succeeded in achieving high levels of institutional quality that lead to greater accessibility to different financial products and services, although some emerging and developing economies still experience deficiencies in this field. As a consequence, and from the discussion included in the last section of this chapter, the conclusion can present conceivable answers as to the main issue of this research, summarised in the following arguments: • The FinTech industry revolution is now considered to be a new real challenge that might highly influence global financial activity. This industry has known

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significant advances during the past decade, where the rate of VC and M&A activity has risen, particularly in the past 3 years. Moreover, based on recent research reports, the FinTech industry has shown huge future potentials to create or penetrate new markets and products in different regions in the world and specifically in many developing countries. Therefore, these effects could drive new investment opportunities for new ventures to create startups. FinTech could afford developing countries the possibility to leap directly to the new e-commerce and e-finance operations by the significant evolution in financial services through the development of mobile phone uses, mobile money transactions, payment solutions, etc., such as M-Pesa, BitLand, BitPesa, Musoni, and Flutterwave. FinTech startups are doing business in different countries of three regions: Latin America, Africa, and Asia. These regions have the largest concentration and intensive existence rate of unbanked and underbanked populations in the world. In fact, there are nearly 1.7 billion people, mostly in Asia and Africa, who do not yet have a proof of identity and essentially are cut off from accessing basic services and rights. Without proof of identity such as an ID card, the simple process required to open a bank account becomes more onerous, as a bureaucratic operation that may lead inevitably to the rejection or nonacceptance for opening an account. However, an electronic national ID or other digital identification system can facilitate and enhance FinTech startups activities, and allow customers who have wide access to financing institutions to reach other digital financial platform services as well. Despite all its capacities and advantages, FinTech might also present risks and dangers for such developing countries at most levels of development. Distinct doubt has also arisen widely about undesirable impacts that can seriously affect some emergent markets driven by FinTech companies. FinTech will certainly have broader unintended consequences, with potential downside risks for sustainable development. From an ethical aspect, cryptocurrency developments, in particular blockchain, have enabled illegal and illicit financial transactions, money laundering, fraud and criminality, tax evasion, and other unwanted actions. The FinTech industry also increases the need for strong cybersecurity, with the attendant costs. Hence, the investment industry is always facing several challenging actions and perspectives through the partnership with large financing institutions and companies and also substituting to all new markets. Also, FinTech achieves considerable amounts of transaction deals and capital, private data, and market-sensitive algorithms. The industry firms are also accompanied with regulation and legacy issues against their core structure and through new challenges of technological activity status. Governments need to be prepared and motivated to address, treat, and solve other existing problems by the evolving FinTech industry, particularly consumer protection issues, the cybersecurity transaction environment, and fair and available accessibility to the financial products and services for most potential users.

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Mazambani L, Mutambara E (2019) Predicting FinTech innovation adoption in South Africa: the case of cryptocurrency. Afr J Econ Manag Stud 11(1):30–50. https://doi.org/10.1108/AJEMS04-2019-0152 McKinsey & company (2018) Fintech decoded: Capturing the opportunity in capital markets infrastructure. Retrieved from https://www.mckinsey.com/industries/financial-services/ourinsights/fintech-decoded-the-capital-markets-infrastructure-opportunity Murthy G, Fernandez-Vidal M, Faz X, Barreto R (2019) Fintechs and financial inclusion. CGAP, Washington, DC. Retrieved from https://www.cgap.org/research/publication/fintechs-and-finan cial-inclusion Musoni (2019) Musoni services – about. Retrieved 10 Dec 2019, from http://musonisystem.com/ about/ Ortiz Vidal-Abarca Á, Xia L, Sumedh D, Tomasa R, Ugarte A (2017) Fintech in Emerging ASEAN Fintech - Trends and prospects-. BBVA Research, (Issue June). https://www.bbvaresearch.com/ en/publicaciones/fintech-in-emerging-asean-trends-and-prospects/ Oxford Analytica (2010) Latin American Banks Attractive to Investors as Loans and Profitability Grow. Research Recap (Seeking Alpha). Retrieved from https://seekingalpha.com/article/ 182166-latin-american-banks-attractive-to-investors-as-loans-and-profitability-grow Gupta P, Tham T (2019) Fintech: the new DNA of financial services. Berlin, Boston: De Gruyter. https://doi.org/10.1515/9781547400904 Tanjib Rubaiyat (2020) Future of Fintech in Bangladesh. Retrieved 26 Mar 2020, from https://www. daily-sun.com/printversion/details/455789/Future-of-Fintech-in-Bangladesh Pereira da Silva LA (2018) Fintech in EMEs : blessing or curse? Bank for International Settlements. pp 1–11. https://www.bis.org/speeches/sp180620.pdf Sesinye N (2018) 66 percent of sub-Saharan Africans are listed as “unbanked” – World Bank. IT News Africa. Retrieved 9 Dec 2019, https://www.itnewsafrica.com/2018/12/66-percent-of-subsaharan-africans-are-listed-as-unbanked-world-bank/ Soriano, Miguel Angel. (2017). Factors driving financial inclusion and financial performance in Fintech new ventures: An empirical study. Dissertations and Thesis Collection (Open Access). pp. 1–258. Available at: https://ink.library.smu.edu.sg/etd_coll/145 Soriano M, Ziegler T, Umer Z, Chen H, Jenweeranon P, Zhang B, . . . Rethda N (2019) The ASEAN FINTECH ecosystem benchmarking study. Cambridge, UK. Retrieved from https://www.jbs. cam.ac.uk/fileadmin/user_upload/research/centres/alternative-finance/downloads/2019-ccaf-aseanfintech-ecosystem-benchmarking-study.pdf Sy A, Maino R, Massara A, Saiz HP, Sharma P (2019) FinTech in Sub-Saharan African Countries. Departmental Papers / Policy Papers, 19(04):1–51. https://doi.org/10.5089/9781484385661.087 Michael Tegos (2018) Razer Pay launches in Malaysia, its 1st Southeast Asia market. Retrieved March 27, 2020, from https://www.techinasia.com/razer-pay-launch-malaysia UN Environment inquiry (2017) Fintech, green finance and developing countries. Geneva. Retrieved from http://unepinquiry.org/wp-content/uploads/2017/06/Fintech_Green_Finance_ and_Developing_Countries-input-paper.pdf Yomi K (2019) Everything you need to know about African fintech right now. Retrieved December 9, 2019, from https://qz.com/africa/1751701/everything-you-need-to-know-about-africanfintech/ World Bank data (2018). Global Conpetitevness Index. Retrieved from, https://tcdata360. worldbank.org/indicators/gci?country=BRA&indicator=631&viz=line_chart&years=2007,2017

Ethics in Islamic Finance Opportunities and Challenges in Times of Economic Turbulences Ivan Ureta

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Religious and Ethical Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Naissance and Evolution of IBs and IFIs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IBs, IFIs, and Ethical Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Importance of Standardization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current Challenges: Corporate Social Responsibility (CSR) and Transparency . . . . . . . . . . . . . . . IBs, IFIs, and Their Behaviour/Performance During Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Over the last decades Islamic finances and Islamic banking have been gathering momentum. As such, Islamic finances and Islamic banks have been trespassing the boundaries of Islamic countries and have arrived to conventional markets where they have been gaining attractiveness. Within a context of global interconnection and interdependence, alternative formulas have been rehearsed with the aim of reducing uncertainty and vulnerability. Islamic banking and finances as well as ethical banking share similarities. The public opinion has been increasingly demanding more transparency and accountability especially in the aftermaths of the 2008 financial crisis. Amidst this turbulent context, some experts have argued that Islamic finance could be an alternative to Western finance. As an alternative, it should not be seen as a risk for Western finances and conventional banking systems but as a complement which could contribute to increase the debate around ethics in finance. Through a higher level of consciousness and consensus around ethical practices, the current economic and financial context

I. Ureta (*) Economics and Management, SUPSI, Manno, Switzerland e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_32

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would increase their robustness and sustainability (also at social levels) by inhibiting speculative behaviours. In considering these aspects, this entry aims at replying to the following questions: What are the main religious features characterizing and inspiring Islamic Banking (IB) and Islamic Financial Institutions (IFIs)? Why IFIs and IBs have been gathering momentum over the last decades? Are IBs and IFIs more resilient to crises? Are the ethical principles and practices guiding IBs and IFIs in line with the evolution of the conventional banking and financial industry? Where do they differ and which are the most relevant strengths and weaknesses? To what extent can IB and IFIs be considered as valid alternatives to increase the solidity and sustainability of the existing financial and economic markets? Keywords

Islamic finance · Islamic banking · Ethics · Crises · Resilience

Introduction The contemporary world would not be imaginable without the existence of banks and financial institutions. The pervading interconnection linking all business sectors across the world, the economic and financial interdependence of economic and financial markets as well as the globalization of information flows influence the way our institutions work and behave at local, national, and international levels. Within a context dominated by vulnerability, uncertainty, complexity, and ambiguity, good-governed banks and financial institutions may make a difference in smoothening the way this global complexity challenges our societies and political systems on a daily basis. As Bell has pointed out, one of the most significant hurdles many banks have had to overcome for the last decades is to show that they can manage business well and ethically placing at the center of their decisions and actions the interests of customers and the wider society (Bell 2020). After the 2008 global economic and financial crisis, many attempted to find out who was responsible for this dramatic scenario. The consensus among the economists blames the banks themselves (Villa 2015). It is interesting to note that banks and financial institutions are very accurate in the way they portray their core values, their standards of integrity, and business principles. Most of them coincide in adhering to adjectives such as integrity, stability, excellence, responsibility, honestly, trustworthiness, fairness, and confidentiality. Those adjectives are, naturally, at the very core of any type of human relation and customers have to remain assured that banking institutions defend those values. Nevertheless, it has been possible to observe that there is a lack of alignment between those declared values and principles and the real actions and behavior of banks and financial institutions. After the 2008 global economic and financial crisis, trust in banks has become a clear concern among customers as they have clearly lost this trust in banks (Knell and Stix 2015).

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A survey conducted by Ernst and Young stated that while banks are largely trusted to keep consumers’ money safe, few consumers really “trust banks to provide unbiased advice that puts their needs ahead of the banks’ objectives. Traditional banks also fall behind nontraditional competitors relative to transparency of fees and recommending products and services most relevant for their customers’ needs” (EY 2016). Therefore, it is possible to confirm that there is a difference between the declared principles and values and the way they behave. In the midst of this turbulent context, conventional banks (CBs) and financial institutions have been declared responsible for the 2008 economic and financial crisis. Both the scholarly and the sectoral debate has tried to identify which financial and banking sectors were less prone to generate crises as well as been more resilient to the effects of the overall slowdown. In this stream, a growing interest has been raising around the features of the Islamic Banking (IB) as a banking system has been probably less damaging than CBs. Despite their features that have to be Shariah compliant, IBs are equally exposed to similar risks as CBs and therefore to remain competitive and profitable they have to adapt their offers and practices to a turbulent macroeconomic environment (Hussain et al. 2015). This chapter is structured around six main elements. Firstly, the main religious and ethical principles pertaining to Islamic Finance and Islamic Banking (IB) are presented and discussed. Secondly, a historical account about the naissance and evolution of IBs and Islamic Financial Institutions (IFIs) is presented. Thirdly, the similarities between Islamic Finance and IBs and the main principles driving Ethical Banking are analyzed. Fourthly, despite the increasing evolution of IBs and IFIs over the last years, it is important to acknowledge that these practices are still in their infancy. Therefore, the maturity of IBs and IFIs is related to the stronger standardization of the processes that should be shared across the countries offering products and services of this nature. Fifthly, two main challenges and trends affecting IBs and IFIs are presented: Corporate Social Responsibility (CSR) and transparency. Sixthly, the chapter focuses on trying to understand if the characteristics of IBs and IFIs make these financial institutions less prone to induce economic and financial crises and if they are more resilient to those.

Religious and Ethical Principles Although it seems that Islamic finance and Banking are gathering momentum over the last decades, the concept of interest-free financing (Riba) was widely practiced by the Arabs before Islam. This practice was adopted by the Arabs, as a form of financing for trade (Kabir Hassam and Umar Faruq 2007). Afterward the concept was integrated and consolidated in Islam. In his last sermon, Prophet Mohammed focused on three specific points: basic belief of one Allah, rule of law and morality, and rule of justice. These three elements represent a clear guide for all Muslims. More specifically, in this last address, Prophet Mohammed clearly stated that: “Allah has forbidden you to take usury (interest); therefore all interest obligations shall

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henceforth be waived. Your capital is yours to keep. You will neither inflict nor suffer any inequity. Allah has judged that there shall be no interest” (Verny Uywibba 2017). The cornerstone of IBs and Islamic Finance Institutions (IFIs) is therefore justice. Under this concept, justice is attained through the sharing of risk and all involved stakeholders must share both profits and losses (Dridi and Hassan 2010). As El-Gamal points out, justice here is conceived in its economic sense, not merely the asymmetric exploitation of debtors by creditors (El-Gamal 2001). Despite this connection to religious practices and ethics, IBs and IFIs do not behave as religious institutions. IBs like CBs are profit-maximizing organizations (Imam and Kpodar 2010). In respect of these principles and ethics, IBs and IFIs could contribute to diversify systemic risk. In IB both the entrepreneur-debtor and the bank share benefits or failures. Whereas in CB the creditworthiness of the client is crucial to authorize a loan based on the possibilities of paying back the interests, in IB credit institutions will receive a return if the project is successful. This practice is less speculative and may be prone to fund more sounding projects. It is generally accepted that the main difference between Islamic Banking (IB) and conventional banking (CB) is the absence of riba (interest). In theory, IB would not be allowed to offer a fixed-rate of return on the deposits. Equally, they would not be allowed to charge interests on loans. The financial operations in IB would follow a profit-and-loss sharing (PLS) paradigm (Ben Jedidia and Hamza 2014). Beyond the riba-associated practices it is relevant to mention that this paradigm is based on the mudarabah (profit-sharing) and on the musyarakah (join venture), which are concepts of Islamic contracting. Apart from these two elements, there are other dimensions to be taken into consideration. Gharar (speculation or chance) is not permitted and it includes aspects such as pure speculation, gambling, hedging, or any other type of financial transaction or contract having inherently any element of chance (UNDP 2016). Haram (proscribed by Islamic law) business sectors or industries are also excluded from IB even if 5% of their total income is generated through forbidden activities such gambling, pork, or alcohol. Given that IBs and IFIs are based upon the Profit and Loss Sharing paradigm (PLS), it can be assumed that IB may be more resilient to absorb external shocks because the possible losses are partially covered by the depositors (Bellalah and Massod 2013; Kettel 2010). Despite this risk, participating in a PLS method never means becoming an entrepreneur. Loans must finance productive, nonspeculative investments and the entrepreneurs/borrowers cannot determine the dividends at will because the distribution of profits has been decided in advance. It should be noted that the percentages and not the absolute amount are determined in advance. In its stricter formulation, the PLS methods appear limited and inflexible. As revenues may be underestimated and costs overestimated, the system presents high application difficulties. It should be added that the banks are given increased tasks in the evaluation and supervision of projects due to the presence of high risks and their insertion in the production process. The advantage of the PLS system may be of a noneconomic nature; it offers the Muslim community an opportunity to be faithful to its religious beliefs. It should not be forgotten that lower possibilities of

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bankruptcy can lead to greater stability in the financial system and greater demand for financial resources for investment (Khan 1987). To sum up, Islamic finance can contribute positively in three main dimensions. Firstly, it accelerates financial inclusion especially for less-favored Muslim populations bolstering the basis of a more sustainable socioeconomic development. Secondly, given that Islamic finances and IBs put their emphasis on asset-backed financing embedded within the PLS framework, Small and Medium Enterprises (SME) can be better served and public infrastructure can be funded. Thirdly, the risk-sharing approach along with the prohibition to speculation may reinforce the idea that Islamic finance and IBs are less prone to generate systemic risks than CBs and finance (Kammer 2015). Despite these promises, Islamic finances and IBs are still in their initial phases of development and the standardization processes and mechanisms have to be increasingly optimized and adapted to the global markets. In considering this status, IBs are as exposed to risks as CBs (López-Mejía et al. 2014). The concept “Islamic Social Finance” is referred to modalities of finance, which are Shari-ah compliant and are intended for social benefit. These modalities may include Zakat (almsgiving), Waqf (endowments), Sadaqa (charity), or Qard Hasan (interest-free loans) (Rehman 2019). Particularly interesting are the Waqf as they represent a crucial element of Islamic Social Finance aiming at optimizing resources to fight poverty, promote economic inclusion, and boost social development. The Waqf acknowledges the relevance of the nonprofit sector in both social and economic development and provides the needed legal and institutional protection against governmental interferences (Suleiman 2016).

Naissance and Evolution of IBs and IFIs The Ottoman Empire experienced some forms of IB and IFIs. Evidence is well recorded especially between 1600 and 1914 (Çaǧatay 1970). The strategic situation of Turkey and the growing international trade favored this expansion. For instance, one of the most used instruments for long-distance trade was the mudaraba partnership. The investor trusts his capital or merchandise with the agent who is trading the goods and then the original amount is returned. At this point, the profits are shared between the principal and the agent respecting a pre-determined scheme. Eventual losses of the capital due to the exigencies of the travel were borne by the principal (Pamuk 2004). Apart from these historical examples the real nascence of the modern IB was in the 1960s. The first example of IB can be traced back to its launch in 1963 at the Mit Ghamr Savings Bank in Egypt. It was created on the model of the European cooperative banks that he had long studied. In this bank, savers and fund takers were members of the institute and shared the results in compliance to Muslim ethics, while a religious watchdog council (Shari-ah board) supervised the operations performed by the bank. His enormous success was therefore born from the encounter between a current of Western thinking and Arab farming traditions. Soon, however, it aroused the mistrust

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Graph 1 Islamic finance assets growth projection. (Source: Elaborated by the author from the Islamic Corporation for the Development of the Private Sector (ICD) 2019)

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of the Egyptian government and the closure was imposed in 1968. Some authors considered that the business model rehearsed by this bank was utopic (Hafsa 2018). In 1963 was also born the Lembaga Tabung Haji in Malaysia, today the oldest Islamic institution in existence. It was the first Islamic institution providing services to the Muslim ummah (community) to save for attending Hajj (annual pilgrimage to Mecca). Many Muslims at that time were reluctant to deposit money in CBs for their pilgrimage because the pilgrims wanted to make sure their hajj savings were free from riba (usury). It is important to mention that Hajj represents one of the fifth pillars of Islam. Here, the connection between banking and religion is clearly represented. The 1970s were very active years with regard to the creation of other IBs and IFIs. In 1975, following the initiatives of the finance ministers from different Arab countries, the Islamic Development Bank (IBD) was created under the umbrella of the Organization of the Islamic Conference (OIC). Indirectly this initiative was motivated by the need to direct the growing quantities of petrodollars coming from the oil-producing countries. The main objective was to promote, in accordance with the principles of Shari-ah law, the social and economic development of all Muslim communities. Nevertheless, research has shown that since its creation, the IBD may have acted by privileging some political stances over others. Alignment with the political–religious interests of Saudi Arabia may make a difference in terms of loans allocation (Hernandez and Chaitanya 2017). In this context, the first private IB, the Dubai Islamic Bank (1975), the Faisal Islamic Bank of Sudan (1977), the Islamic Bank Faisal of Egypt (1979), the Islamic Bank of Bahrain (1979), etc., were also created. In 1979, postrevolution Iran was the first country in the world to Islamize the entire banking system (Parveen et al. 2015). Pakistan did the same in 1980 and Sudan in 1992 (Najaf 2016; Ebrahim 2011) (Graph 1). Since then the evolution of IB and IFIs has been strong as can be seen in the following graphs (Graph 2). These figures representing a consistent growth confirm that Islamic banking represents 70% of global Islamic industry assets in 2018 amounting to USD 1.76 trillion. In total there are 72 countries across the world with operating Islamic banks. Generally, the largest part of these Islamic banks is commercial. Out of the world’s 520 IB, 219 are IB windows belonging to CBs as there are some countries which

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regulate the sector imposing that restriction. According to the IMF, the African continent may represent a region where IBs and Islamic finance could grow over in the next years with its inception back in 2013 (MacNevin 2019) (Graph 3). In considering the abovementioned evolution of both Islamic finances and Islamic banking, it is important to ask whether this growth can be sustained in the future or not. As a matter of fact, Shari-ah compliant practices may represent some hurdles toward the rapid growth of IFIs and IBs within the next decades, especially considering the global interconnection of economic and financial markets. In order to understand this, the following section analyzes, among other aspects, how an ethical dimension may contribute positively to the expansion of this industry due to the fact that society increasingly demands more transparency and accountability.

IBs, IFIs, and Ethical Banking Ethical investments started to emerge during the 1970s in a global context when also NGOs proliferated at a fast pace in the Western world (Banks and Hulme 2012). Across the Arab World it is possible to see the same trend. In the late 1960s, and mostly in the 1970s, the Arab Fund for Economic and Social Development (AFESD), the Arab Bank for Economic Development in Africa (BADEA), the

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Islamic Development Bank (IsBD), the OPEC Fund for International Development (OFID), and the Arab Monetary Fund (AMF), among others, were created (Rouis 2010). This trend of increasing developmental and ethical awareness was underpinned by a growing demand of ethically concerned customers. This trend was identified by financial and banking institutions as an opportunity to expand their business models and attract more clients. Wilson pointed out that this ethical shift could be seen by some as a mere fade pushed by political correctness, while others may see it as a cynical attempt to exploit a client’s compassionated impulse (Wilson 1997). In 2007–2008, 2011, and 2013, three waves of surveys were launched aiming at better knowing the characteristics of the public opinion in Muslim countries. In this Arab Barometer it was found that a large percentage of individuals believed that conventional banks’ interest (CB) is contrary to the teachings of Islam. Even though Islamic finances can be associated by the broad public opinion to be attractive mostly for Muslim clients, in reality they attract a vast number of non-Muslim clients. For instance Al-Rayan Bank has published that more than the 80% of all fixed-term deposit customers are non-Muslims. Social Responsible Investing and Impact Investing are two terms that have been disseminated over the last two decades (UNDP 2014). Nevertheless, they cannot be used equally. As Hebb points out, “Responsible investment takes environmental, social and governance factors into consideration in investment decision making. Impact investing is a sub-set of responsible investing” (Hebb 2013). The main idea supporting impact investing is that investors can both seek financial returns and address social and environmental challenges. This approach has taken off after the 2008 financial crisis (Bugg-Levine and Emerson 2011). Despite its growth, impact investing has been mostly concentrated in the United States and Europe (Jackson 2013). Islamic finance has inherent features to boost social enterprise as well as to create shared value within society. However, in order to attain social impact investing, which contributes to social efficiency, sustainability, and stability, Islamic investing needs to develop stronger forms of governance that should be overseen by the Shariah Council in order to comply with Islamic tenets (Sheng 2013). In order to progressively create the conditions to comply with the Shari-ah principles over the years, a number of institutions have been created: the Islamic Financial Services Board (IFSB), the Malaysian Islamic Financial Services (MIFS), the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the International Centre for Education in Islamic Finance (INCEIF), the International Shari-ah Research Academy for Islamic Finance (ISRA), and the International Islamic Liquidity Management (IILM). Apart from these institutions, each IFI must have Shari-ah Supervisory Boards (SSB). As stated in the beginning, CB highlights profit-maximization considering that individual self-interest may generate well-being. Conversely, IB is rooted on the ethical and moral framework of Shari-ah meaning that IBs have to incorporate “both profits and social responsibility into their decision-making process” (Sheng 2013 p. 2). A study investigated Malaysian banks and the authors found that IB is not far different from CB. According to this research, a very small portion of IB financing

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was strictly PLS based and that Islamic deposits were not interest-free as they were narrowly pegged to conventional deposits.

The Importance of Standardization Despite the strong growth over the last three decades from 2018, it is possible to observe how this growth is not following the same pace. Total assets grew by only 2% in 2018 against the 10% in 2017 once a decline in the sukuk (Islamic bonds) market was detected (Damak 2020). In order to revert this negative context there are three main accelerators that should be considered: Inclusive standardization, Fintech, and Environmental, Social and Governance (ESG) opportunities. The inclusive standardization is of utmost importance. While the three main standardization setters – Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the International Islamic Financial Market (IIFM), and the Islamic Financial Service Board (IFSB) – are strengthening efforts to achieve a higher degree of standardization in interpreting shariah law, there is still the need to improve this emergent legal architecture, which is intertwined in the global economy (Ercanbrack 2020). Another problem that standardization faces is that in many countries this industry is regulated and governed by frameworks, which have been designed and conceived for conventional finance and CBs. Some of the most notable challenges IBs have to face are expressed as follows (Kammer 2015): • Although specific standards have been defined by the aforementioned standardsetting bodies, both regulatory and supervisory frameworks in many regions do take completely into consideration the unique risks pertaining to the industry. • One of the fundamental regulatory challenges is to guarantee that profit-sharing investment accounts (PSIA) are managed considering the financial stability. • Many times, regulators loosen their efforts to ensure Shari-ah compliance. This behavior contributes to erode the consistency of practices and approaches in local, regional, and international markets. • Even when IBs may appear well-capitalized, it would be difficult to apply the principles of the Basel III Accord. This accord was signed to strengthen the regulation, supervision, and risk management of banks after the 2008 economic and financial crisis. • IBs’ safety nets and resolution frameworks are still underdeveloped. Reducing complexity is also important in Islamic finance. If conventional bonds and sukuk (Islamic bonds) are compared, there are important bureaucratic differences. A conventional bond takes three main steps to be issued: decision to issue, standard documents, and market. Whereas a sukuk has to follow the following steps: decision to issue, adjust to the legal environment, identify the asset structure, negotiation (Shari-ah and lawyers), finalization of documents, and market (Damak 2020). Nevertheless, it is important to note that intermediate steps focusing on the

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legal environment, identification of the asset structure, and negotiation may contribute to reduce the incentives of speculative behavior.

Current Challenges: Corporate Social Responsibility (CSR) and Transparency In considering the growth of Islamic Finance it is also relevant to acknowledge that these institutions are also coping with trendy topics such as Corporate Social Responsibility (CSR). In this regard IFIs disbursed USD 518 million in 2018 in CSR funds. Nevertheless, only the 28% of these institutions stated these funds in their annual reports. This can be attributed to “a lack of transparency is still hindering corporate governance and CSR within the Islamic finance industry” (Mohamed et al. 2018). In general, higher levels of transparency may contribute to maintaining stakeholders better informed about the general practices and procedures of financial and banking institutions and prevents banks from bearing excessive risks. Transparency may reduce moral hazard, fosters accountability, and boosts integrity and efficiency in markets by strengthening discipline (Srairi 2019). Is this assumption completely correct? There are some issues that have to be taken into consideration. Firstly, discussions around financial risks may not always take into consideration the distinction between risks that are taken consciously and those being taken unawares (Draghi et al. 2003). In this sense, even if a bank or financial institution discloses very transparently their internal information, the ways in which risks are perceived and managed are independent to their will to communicate transparently. A bank or financial institution may be taking excessive risks unawares but can be very transparent communicating their operations. Secondly, when a bank or financial institution faces difficulties, a very open disclosure to the market could lead to bank losses because depositors lose their trust (Bovaiss et al. 2017). Within this context, IBs and IFIs have been labeled as organizations displaying limited transparency compared to CB as it has been said earlier. This feature could be a challenge IBs and IFIs have to fight against. Some studies focusing on IBs operating in the GCC region have demonstrated that there is a wide variation in the way banks disclose their information. This lack of transparency impacts corporate governance, shari-ah governance, and risk management (Srairi 2019). However, it is important to mention three aspects. Firstly, while trust is a central aspect in regulating the relations between depositors and CBs, in IBs and IFIs the importance of trust is augmented due to obligation to adhere to shari-ah. A great accent is put on Amanah (trustworthiness) that should be guiding every transaction (Nazim Ali 2017). This strong emphasis in connecting transactions with shari-ah compliance is at the very root of the expansion IBs and IFIs have been experiencing over the last decades across Muslim countries and beyond. Secondly, as Ashraf et al. point out, despite CBs trying to improve their transparency, “there is a lack of optimal transparency in conventional banking products. This deficiency is caused by the lack of the determination of the rate of change of interest and the variable interest loans, the securitization and the sale of the debt” (Ashraf et al. 2015).

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Conversely, as it was explained in the beginning, important normative and legislative filters such as the prohibition of riba and gharar would underpin transparency in IBs’ transactions. Hence, financial transparency would be more enforced in IBs than in CBs (Khammar and Ben Jedidia 2018). Thirdly, all CBs and IFIs are strongly audited organizations. They are audited by regional institutions like the Islamic Financial Services Board (IFSB), the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the General Council for Islamic Banks and Financial Institutions (CIBAFI), the Islamic Research and Training Institute (IRTI), which are part of the Islamic Development Bank. Apart from them, it is possible to find very accurate information from the Stock Exchange in Saudi Arabia (TADAWUL). Beyond this, IBs and IFIs are not only audited by Islamic organizations, they are also audited by western organizations like KPMG, E&Y, or KPMG, to name few.

IBs, IFIs, and Their Behaviour/Performance During Crises It has been generally accepted that IBs are safer and more resilient than CBs (conventional banks) especially in times of crisis (Farooq and Zaheer 2015). One of the main reasons supporting this belief is their product structure, which is basically asset-backed financing. Beck and other authors, by conducting a research, which included data of 141 countries between 1995 and 2007, have highlighted that, during the global financial crisis, IBs had a higher intermediation ratio as well as higher asset quality. They were also better capitalized. For the same time span, they concluded that these IBs had better stock market performance (Beck et al. 2013). A study has demonstrated that IBs suffered more than CBs over the 2008 financial economic crisis with regard to capital ratio, leverage, and return on average equity. Conversely, CBs suffered more than IBs in terms of return on average assets and liquidity. Altogether, IBs performed better than CBs between 2006 and 2009 (Parashar 2011). From the 2008 global economic and financial crisis, some scholars have been researching about the performance of Islamic finances and banking in economic downturns. It has been found that after the 1997–1998 crisis, which mostly hit Asia, depositors’ behavior changed and attributed more trust to Islamic banking believing that IBs were more resilient in coping with financial crises. That may explain the reasons why the inflow of deposits toward IBs increased during the 2007–2008 global financial crisis (Muhamad et al. 2011). Some of the research questions posed by these scholar aim at investigating if the Islamic finance model is capable of performing better in times of crises (Ahmed 2010). Bourkhis has studied the effect of the aforementioned financial crises on the soundness and stability of Islamic Banks (IBs) and conventional banks (CBs). This research took into consideration a sample of 34 IBs and 34 CBs from over 16 countries. By using the Z-score as the main indicator of bank stability, the findings revealed that there was no significant difference on the soundness of both types of banks because IBs have been diverging from their theoretical business model, which

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would have allowed them to do better than CBs. (Bourkhis and Sami Nabi 2013). Considering a longer timeline, a research studied 24 IBs operating across the Gulf Cooperation Council (GCC) between 2005 and 2012. This study focused on analyzing the impact of the global financial crisis on the profitability of these IBs. The findings confirmed that the financial crisis did not have a significant impact on the profitability of the IBs studied. It is relevant to mention that the findings achieved by these researchers confirm that IBs based within the boundaries of the Gulf Cooperation Council (GCC) are more compliant with Shari-ah principles and therefore, this higher degree of compliance favored a higher resilience during the crisis than IBs abroad. A study conducted by Ali investigated the efficiency of 47 IBs of different sizes both in the Middle Eastern region between 2006 and 2009. His findings suggest that larger IBs increased their efficiency between 2006 and 2008 and curved during 2009. On the contrary, small- to medium-sized IBs started with lower levels of efficiency and improved during 2009. Apart from these differences, the author noted that IBs operating in both Middle Eastern and non-Middle eastern countries increased their overall efficiency during the economic crisis (Said 2012). A larger comparative study found that IB’s business model contributed to buffer negative impacts on profitability in 2008, but it was revealed that weaknesses in risk management practices performed by some IBs worsened their profitability in 2009 compared to CBs. These analyses confirmed that within the short term IBs’ credit and asset growth performed better than CBs’. That behavior generated more financial and economic stability and external rating agencies ratified that by assessing better the risks of IBs (Hasan and Dridi 2010). Farooq and Zaheer, in studying Pakistan, state that Islamic branches of banks offering both Shari-ah compliant operations and conventional operations attract more deposits in times of panic. This behavior underlines the importance of religion in conditioning financial operations in Muslim countries. They conclude by saying that a greater financial inclusion of faith-based groups can contribute to reinforcing the overall stability of the banking system (Farooq and Zaheer 2015). In considering these findings, it is possible to say that within the short term IBs and IFIs are more resilient than CBs; however, within the long term, the differences between both systems appear to be limited due to the fact that international finances operate within the same global system and the degree of interconnection and interdependence is very elevated.

Conclusions Some of the most relevant ethical principles adopted by IBs and IFIs can be found in pre-Islamic times. With the advent of Islam, those principles were developed, codified, and shaped the main features of trade, economic, and financial relations, in both practical and philosophical terms. From this moment onward, these economic and financial relations had to be compliant with Shari-ah. Hence, when we talk about Islamic banking and Islamic finance, there is the temptation to simplify the

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concept and the common wisdom may associate IBs and IFIs with religious institutions. Nevertheless, IBs and IFIs are not religious institutions and they are not governed as such. IBs, IFIs, and CBs are equally exposed to similar risks and to remain competitive and profitable they must adapt their offers and practices to a turbulent and unpredictable macroeconomic environment. The exposed practices and concepts associated to Islamic finance based upon the PLS paradigm may suggest that IBs and IFIs can be more resilient to absorb external shocks because the possible losses are partially covered by the depositors. In this sense, it is somehow accepted that these IBs and IFIs are, in principle, less speculative. The risk-sharing approach along with the prohibition to speculation may reinforce the idea that Islamic finance and IBs are less prone to generate systemic risks than CBs and finance. It should not be forgotten that lower possibilities of bankruptcy can lead to greater stability in the financial system and greater demand for financial resources for investment. In that sense, it is possible to appreciate similarities between IBs and IFIs and conventional ethical banking. As expressed in precedent pages, the main advantage of the PLS paradigm may be of a noneconomic nature; it offers the Muslim community an opportunity to be faithful to its religious beliefs. Moreover, Islamic finance can be seen as an instrument boosting socioeconomic development and sustainability. It accelerates financial inclusion for less-favored Muslim populations. SMEs can be better served and public infrastructure can be funded. It is important to note that despite the phenomenal evolution experienced by Islamic finances over the last decades, only the 20% of the potential market has been exploited so far. With the growing accumulation of wealth by oil-exporting Islamic nations, and the sharp increase in the Muslim population within and outside the Islamic world, the future of Islamic finance looks promising. Before and after the 2008 economic crisis, it has been possible to appreciate a competition among three main financial spots: Dubai (supported by Saudi Arabia), Kuala Lumpur, and London. These three centers have been competing among themselves to become the world’s leading center of Islamic finances. This competition sheds light on the promising future of Islamic finances as an alternative to CBs and Western finances. Due to its ethical principles, IBs and IFIs attract Muslims and non-Muslim clients. As it has been seen in the preceding part of the entry, the attractiveness of IFIs and IBs have been growing in popularity among non-Muslim markets and clients. Considering the current context, plagued with uncertainties and the shadow of coming crises, ethical banking and IBs and IFIs may represent a safer haven. In some cases, Islamic institutions have proven to be more resilient to crises than CBs. Regardless of their actual performance in times of crises, Islamic Banking has embedded an important corpus of ethical practices that, applied consistently, would generate the basis for a less speculative and fairer economy. Despite these promises and the growth experienced over the last decades, IFIs and IBs are still in their initial phases of development and there are a number of challenges that have to be faced. Standardization processes and mechanisms have to be increasingly optimized and adapted to the global markets. As it was said, the three main standardization setters are strengthening efforts to achieve a higher

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degree of standardization in interpreting Shari-ah law, as there are divergences among countries, GCC countries being more reliable from this point of view. Apart from that, IBs and IFIs have to break the generalized perception about the lack of transparency and accountability. It is important to recognize that culturally and politically speaking the last decades have been deepening the tensions between the Western world and Islamic countries. These tensions do not contribute to generate a positive climate where Westerners may feel curios and inclined to know more about IBs and IFIs as possible alternatives of investment despite their inherent ethical principles. This is because the common wisdom associates IBs and IFIs to religion and therefore this bias represents an important cultural hurdle that will affect the growth of this industry. Linked to this increasing cultural misunderstanding, it is also important to reflect about the recent geopolitical developments that have been destabilizing the Middle East and North Africa region. The aftermaths of the Arab Spring have been posing several problems to socio-political stability. Some MENA countries have lost the attractiveness for international investors and that situation has slowed local economies, unleashing more economic, political, and social risks. Considering MENA countries, it is important to remind that the vast majority of their economies rely mostly on oil and are scarcely diversified. Over the last few years, oil prices have been curbing and these countries have been encountering problems of liquidity, especially those with smaller oil reserves and higher extraction costs. Therefore, the promising development of IBs and IFIs in Islamic countries has been curbed over the last 2 years as seen in the preceding pages. Over the following years it will be possible to see that the growth of this industry will be slower. In order to become more competitive, IBs and IFIs will have to face an additional challenge: to maintain the compliance with Shari-ah and to keep pace with the international economy, which is mostly dominated and driven by a speculative behavior and a dubious ethical approach.

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Investment Inspired by the Principles of Catholic Social Teaching (CST) as a Contribution to the Social Development Goals (SDG): A Case Study Jose´-Luis Ferna´ndez-Ferna´ndez and Diego Bla´zquez Bernaldo de Quiro´s

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expectations, Risks, and Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Threats and Opportunities for Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Genesis, Development and Fundamental Principles of Catholic Social Teaching . . . . . . . . . . . . . Key Documents of Catholic Social Teaching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Framework of Values, Principles, and Ethical Criteria of Catholic Social Teaching . . . . . . The Church’s Position on Finance After the Great Recession of 2008 . . . . . . . . . . . . . . . . . . . . . . . . Towards Reforming the International Financial and Monetary Systems in the Context of a Global Public Authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oeconomicae et pecuniariae quaestiones: Considerations for an Ethical Discernment Regarding Some Aspects of the Present Economic-Financial System . . . . . . . . . . . . . . . . . . . . . A Case of Application: Altum Faithful Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Altum Faithful Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

This chapter describes Altum Faithful Investing, a case study of an investment product, oriented from the principles of CST. After an introduction where we point out the most relevant threats and opportunities for Finance today, we present the paradigm of the Catholic social teaching: its genesis, development, and the fundamental principles that emanate from their key documents, from Rerum Novarum (Pope Leo XIII), to Oeconomicae et pecuniariae quaestiones.

J.-L. Fernández-Fernández (*) Pontifical University Comillas, Madrid, Spain e-mail: [email protected] D. B. B. de Quirós DiverInvest, Madrid, Spain e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_33

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Considerations for an ethical discernment regarding some aspects of the present economic-financial system. Catholic social teaching (CST) recognizes the relevance of financial dynamics, markets, and investment products as key elements for economic development and human progress. However, it sees neither exorbitant speculation nor furious short-termism as desirable. On the contrary, it encourages looking to the long term, seeking the sustainability of economic and human processes. Assuming that any investment decision always has a moral component, in addition to the economic-financial one, the CST proposes a series of criteria, values, and principles that are aligned with ESG investment products. Such are, among others: the dignity of the person; the universal destination of goods; the principles of solidarity and subsidiarity; the common good; the preferential option for the poor. This chapter actively promotes the notion that strong ethics, based on solid values, are essential to businesses, to the economy, and, ultimately, to the wellbeing of society and of human beings around the globe. We highlight the relevance of the ethical dimension of finance and financial markets, because even the decision to invest in one place rather than another. . . is always a moral and cultural choice. Keywords

Catholic social teaching · Altum Faithful Investing · Finance moral dimension · Principle of common good · Principle of subsidiarity · Principle of solidarity

Introduction The dynamics of the globalized economy in which we have been living for decades is undergoing important transformations in recent times. This is mainly due to unprecedented technical development, which is making possible, among many other things, what has been called the fourth industrial revolution and industry 4.0. As technologies, that enable and enhance this new circumstance, are usually identified under the acronym NBIC, i.e., nanotechnology, biotechnology, computer science, big data, Internet of things, virtual reality, additive manufacturing or 3D printing, cloud computing, blockchain – and finally, cognitivism, with artificial intelligence and robotics as highlights. From the above, a series of threats and risks will have to be combined, while opportunities will emerge that should be exploited to shape a more just, egalitarian, and inclusive world, from an economic activity, driven by innovative, efficient, ethical, and sustainable finances. In the first part of this chapter, the genesis and the theoretical-practical proposal of the moral principles proper to Catholic social teaching (CST) are presented. Next, some of their scopes with respect to the economy in general and finance in particular are pointed out. It concludes with the presentation of the case study of Altum Faithful Investing, a financial company based in Madrid, which orients its activity by reference to the criteria emanating from the Catholic social teaching.

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As will become clear later on, Catholic social teaching (CST) recognizes the relevance of financial dynamics, markets, and investment products as key elements for economic development and human progress. Moreover, one of its most conspicuous representatives, Pope John Paul II, stressed that the moral dimension in all human action, free and conscious, is always unavoidable; this also applies to all economic activity, to the business world and, of course, to finance, financial markets and investment activity: “Even the decision to invest in one place rather than another. . .is always a moral and cultural choice” (John Paul II 1991 § 36). However, CST sees neither exorbitant speculation nor furious short-termism as desirable. On the contrary, it encourages looking to the long term, seeking the sustainability of economic and human processes. Assuming that any investment decision always has a moral component, in addition to the economic financial one, the CST proposes a series of criteria, values, and principles that are aligned with environmental, social, and governance (ESG) investment products.

Expectations, Risks, and Proposals The new scenario offers, as it could not be otherwise, two sides of the same coin. On one hand, it comes loaded with exciting hopes, derived, no doubt, from the possibilities that technology is already able to offer for the achievement of a better world. On this friendly side, derived from technological progress, we can sense a scenario where development means not only economic growth but, above all, the possibility of human progress, of individuals and peoples, generalized to all humanity, in a sustainable way. On the other hand, the potentially negative aspect of the technocratic paradigm, as it is qualified by some people, with its impacts in multiple fields of life, is seen as a threat. From the ecological perspective, an objective look at natural life and the ecosystems that keep the common house alive and functioning, what the earth represents for humanity as a whole, reveals, with concern, the planetary limits and the deterioration of certain balances, among which climate change appears as the first – but not the only – of the most dangerous and immediate threats. In social life, on its part, we see the undesirable and unsustainable increase in inequality between people, regions, and countries; population growth; and the ageing of the population, at least in large parts of the developed world. The political sphere, for its part, offers unstoppable waves of immigrants in search of opportunities to lead a dignified life; and, with them, endless queues of refugees, fleeing from dangerous places and seeking asylum at the gates of the developed world. In connection, sometimes causally, with all this, we are witnessing undesirable polarizations, truffled with populism which, if they persist and are taken to the extreme, could end up with dangerous consequences in the midterm. Finally, and connected with all the above, with regard to the economic dimension of life, we can observe, with concern, how the lack of definition hovers, as a challenge, over such relevant areas as the following: on the one hand, the need to redesign the economy so that it continues to be viable and sustainable, making it

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move from a default linear model – extraction, production, distribution, consumption, and waste – to another circular model by design, where waste becomes the raw material for new products. On the other hand, there is a concern for the future of paid employment and what this means: not only access to income for large sections of the population, but also the opportunity to develop personal skills through work, and full integration into the social dynamic, on an equal footing with others. In short, it is becoming clear that there is an urgent need to undertake a strategic redefinition, not only of individual companies that must rethink their business models in depth if they are to continue operating in a more competitive market and in a society that is more demanding in terms of legitimizing them and granting them the essential license to operate, but also of entire sectors and industries that had been key players in economic and social development until now. These are, for example, the automobile, energy, oil, and, of course, banking and finance sectors. All these circumstances point to the need for an appropriate reorientation of the management of the economic dimension of human life in society. Because, undoubtedly, in order to achieve the common good – the ultimate goal of social progress and personal happiness – sufficient material conditions are necessary. Precisely, the economic activity is responsible for providing them; but, in this context, finance acts in the whole process as the instrumental means, on whose efficiency and agility economic success largely depends. Hence there lies the relevance of finance and financial management and therefore, the importance of aligning financial technology with economic efficiency, for the sake of a fairer and more developed society.

Threats and Opportunities for Finance It is in this context of profound transformation that the financial world is currently immersed and will have to develop in the immediate future. The possibilities that technology offers, together with the threats that are being detected, are becoming clearer and more peremptory. Many of the entry barriers will be eliminated and new competitors will appear in the sector; consequently, the ways of financing business projects will be transformed. This will result in increased demands on the design and delivery of financial services and the marketing of products that can address the growing needs of businesses and individuals in a sustainable manner. Furthermore, markets and their dynamics will also have to be transformed, either by provisions emanating from legislative authorities and regulatory bodies or by voluntary movements and self-regulation exercises. The latter, in turn, could have a double source; on the one hand, that of the conviction that emanates from self-assumed ethical values and which is substantiated by the explicit moral choice of good work, good practice, and financial ethics. And on the other hand, from the complementary source of compulsion, that is, from intelligent attention to demands that are increasingly impossible to neglect – at the risk of seriously endangering not only expansion but even survival in the market, from the fact that they come from a society that is increasingly better informed, more demanding and with more power in its hands.

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Evidence of this is the appearance and implementation of the so-called Agenda 2030, from which the 17 sustainable development goals (SDG) derive on a global scale, and on a regional level the recent European Green Deal, which expresses the will to make the European Union the first climate-neutral continent, through social innovation that can lead to sustainable solutions and new companies and business models. This, of course, requires, firstly, political involvement and citizen commitment; and then, large investments in green technologies. All of this, without a doubt, offers great opportunities for finance, financial activity, and markets to carry out an exercise in innovation and take advantage of the great opportunities that are going to be opened up to them in the immediate future. In the following section, we will give a brief account of the genesis and significance of the CST. We will also state the principles that could inspire, from the tradition that concerns us, the design of sustainable and ethical financial products and investment funds, aligned with the requirements and expectations implicit and declared in Agenda 2030 and the sustainable development goals (SDG). On the basis of these approaches derived from the CST, financial institutions could undoubtedly be in tune with the demands and expectations of a citizenry that we have previously described as being increasingly empowered and demanding with regard to the planetary sustainability of production and distribution processes; increasingly aware of the need for justice in social relations on a global scale; and increasingly concerned with ethics and good practice when it comes to granting trust to financial institutions. As will be seen, after the presentation of the case studies that will follow our presentation of the nature and fundamental principles of the CST, there shall be no need to choose between the artificial dichotomy of profitability and integrity. By using an ethical filter, investors can select from a wide range of companies, in all industries and geographical locations, and will feel comfortable about their investments by investing in products that have been ethically certified. Therefore, people can be sure that their money is not being used to finance evil, pollute our world, or violate human rights. We are devoted to promote ethics in the business world. With this chapter we actively promote the notion that strong ethics based on solid values are essential to businesses, to the economy, and ultimately, to the well-being of society and of human beings around the globe.

Genesis, Development and Fundamental Principles of Catholic Social Teaching Catholic social teaching has been evolving for more than a hundred years, in line with the concern for the problems arising from what was then known as the social question. The changing circumstances and the emergence of new situations led the magisterium of the Catholic church to progressively take into consideration unprecedented sociopolitical and economic aspects and problems, which until then had not required specific treatment.

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Precisely this historical, evolutionary character – in methods and contents – and attentive to the new realities of each historical circumstance is, perhaps, one of the characterizing features of this theoretical corpus, as well as of its practical concretions. The first reflections carried out by Pius IX (1848–49), as well as the theoreticalpractical work of the first so-called social Catholics, are usually considered as the antecedents of CST. Among them, it is worth mentioning, in the group of ecclesiastics, Msgr. Ketteler, Bishop of Mainz, and Msgr. Gibbons, Cardinal of Baltimore. Among the seculars, the French La Tour du Pin and Albert de Mun, promoters of the Catholic workers’ circles, deserve to be noted.

Key Documents of Catholic Social Teaching Apart from other materials and proposals of unquestionable importance, the most significant milestones of the CST are the following documents: the encyclical Rerum Novarum, published in 1891 (Leo XIII 1891); the encyclical Quadragesimo Anno, published in 1931, as the title indicates, to commemorate the 40th anniversary of the publication of the previous one (Pius IX 1931); some radio messages of Pius XII (particularly the titles: “La Solemnitá,” 1951 and “Il Popolo,” 1953); the encyclicals Mater et Magistra (John XXIII 1961), and that of the year 1963 under the title Pacem in Terris by Pope John XXIII; the pastoral constitution Gaudium et Spes, 1965; the encyclical Populorum Progressio, written in 1967 by Paul VI; as well as the apostolic letter Octogesima Adveniens, dated 1971 and which, as the title indicates, wants to echo the publication of Rerum Novarum, 80 years before Paul VI, 1971. With regard to the pontificate of John Paul II, and in relation to the aspects that concern us in this chapter, the following encyclicals should be noted more directly: Laborem Exercens, published in 1981 (John Paul II 1981); Sollicitudo Rei Socialis (John Paul II 1987); and Centessimus Annus (John Paul II 1991), written precisely to commemorate the centenary of the appearance of Rerum Novarum. To close this rosary of social encyclicals, mention should be made of the one given to the prayer card by Pope Emeritus Benedict XVI, under the title Caritas in Veritate (2009). Naturally, the apostolic exhortation Evangelii Gaudium, by Pope Francis (2013), as well as the encyclical Laudato Si0 , on the care of the common house (Francis 2015), dedicated to ecology, should also be taken into account. After this brief summary that identifies the key documents of the CST, it is important to insist on the fact that the Catholic church expressly declares that, with its teachings, it does not seek to enter directly and formally into questions of a technical nature, more appropriate to experts in finance and economics. On the contrary, she prefers to speak simply from her millennial experience as an expert in humanity. In this sense, she affirms that she does not intend to offer concrete solutions that must be followed inflexibly; rather, she seeks to place herself at the level of the great principles, from which it is possible to articulate projects that develop them in practice in an innovative and creative manner. Let us see, then, in which framework those principles are inscribed and which are the most relevant.

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Framework of Values, Principles, and Ethical Criteria of Catholic Social Teaching The Catholic social teaching places economic activity in a theological framework as broad as the history of creation itself. This framework could be summarized in the following points: 1. 2. 3. 4. 5.

God creates human person in his image and likeness. The world is created for all men and women. Men and women must preserve and administer it. Men and women are called to action and to collaborate in God’s creative work. In so doing, person develops, perfects itself, and sets out in truth to dominate the earth and guard it. 6. The way to carry out this economic-collaborative mandate in the process of creation is through work, done in a social way. 7. Economic activity, then, is to be understood not merely as an end in itself, but rather as a dimension of life in society that aspires to the fullness and complete development of the human being. This begins with the satisfaction of the needs experienced by the individual and for which there are established resources, which must be managed prudently and efficiently, setting in motion the dynamics of economic life: production, distribution, and consumption, counting, in any case, with an efficient and agile access to the financing of the processes. The lack of resources, their economy, the planetary limits, have to be assumed as an evident fact in every moment of history. Therefore, to put ourselves in the line of fulfilling the divine plan, conceived by God for the human species, the ethical dimension of economic activity could be synthesized by reference to the following questions: What to produce?, For whom to produce?, How to produce?, How to distribute what is produced?, and How to consume what is produced? This is precisely what the church has been formulating over time, starting from the message of Jesus Christ, in line with tradition and the thread of faith. And this is what, in the end, is left as a result of the clash and contrast between this theologicalevangelical tradition and the historical realities that it tries to illuminate. It constitutes, therefore, the tenor of the principles, criteria, and orientations that will inspire an economic and financial ethics in line with the Catholic social teaching. Let us look at it in broad terms. The starting point is the human person, imago Dei and relational, who must be understood as the principle, the subject and the end of all social institutions – finance included – and as the author and the center of all economic and financial life. Human person has the right and the duty to develop fully, in all facets of his or her personal and social life; and it is in this dignity that human rights take their place, as well as an essential equality among all men and women, compatible with a no less real and legitimate variety. In particular, the church has long emphasized the dignity of work, from which flows the right to – and the duty to – work, as well as a whole set of rights deriving from that capacity to work.

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Now, given that the person, in a manner of speaking, has two dimensions – one private and one social, in an analysis of these, we find two blocks of fundamental ethical principles, interrelated in a harmonious way. First, there are the principles that are based on the individual dimension; second, those that point to the social dimension of the person. Among the former are the following: 1. The right to free initiative 2. The principle of subsidiarity and 3. The right to private property The principles based on the social dimension of the person are these others: 1. 2. 3. 4. 5.

The social function of property The search for the common good The principle of solidarity The preferential option for the poor and less favored people and A revision of the model of growth which, by committing itself to an integral ecology that questions the unfeasible unilateralism of a supposed constant economic growth, respects the environment, takes care of creation as a divine work and the common home of all living beings, and favors the integral development of all persons and the progress of all peoples and cultures

The table of values, principles, and criteria that emerges from the CST could be outlined by reference to Fig. 1.

Fig. 1 Principles, values and criteria of the Catholic social teaching. Source: Authors

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What has just been said is useful to understand the comprehension keys of projects such as the one we are going to describe below, as a case study and example of application: Altum Faithful Investing.

The Church’s Position on Finance After the Great Recession of 2008 When in October 2011 the Great Recession was in full swing, derived from the economic crisis that had started in 2008 as a result of the consequences of the speculative bubble and the so-called subprime mortgages, the Pontifical Council for Justice and Peace (2011) published an interesting and – to some extent – controversial note entitled: Towards Reforming the International Financial and Monetary Systems in the Context of a Global Public Authority (Pontifical Council for Justice and Peace 2011). Years later, it was the Congregation for the Doctrine of the Faith together with the Dicastery for Promoting Integral Human Development who brought to light another suggestive document: Oeconomicae et pecuniariae quaestiones, considerations for an ethical discernment regarding some aspects of the present economic-financial system (Congregation for the Doctrine of the Faith and Dicastery For Promoting Integral Human Development 2018). Below is a brief summary of the main ideas of each of these texts. This will give a better outline of the Catholic social teaching’s approach to finance and financial activity. This will also serve as a framework for the case we will refer to in the next section of this chapter.

Towards Reforming the International Financial and Monetary Systems in the Context of a Global Public Authority In the wake of Pope Paul VI’s Encyclical Letter Populorum Progressio, we began to recognize that the critical situation we were experiencing required a concerted effort by many agents and institutions to analyze, understand, and then try to resolve the various facets of the problem – financial, economic, cultural, ethical, and spiritual – by establishing new commitments and new rules to redirect financial activity to improve social coexistence in the future. In fact, in the preface of the document, the president of the Pontifical Council for Justice and Peace, Cardinal Peter K. A. Turkson, quoting the words of Benedict XVI in the encyclical Charity in Truth, pointed out how: “The crisis thus becomes an opportunity for discernment, in which to shape a new vision for the future. In this spirit, with confidence rather than resignation, it is appropriate to address the difficulties of the present time” (Benedict XVI 2009, § 21). Charity in Truth (2012) itself was a lucid analysis of some of the most relevant factors in an economic crisis that, when it was published in 2009, was beginning to be experienced in all its severity. In that encyclical, Pope Benedict XVI insisted on the ethical and ideological factors of the crisis, while indicating some of the most

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significant challenges that the international community would have to face in the immediate future if it wanted to guarantee the common good. For their part, the Note of the Pontifical Council for Justice and Peace that we are dealing with here was structured in four sections, along with a preface and a section dedicated to conclusions. The first section dealt with the issue of economic development and inequalities and, recognizing that in the last part of the twentieth century economic well-being had experienced a very significant rate of growth in general terms; however, the inequalities between the economies of the different countries had been growing in parallel in a worrying, undesirable, and, surely, unsustainable way. With a good diagnosis, it was pointed out there how “the speculative bubble in real estate and the recent financial crisis have the very same origin in the excessive amount of money and the plethora of financial instruments globally” (Pontifical Council for Justice and Peace 2011, Ibid.). Consequently, the origin of the problem was identified in a trend, which had already begun in the 1990s, towards the excessive expansion of liquidity and credit in international financial markets. These circumstances had led to several speculative bubbles, the most serious of which had been the real estate bubble in 2008. In the end, this led to a severe solvency crisis, which was soon followed by another, even more serious, crisis of confidence in the system. As a corollary to all this, the Great Recession – a fall in production and an increase in unemployment rates – took place. The deep causes that explained the phenomenon, apparently of the Pontifical Council, were nothing but utilitarian individualism, truffled of selfishness, greed, and hoarding of goods on a large scale. In short, the blame lay with the predominance of the ideology of an exaggerated economic liberalism, which was firmly committed in – and had succeeded through convenient pressure from powerful lobbies – relaxing regulation and many of the controls over global financial markets. And, in any case, they pointed to the core of what they considered to be the main problem: “Regulations and controls, imperfect though they may be, already often exist at the national and regional levels; whereas at the international level, it is hard to apply and consolidate such controls and rules” (Ibid.). The second section focused on considering the role of technology and the ethical challenge. At this point, it is pertinent to highlight, very much in line with the criteria and principles what we underlined in the previous section of this chapter, the fact that how “the primacy of being over having and of ethics over the economy, the world’s peoples ought to adopt an ethic of solidarity to fuel their action. This implies abandoning all forms of petty selfishness and embracing the logic of the global common good which transcends merely passing and limited interests. In a word, they ought to have a keen sense of belonging to the human family, which means sharing in the common dignity of all human beings” (Ibid.). A third section – an authority over globalization – opened the door to considerations which, in line with the spirit of John XXIII’s encyclical Pacem in Terris (1963), were ultimately controversial; and which, in fact, had to be the object of criticism and subsequent nuances. In fact, perhaps the most controversial idea in the whole document that we have been discussing was the proposal that advocated the

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need to constitute a world public authority. As we indicated, within the framework of Catholic social teaching, this aspiration was by no means new. In fact, John XXIII (1963) not only, but also Benedict XVI himself (2009) had expressly stressed it. Nevertheless, in the opinion of the writers of the Note, personified by Cardinal Turkson, President of the Pontifical Council for Justice and Peace, it was now more evident that the need for a world authority that would look after the common good on a global scale was more real than ever, as we were living in an increasingly interconnected world, where problems that could not be tackled unilaterally with solvency were emerging. These included issues such as peace, health, development policies, migration flows, environmental protection, and security, effective protection of human rights, disarmament, and financial crises. As it could not have been otherwise, critical voices were soon raised against this proposal. They pointed out, not without reason, the foreseeable inefficiencies, as well as the undesirable bureaucratic rigidities – in all kinds of economic and political relations – that would result from the implementation of a measure such as the one proposed; and which many – even from within the church and the Vatican Curia itself, for example, the secretary of state himself, Tarcisius Bertone – considered as a direct attack on the waterline of the capitalist system as a whole. As we have said, the real meaning and nuances of the proposal had to be clarified, in line with the traditional teaching of the Catholic church and the principles referred to above. As a result, it was said that they were not advocating an all-encompassing and monocratic superpower, but only a world authority oriented to the common good, constituted by agreement, based on representativeness and the division of powers, founded on moral reason and governed by law. It would act in the service of the various nations, with the utmost respect for the principle of subsidiarity. Such an authority could only emerge after a slow and gradual process, based on multilateralism, from which the transfer of sovereignty and competences by the different states would have progressed. The strategy of making this possible and slow to institutionalize this more or less utopian aspiration was based on the recognition that “it is not possible to arrive at global Government without giving political expression to pre-existing forms of interdependence and cooperation” (Pontifical Council for Justice and Peace 2011). From the state level, progress could be made towards regional and international frameworks, in order to – starting from a profound reform of the current United Nations Organization – end up constituting a global, decentralized, limited, and participatory authority, capable of making the primacy of ethics and politics viable, and of placing the economy and finance at the service of social justice and universal brotherhood. The fourth section focused on some specific proposals for reforming the system, in line with what the title of the Note anticipated: Towards Reforming the International Financial and Monetary Systems in a Way that Respects the Needs of all Peoples. Among these aspects, it underlined the convenience of reflecting on elements such as: (a) taxation measures on financial transactions; (b) new forms of recapitalization of banks with public funds; and (c) the definition of the two domains of ordinary credit and of investment banking to allow a more effective management

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of the shadow markets, which have no controls and limits nowhere. In addition, it insists on the convenience of opening up a new era of responsibility and of moving towards the establishment of a kind of Central World Bank, which would accommodate and improve the structures of the architecture of the current international financial system. The final conclusion of the document is contained in the last sentence: “The spirit of Babel is the antithesis of the Spirit of Pentecost (Acts 2:1-12), of God’s design for the whole of humanity: that is, unity in truth. Only a spirit of concord that rises above divisions and conflicts will allow humanity to be authentically one family and to conceive of a new world with the creation of a world public Authority at the service of the common good” (Pontifical Council for Justice and Peace 2011, Ibid.).

Oeconomicae et pecuniariae quaestiones: Considerations for an Ethical Discernment Regarding Some Aspects of the Present Economic-Financial System This new document, which was issued on 6 January 2018, follows on from the document presented in the previous section. In this regard, footnote 35 clarifies the meaning of the Oeconomicae et pecuniariae questions: “We now intend to proceed in the line of a similar discernment in order to encourage a positive development of the economic-financial system and to contribute towards the elimination of those unjust structures that limit potential benefit of them” (Congregation for the Doctrine of the Faith and Dicastery For Promoting Integral Human Development 2018, note 35). Divided into four sections – I. introduction; II. fundamental considerations; III. some clarifications in today’s context; and IV. conclusion, this new document reiterates the basic principles of the Catholic social teaching, to which we have already referred, as anthropological and ethical prerequisites – such as the dignity of the person, in which the relational character is now emphasized; solidarity, subsidiarity, the common good, the universal destination of goods, the preferential option for the most disadvantaged; and advances some other ideas and considerations trying to speak from the circumstance that represents the situation that is lived in these first decades of the twenty-first century. It suggests the possibility – and, consequently, the moral obligation – of designing a new economic order and developing a new way of organizing financial dynamics. This is all the more so when we take into account two of the most significant features of the moment, which could be of prime importance in this respect: globalization, on the one hand, and digitalization, on the other. A paragraph, in section five, is particularly explicit in this regard: “The recent financial crisis might have provided the occasion to develop a new economy, more attentive to ethical principles, and a new regulation of financial activities that would neutralise predatory and speculative tendencies and acknowledge the value of the actual economy. Although there have been many positive efforts at various levels which should be recognized and appreciated, there does not seem to be any

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inclination to rethink the obsolete criteria that continue to govern the world” (Congregation for the Doctrine of the Faith and Dicastery For Promoting Integral Human Development 2018, § 5). And in the next line it is acknowledged that:“On the contrary, the response seems at times like a return to the heights of myopic egoism, limited by an inadequate framework that, excluding the common good, also excludes from its horizons the concern to create and spread wealth, and to eliminate the inequality so pronounced today” (Ibid.). Based on a kind of an axiom that Pope Francis had formulated – “Money must serve, not rule!” – it is emphasized the need to move towards a form of economy and finance, with rules and regulations that would guarantee the respect and centrality of the person in the whole economic and financial process; that would unite ethical considerations to economic efficiency; that would extend the aspiration not only to material goods, but also to the spiritual well-being of people; that it looks to the long term, bets on social responsibility and sustainability; that it takes as criteria for economic success not only the increase in GDP, but also other standards, such as “safety, security, the growth of human capital, the quality of human relations and work;” and, above all, that it watches over the common good. All this, from the express declaration, “profit and solidarity are no longer antagonists” (Ibid. § 11). After challenging the claim that financial activity is immune to ethical considerations, the document points out and critically reviews some of the deficiencies observable in the market, which is clearly incapable of self-regulation and of achieving the desired balance on its own. From the purest realism, it indicates that “it is impossible to ignore the fact that the financial industry is a place where selfishness and abuse of power have an enormous potential to harm the community” (Ibid. § 14). Among the most significant shortcomings, the following are indicated: the mere speculative exercise, increasingly re-qualified and distant from the real economy; the manipulation of quotations, potential fraud and market abuse; and certain asymmetries – above all, related to the transfer of risk and to the hypercomplexity of certain financial products, such as derivatives and securitization processes, which tend to result in deception and harm to a majority of the agents intervening in the markets, as well as to the common good; these are usually followed by the exclusive – and often illicit – benefit of a privileged minority, which tends to indulge in oligopoly, tax evasion, offshore operations, and maintenance of an unfair and generally inefficient status quo. Such a circumstance, what it makes see, is that the system does not enjoy good health; and it is far from the fulfillment of the end towards which it should be oriented: “Here financial activity exhibits its primary vocation of service to the real economy: it is called to create value with morally licit means, and to favor a dispersion of capital for the purpose of producing a principled circulation of wealth” (Ibid., § 16). In order to try to close these gaps and orient the economic and financial system towards an economy that is not only more efficient, but also more just, with greater solidarity and capable of humanizing the lives of individuals and peoples, the call is once again for the necessary supranational coordination, cooperation, and the search for synergies between agents and administrations. Transparency, prudence, and

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well-designed and implemented rules and regulations could reduce the systemic risks that financial innovations could bring, which could take the form, inter alia, of speculative bubbles, irrational exuberance in the markets, and irresponsible asset management, as well as in many ethically questionable activities by finance professionals who, rather than looking after the good of their clients and the security of stock market movements, seek above all to move and carry out multiple transactions, with a view to obtaining commissions, for their own benefit and at the client’s expense. The proposals made to improve the economic and financial dynamics – among which the need to institutionalize ethical committees is expressly pointed out, and that the compliance function should not be limited simply to complying with the laws to avoid sanctions, but should go beyond that, in a positive way, the proposals are undoubtedly set against an optimistic backdrop, which is worth highlighting, so that the coordinates from which to understand applications of catholic social teaching to the design of financial products or investment funds according to these moral approaches are clear. To close this section and make it clear that, according to the approach of the Catholic social teaching, it is feasible – and even desirable – to coordinate the search for profitability with good moral practice, we transcribe the following sentence as corollary: “the natural circularity that exits between profit and social responsibility reveals its full fruitfulness and exposes the indissoluble connection between the ethics respectful of persons and the common good, and the actual functionality of every economic financial system” (Ibid., § 23).

A Case of Application: Altum Faithful Investing As we have pointed out above, financial activity, as expressed in the markets, instruments, intermediaries, and financial services – in principle, and provided that all of this is not diverted and oriented exclusively towards self-referential speculation or towards some of the failures that we have just pointed out in the documents mentioned in the previous section, constitute realities that are perfectly compatible with Catholic morality (Gregg 2016). Moreover, when that activity is placed, in fact, at the service of the real economy; and when it manages to be inserted into a robust, efficient, and, above all, ethical institutional framework, finance constitutes a key element in the attainment of the common good. In any case, it is recognized that in order to guarantee precisely that contribution to the common good, “what is needed, on the one hand, is an appropriate regulation of the dynamics of the markets and, on the other hand, a clear ethical foundation that assures a well-being realized through the quality of human relationships rather than merely through economic mechanisms that by themselves cannot attain it” (Congregation for the Doctrine of the Faith and Dicastery For Promoting Integral Human Development 2018, § 1). Assuming the above, in this section, as stated above, we will briefly present the case of a financial company initiative, aligned with the ethical postulates emanating

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from Catholic social teaching. To this end, we will briefly describe a financial consultancy firm based in Madrid (Spain), Altum Faithful Investing (2020). With this, we simply seek to illustrate, by way of an example, how it is possible and real to set up products and articulate business models which, operating in the financial markets on equal terms with other agents, do so, however, attentive to moral criteria and ethical values as demanding as those emanating from the moral proposals of the Catholic social teaching. In fact, the example we will give below goes beyond what is known as the SRI (socially responsible investment) criteria; it even takes on board, and even exceeds in terms of moral requirements, the approaches of that type of investment that chooses to take into consideration the so-called ESG aspects (environmental, social, and governance). Of course, the case we are about to make is far from unique. In other cultural traditions and in different religious confessions it is possible to find initiatives similar to the one that Altum represents. Even within the very orientation of Catholic social teaching, it is relatively easy to find similar proposals. Although we do not need to go into more detail on examples, it is possible to indicate some other interesting initiatives. Such would be, for example, the one represented by E.T.H.I.C.A., an investment fund, also based on the principles of CST, which originated in France in 2007, to manage the funds of a religious congregation; and which in Spain has been operational since September 2019 and is managed by Allianz GI (https://es.allianzgi. com/es-es/nosotros/sala-de-prensa/notas-de-prensa/fondo-invierte-siguiendoprincipios-iglesia-catolica). Having said that, let us make a brief presentation of Altum Faithful Investing.

Altum Faithful Investing Altum Faithful Investing, very probably takes its name from the recommendation that, according to the evangelist Luke, Jesus made to Simon Peter and some of his later apostles when, after getting into their boat and addressing the crowd that gathered on the shore of the lake of Genesareth to hear his word, he told Simon to row out to sea and cast his nets deeper into the sea. The text of the verse, in Latin, reads as follows: “Utcessavitautemloqui, dixit ad Simonem: ‘Duc in altumetlaxate retia vestra in capturam’” (Lk 5, 4); in other words: “After he had finished speaking, he said to Simon, ‘Put out into deep water and lower your nets for a catch’” (Lk 5, 4). In short, in Latin, altum is the nominative neutral singular of the adjective, altusa-um, which has different meanings; among them, the following: the high, the height, the depth, the deep and even, high seas, the sea. Consequently, in addition to a venerable pedigree, the name of the financial company we will be dealing with in the following paragraphs leaves the meaning open to powerful metaphors that point to challenges of the magnitude of the effort to navigate the stormy sea of financial management, with the boat of ethics and the networks of professionalism. Indeed, as can be read on the company’s website (https://altum-fi.com/), Altum Faithful Investing is a financial advisory company regulated by the Spanish National Securities Market Commission (CNMV), founded by Borja and Jaime Barragán, two

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secular professionals from leading investment banks, who openly declare: “We have founded Altum Faithful Investing to place what we know – economy, finance and wealth management – at the service of our clients, helping them to be consistent in the form of assuming the specific responsibilities of the evangelical management of their wealth” (https://altum-fi.com/en/who-we-are/). In its corporate philosophy, Altum takes, as its starting point, the fact that investing in the stock market and acting in the financial world is a perfectly dignified and legitimate activity; compatible, in principle, with the postulates and aspirations of the Christian religion; embedded, in this case, in the principles emanating from Catholic social teaching. In this regard, the important thing is not so much the fact of operating in the field of finance – buying and selling assets, trading products, hedging risks and market volatility through the use of derivatives – as the concrete way in which this activity is carried out. If it is done with expert competence; and if it is always operated from an exquisite respect for the strictest requirements of financial ethics, there is no reason to have any scruples about the intrinsic goodness, firstly, of the professional work of those engaged in this type of activity; and secondly, of the legitimacy of an organization that chooses to implement and develop a business model such as that involved in portfolio management and financial advice. The key, in the final analysis, lies in the dichotomy that Paul H. Dembinski uses to give a title to a well-worked study: Finance servanteou finance trompeuse, or in other words, servant finance or deceptive finance (Dembinski 2009). The ethical values that guide Altum’s professional work are expressed by reference to the following four categories: Independence – dedicated to their costumers, they avoid absolutely conflicts of interests and we only receive our compensations from the fees our clients pay us, without receiving any type of kickback or commission of any other type; prudence – by helping wealth managers to act with practical wisdom when managing their investment, harmonizing the moral rectitude of the investment decisions with the intention of obtaining a fair return on it; ease – focusing on proposing simple portfolios and investments, eliminating complex a hiper speculatiuve products; and, finally, transparency and reporting. In this regard, they state: “Transparency is one of our objectives and reporting is an instrument apt to achieve it. At Altum, we explain each and every one of our investment recommendations too our clients so that they, in turn, may report back to the appropriate entity (Provincial Governmentes, Dioceses, Trusts, etc.)” (Ibid.). As far as they are concerned – and assuming that, as we have stated above, there shall be no need to choose between profitability and integrity – its declared business objective is no other than “to give investment solutions, at the same time seeking the strong and stable growth of the wealth with minimum cost, applying Catholic principles in each and every one of our investment decisions.” And this is so, because, as indicated below: “We are convinced that one can also give witness with parrhesia (with courage and freedom), through the act of investing, where the fruit, as well as the economic benefit, promotes the full development of the person” (Ibid.). In that sense, aligned as it is said, with the postulates of Catholic social teaching, Altum Faithful Investing declares that its mission consists in advising the

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management of the investments of their clients with professionalism, always seeking two objectives: obtaining adequate profitability and ensuring that the investment portfolio fulfills the teaching of the Catholic church at all times. Since, as it expreselly states: “We seek not only the greatest return for our clients, but also to be an instrument of evangelization” (https://altum-fi.com/en/home-en/). Altum’s clients are, mainly, religious institutions and Christian-inspired foundations. But not just that. They also advise the wealth management of individuals and civil entities that have Catholic sensitivity when it comes to managing their assets. Such are, for instance: dioceses, parishes, and religious institutions; but also, foundations, family offices, and even individual investors. At Altum they are convinced that investors have the moral responsibility to know what they are investing in; and how it is invested, thus to invest with consistency. This is, precisely, what makes the difference and the raison d’être of Altum. Therefore, they have developed the Altum Investment Guidelines, which are the investment principles that they always apply in their consulting activity: (1) promotion of human dignity; (2) promotion of family; (3) promotion of human life; and (4) care and protection of the Creation. Such guidelines, from a positive perspective, emphasize the investment in companies and securities that manifest responsible management practices; that behave responsibly towards preserving human dignity; and that operate with integrity – respect for labor law, no corrupt practices or unfair business practices – in the interaction with its stakeholders. On the other hand, those guidelines offer at the same time negative criteria for avoiding to invest, for instance, in business with a significant involvement in producing, directing, publishing, distributing, and retailing of adult entertainment of pornographic nature. From another point of view, as they at Altum promote person’s independence from addictions, they positively weigh companies and securities that promote freedom from addictive behaviors, especially those caused by alcohol, tobacco, and gambling. Another important investing criterion at Altum has to do with their defense of religious freedom. Therefore, they avoid investing in assets from governments or companies who promote or carry out religious persecution against any faith, or deprive people from the right of religious freedom. In general, Altum avoids taking part in companies or investments whose activity and objectives conflict with the principles and values of Christian morals and Catholic social teaching. In order to build their portfolios from the Catholic ethical point of view, they trait to be “inclusive with those initiatives that promote the teaching of the church and by being clear when excluding companies whose activity openly conflicts with Christian morals” (Ibid.). Furthermore, “for the customers who want it and as part of the evangelizing aspect of the investments,” they establish dialogue with the companies with the intention of influencing their conduct in matters related to the protection of the Creation and the promotion of life, family, and human dignity. A last feature among the cultural characteristics of Altum is represented by the fact that they seek to carry out their work well performing financial consulting from beginning to end.

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Conclusion Human life on the planet has always sought the same objective: to develop, unfold, and flourish, to reach the highest possible degree of that state which is known as happiness. Now then, for this, it is necessary that social life be oriented towards the common good. In other words, social life must offer the conditions of possibility so that individuals, families, and the various collectives and intermediary groups of society can achieve their own development and come as close as possible to their own perfection. Although anthropological realism, historical experience, and lucidity in the analysis of reality prevent us from dreaming of the possibility of building a paradise on Earth – a pretension that, more than utopian, would deserve be conceptualized as chimerical, destined to create more suffering, more injustice, and greater misery than that derived from the evils thar, paradoxically, it is trying to avoid with it – it is no less true that it is possible to strive to build a more humane and just world than the one we have and in which we live. For this reason, as we say, without trying to establish heaven on Earth by means of any kind of revolution, the path of improvement that we have in perspective is very wide; and, therefore, it is always worthwhile to try to improve life, and to enhance the contexts in which it develops. As it has been stated above, part of the conditions that make human progress possible has to do with sufficient access to material and instrumental goods. Among them, money and everything related to finance stand out in the first place. Certainly, these are not the highest values to which humanity can aspire – there would be respect, friendship, and love; but, without those capital goods, it would be very improbable to articulate systems where the spiritual aspects of human life could even sprout and flourish. The fundamental legitimacy of financial systems lies precisely in this circumstance: that, properly used, they can make a decisive contribution to the improvement of human life as a whole. To this end, it will naturally be necessary to combine the technical quality, required to operate in the financial sphere, with a high ethical orientation (Fernández Fernández 2004), which, having guaranteed confidence in the system, will always encourage it to operate in accordance with the parameters demanded by justice – both commutative and distributive; and with the breadth of vision that is indispensable, if the strategies to be implemented are also to serve the common good of the whole human race. In this sense, Agenda 2030, made concrete in the 17 sustainable development goals (SDG), should to be seen, throughout the next decade, as the itinerary that we would have to follow, as the true roadmap of humanity. Now then, for those goals to be achieved, it will be necessary to consolidate good, fair finances that help and serve the cause of humanity and the common good. Such finances will require, on the one hand, professionals with vocation and well trained – technically as well as ethically; on the other hand, markets and mechanisms that are well ordered and conveniently regulated; and finally, the legitimacy that stems from social trust in markets and other mechanisms and instruments that should exhibit in their practice efficiency, transparency, good work, and justice.

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As should have been evident throughout this chapter, the theoretical and practical framework from which the moral proposal of Catholic social teaching is derived provides a high level axiological framework. It includes financial management professionally and technically competent, and ethically excellent.

References Altum. Faithful Investing. (2020 de March de 2020). https://altum-fi.com/. Obtenido de Altum. Faithful Investin. https://altum-fi.com/en/ Benedict XVI P (2009) (11 de March de 2020) Encyclical Letter. Caritas in Veritate. Obtenido de http://www.vatican.va/content/benedict-xvi/en/encyclicals/documents/hf_ben-xvi_enc_ 20090629_caritas-in-veritate.html Congregation for the Doctrine of the Faith; Dicastery For Promoting Integral Human Development (2018) (11 de March de 2020) http://www.vatican.va/roman_curia/congregations/cfaith. Obtenido de http://www.humandevelopment.va/en/risorse/documenti/oeconomicae-etpecuniariae-quaestiones.html Dembinski PH (2009) Finance: servant or deceiver? Financialization at the crossroads. Palgrave Macmillan, Basingstoke Fernández Fernández JL (2004) Finanzas y Ética. Universidad Pontificia Comillas, Madrid Francis P (2013) (12 de March de 2020) Apostolic Exhortation. Evangelii Gaudium. Obtenido de http://www.vatican.va/content/francesco/en/apost_exhortations/documents/papa-francesco_ esortazione-ap_20131124_evangelii-gaudium.html Francis P (2015) (12 de March de 2020) Encyclical Letter. Laudato Si’. Obtenido de http://www. vatican.va/content/francesco/en/encyclicals/documents/papa-francesco_20150524_enciclicalaudato-si.html Gregg S (2016) For God and profit: how banking and finance can serve the common good. Crossroad Publishing Company, New York John Paul II P (1981) (12 de March de 2020) Encyclical Letter. Laborem Exercens. Obtenido de http://www.vatican.va/content/john-paul-ii/en/encyclicals/documents/hf_jp-ii_enc_14091981_ laborem-exercens.html John Paul II P (1987) (12 de March de 2020) Encyclical letter. Sollicitudo rei Socialis. Obtenido de http://www.vatican.va/content/john-paul-ii/en/encyclicals/documents/hf_jp-ii_enc_30121987_ sollicitudo-rei-socialis.html John Paul II P (1991) (12 de March de 1991) Encyclical Letter. Centesimus Annus. Obtenido de http://www.vatican.va/content/john-paul-ii/en/encyclicals/documents/hf_jp-ii_enc_01051991_ centesimus-annus.html John XXIII P (1961) (12 de March de 2020) Encyclical Letter. Mater et Magistra. Obtenido de http://www.vatican.va/content/john-xxiii/en/encyclicals/documents/hf_j-xxiii_enc_15051961_ mater.html John XXIII P (1963) (12 de March de 2020) Encyclical Letter. Pacem in Terris. Obtenido de http:// www.vatican.va/content/john-xxiii/en/encyclicals/documents/hf_j-xxiii_enc_11041963_ pacem.html Leo XIII P (1891) (12 de March de 2020) Encyclical Letter Rerum Novarum. Obtenido de http:// www.vatican.va/content/leo-xiii/en/encyclicals/documents/hf_l-xiii_enc_15051891_rerumnovarum.html Paul VI P (1965) (12 de March de 2020) Pastoral Constitution. Gaudium et Spes. Obtenido de http://www.vatican.va/archive/hist_councils/ii_vatican_council/documents/vat-ii_const_ 19651207_gaudium-et-spes_en.html Paul VI P (1967) (12 de March de 2020) Encyclical Letter. Populorum Progressio. Obtenido de http://www.vatican.va/content/paul-vi/en/encyclicals/documents/hf_p-vi_enc_26031967_ populorum.html

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Paul VI P (1971) (12 de March de 2020) Apostolical Letter. Octogessima Adveniens. Obtenido de http://w2.vatican.va/content/paul-vi/en/apost_letters/documents/hf_p-vi_apl_19710514_ octogesima-adveniens.html Pius IX P (1931) (12 de March de 2020) Encyclical Letter Quadragessimo Anno. Obtenido de http://www.vatican.va/content/pius-xi/en/encyclicals/documents/hf_p-xi_enc_19310515_ quadragesimo-anno.html Pontifical Council for Justice and Peace (2011) (11 de March de 2020) Vatican Roman Curia (2011). Obtenido de http://www.vatican.va/roman_curia/pontifical_councils/justpeace/documents/rc_ pc_justpeace_doc_20111024_nota_en.html

Ethics of FinTech and Trading A Founder’s Perspective Damian Crowe

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Why Is Supply Chain Finance So Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Need for a Minimum Set of Ethical Standards for FinTech and Trading (SCF Context) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . President Obama’s SupplierPay Pledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . President Obama’s SupplierPay Pledge (Circa 2015) (https://www.whitehouse.gov/ copyright/) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Voluntary Codes Do Not Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Obillex and the Ethical Digital Supply Chain Finance Product Suite . . . . . . . . . . . . . . . . . . . . . . . . . The Importance of Defending Ecosystems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Philosophy of Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Issues to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Australian Small Business and Family Enterprise Ombudsman (ASBFEO): Supply Chain Finance Review, Final Report (https://www.asbfeo.gov.au/sites/default/files/Final%20Report %202.pdf) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concluding Remarks and Future Predictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cross-References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

A key promise, responsibility, and assumption underpinning democracy is that its participants are bound by a social contract that delivers win outcomes for those who adhere to its rules. But our social contract is under threat. Governments and large corporations are today being tempted to abandon the ancient conventions of our social contract by the allure of emerging technology that promises the leaders

D. Crowe (*) Obillex Limited; Collaborative Economic Systems Pty Ltd, Melbourne, VIC, Australia e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_35

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of large corporations and institutions greater control over LIQUIDITY + DATA. It has traditionally been inaccessible because the digital integration required to create the market was not possible. People intermediated transactions and played an important role in safeguarding important conventions. Machines, however, do not always adopt our conventions. And a big question is, who really owns the data rights anyway? In the absence of concerted action by democracies, the nation the largest source of aggregate demand will set the global standards for the ownership rights of data released from silos by digital integration. Unless democracies work together, with Joe Biden’s election as President of the United States there is now an opportunity to convene the world’s democracies in a call to arms to defend freedom, including our human right to be able to make informed choices. Keywords

Accounting Standards · AgTech · Authoritarianism · Big 4 · Bill of Exchange · Bottom Up · BREXIT · Capital Markets · Cash Cycle · Compliance as a Profit Centre · Corporate Treasury · Counterparty Data · Democracy · Digital Integration · Ethical Standards · FinTech · Freedom · Fully Informed Consent · Human Rights · LIQUIDITY + DATA · Obillex · Off Balance-Sheet Finance · Procurement · RegTech · SME · Social Contract · SupplierPay Pledge · Supply Chain · Supply Chain Finance · Top Down · Trade Credit · Trade Payables

Introduction In sharing expert insights into the ethics of FinTech and Trading that I learned along my journey, I will draw heavily upon two important, directly relevant sources of structured information for appropriate discussion topics: 1. On the Ethics of Trade Credit: Understanding Good Payment Practice in the Supply Chain, by Christopher J. Cowton and Leire San-Jose 2. Australian Small Business and Family Enterprise Ombudsman – Supply Chain Finance Review (https://www.asbfeo.gov.au/sites/default/files/Final%20Report% 202.pdf). The Cowton and San-Jose paper is important to the context of my insights because I am the founder of a “Supply Chain Finance” FinTech: The need for trade credit gives rise to the opportunity for supply chain finance. The Australian Small Business and Family Enterprise Ombudsman (ASBFEO)‘s Supply Chain Finance (SCF) Review is important because it provides a structured, nonexpert analysis of SCF trading activity derived from interviewing dozens of stakeholders in the industry. The Review comments extensively on ethical issues arising from FinTech trading activity using a structured approach that provides a valuable platform for my insider’s perspective on those issues.

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The approach I have taken in writing this chapter is to copy a statement from one or the other or both above two authoritative sources and then provide you with my commentary, drawing upon my professional experience. In addition, I have added a section to list issues that are topical to SCF but not covered in the authoritative sources. Then at the end of the chapter, I will share with you my views on the likely future.

Why Is Supply Chain Finance So Important? Imagine an uninterrupted digital network connecting the entire world comprising the financial and underlying data detail of every transaction of every micro, small, medium, and large business, every government department, and thus effectively, every person on the planet. Then imagine all that data is accessible and available to create new, highly disruptive business models. That is the size of the potential market for SCF. It is the largest untapped market in the world – in 2015, McKinsey estimated the size of the financeable trade payables market at $2 trillion (https://www.mckinsey.com/~/media/mckinsey/dotcom/client_ser vice/financial%20services/latest%20thinking/payments/mop22_supply_chain_ finance_emergence_of_a_new_competitive_landscape_2015.ashx) – and that is just the aggregate value of the accounts payable balances. More recently, Greensill estimated that the size of the potential financing flows at $56 trillion market (https://www.greensill.com/whitepapers/an-introduction-to-supplychain-finance/).

(McKinsey 2015, p. 11)

The value of the data that accompanies those financial transactions is a platform for the future prosperity of humanity or potentially the means with which to enslave it. The question is, who owns the data and how will its value be realized? Traditionally, data associated with those transactions has sat in isolated silos, written on pieces

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of paper, or held in local client-server accounting systems in a box under your desk. But now, the world’s trading data is being migrated into the cloud and is becoming accessible. Supply chain finance provides the core business case for accessing that data. Some say that “data is the new oil” (https://www.wired.com/insights/2014/07/ data-new-oil-digital-economy/) because of the power and wealth that it promises. And therein is a warning about the ethics of FinTech and Trading: Some people who chase power and wealth are nice, but not kind. The potential for power that comes with control over Data + Liquidity is immense, so some governments have begun to colonize the digital landscape. Some governments have even demonstrated they are willing to compromise their standards and harm small businesses all over the world to gain control over data. Colonization of the digital landscape risks becoming as insidious as colonization of the physical landscape in past centuries, particularly if it undermines the potential of Liquidity + Data for capacity building in all countries, including, developing countries. The potential to create new wealth from this data is real: tens of trillions of dollars in new wealth from digital disruption opportunities, in addition to the financial value of the liquidity flows. That combination of Data + Liquidity will eventually be like the nervous system for one or more super intelligent AI capable of a global perspective that is out of reach for humans. Therefore, now is a good time to think about the control systems to mitigate humanity’s risks from authoritarianism, because regardless whether it is AI or human, authoritarianism is a threat to democracy and human rights. In regions that want their own identity while remaining part of a larger national or regional economy such as Catalonia, supply chain transparency enabled by the combination of Data + Liquidity could empower the region’s economic independence by delivering new value from data released silos in supply chains in which Catalonian businesses participate in Spain and the rest of the world. The opportunity for identifying new business models from the data is Greenfield, so at this moment in time Catalonians have an open shot at goal. Data + liquidity really is either the enabler, or the end to humanity’s freedom; it is the decisions our generation and the next generation will make that will determine which it is, and that is the context with which the ethics of FinTech and Trading and the importance of SCF should be considered.

The Need for a Minimum Set of Ethical Standards for FinTech and Trading (SCF Context) The following paragraphs draw upon my experience as a leader in the FinTech industry and Leire San-Jose and Christopher J. Cowton’s paper on the ethics of trade credit (Cowton and San-Jose 2017). 1. The need for a formal standard to distinguish between “operating” trade credit and “financial” trade credit

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Cowton and San-Jose point out that “Trade credit is created when a supplier provides goods or services to another firm in the expectation that payment will be received at a date in the future. Instead of payment in cash or near-cash, the goods or services are supplied “on credit,” usually with an invoice that specifies the payment terms (e.g., payment to be received within 30 or 60 days).” (Cowton and San-Jose 2017, p. 674). Comment: standards to report the difference between “operating” trade credit and “financial” trade credit already exist, but they are being compromised in a geopolitical struggle for control over Liquidity + Data and by a failure of governments and politicians to defend our social contract against senior executives at corporations, vendors, and institutions who are willing to misuse their market power to seize an unfair advantage. The standards include the accounting standards that distinguish between “Trade Payables” and “Financial Liabilities” which are reported separately in statutory financial statements, and have significant implications for calculation of gearing ratios and thus a corporation’s legal obligation for managing risk as described in bank covenants. Following special focus by the UK Cabinet Office on the practice, large accounting firms in London began to sign off Statutory Financial States for listed companies who were using “off balance sheet financing.” Several subsequently collapsed, taking down family-owned suppliers with them. The explosion in cheap debt around the world, which has damaged the ability of the global economy to recover from the pandemic, was not the fault of the former UK Prime Minister, David Cameron. However, he signed his name and that of the Office of the Prime Minister of the United Kingdom up to practices such as delayed/nonpayment of suppliers invoices, pushing out payment terms to remove suppliers’ choice and to force them to fund the working capital requirements of large buyers in a blatant abuse of market power that was specifically identified as such within Citibank when I worked there, by the US government under President Obama, and more recently by Australia’s Conservative Federal Government. The use of off-balance sheet financing to make the balance sheets of large corporations appear more efficient while misleading banks and investors as to the true nature of a corporation’s risks, and abusing small, family-owned businesses to remove their choice and effectively turning them into banks, is a blatant breach of our Social Contract. There must be a better way to deploy SCF. 2. The Need for a Formal Standard to Specify the Purpose of Trade Credit Cowton and San-Jose’s paper “develops a framework for thinking about it (trade credit) by grounding the granting of trade credit in the underlying provision of goods and services used by a purchasing firm in pursuit of its productive activities.” • Trade credit can enable a company to increase sales. • Trade credit can enable a company to ramp up production.

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The purpose of trade credit has traditionally been governed by a business convention. This is a good example of an unwritten law that has governed trading for hundreds of years. I think of these conventions as part of our Social Contract. The risk with FinTech and Trading is that these business conventions upon which our economy depend are not coded into the new trading systems and that may result in a loss of one of the key advantages of English Law over alternatives. 3. We Need Standards, so We Can Defend Our Social Contract For many small firms, companies trade credit is the only source of external financing. It enables buyers to receive necessary supplies in advance of receiving payment for their own products, thus helping to support their production processes and economic activity. However, it puts a strain on suppliers’ own financial resources because goods or services are produced and provided without, at least for a time, receiving cash. (Cowton and San-Jose 2017, p. 674)

• “Man is born free, but he is everywhere in chains” (Rousseau 1762). “Rousseau asserts that modern states repress the physical freedom that is our birthright, and do nothing to secure the civil freedom for the sake of which we enter into civil society. Legitimate political authority, he suggests, comes only from a social contract agreed upon by all citizens for their mutual preservation (https://www. sparknotes.com/philosophy/socialcontract/).” The COVID-19 pandemic has shown just how badly our social contract has been broken by parties on both sides of the political spectrum. It is an opportunity because it has revealed facts that we have previously hidden and priorities that may previously have been forgotten or misunderstood. • Donaldson and Dunfee describe the Social Contract as “an existing (extant) implicit contract that can occur among members of specific communities. including firms, departments within firms, informal subgroups within departments, national economic organizations, International economic organizations, professional associations, industries, and so on. The aggregate of these extant social contracts contains much of the substance of business ethics” (Donaldson and Dunfee 1994, p. 254). Their paper provides a detailed analysis of the ethics of the Social Contract, some of which might be a bit socialist. However, at the other end of the political spectrum, I think Objectivists’ simple articulation of the value of the Social Contract is probably the best: “Because there are no conflicts of rational interests among individuals, the proper society is one in which individuals cooperate for mutual advantage, exchanging value for value (Miller, Foundations Study Guide: Political Philosophy, 2010)” (https://atlassociety.org/ commentary/commentary-blog/3634-foundations-study-guide-political-philoso phy). So, independent of left-wing socialism, our unwritten Social Contract is justified simply on the grounds of rational self-interest. It offers at least some common ground for everyone.

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• The rules that govern trade credit are described in the case law that applies to Bills of Exchange, in religious laws, in accounting principles, and in the business conventions that govern the heart of the Social Contract. The purpose of trade credit was always limited to the working capital required to support the cash cycle of the joint endeavor of the economic actors in a supply chain and not more than that. We know that because that is how the accounting disclosures in balance sheets for investors and other stakeholders used work before they were degraded in the current geo-political struggle for control over Data + Liquidity. • But as the scalability of treasury technology gradually evolved from low-volume, high-value transactions conducted in ivory towers, to also provide oversight of the processing of high volumes of low value operating payments in Accounts Payable, so did the scrutiny of the group treasurer. Fresh from her ivory tower, unconstrained by the business conventions honored by local Procurement and Accounts Payable with their local small suppliers and communities where they did business together, she now had oversight and policy control of payment operations. Some group treasurers, financially incentivized by their boards, used market power to trash those old, unwritten Social Contracts and force family-owned businesses to supply them with finance beyond mere trade credit, to make balance sheets appear more efficient while misleading users of financial statements on corporations’ risk. Many of the performance targets for which Group Treasurers have traditionally been rewarded have no direct relationship with our Social Contract. And the controls that traditionally safeguard small businesses against such parasitic practices were bound in our Social Contract, laid down through business convention a long time before “Corporate Treasurer” was even acknowledged as a profession let alone had oversight of operational payments to suppliers. Some Group Treasurers are using nonpayment of invoices (removal of choice) as a tactic to force their suppliers onto third-party vendor systems where suppliers risk loss of control over their data and its value. Shortly after I founded Obillex Limited, the group treasurer of Carillion Plc told me that if he could not screw his suppliers with a new financial product, then he would not be interested using it. That is how he interpreted his job mandate. Carillion later collapsed, owing its suppliers hundreds of millions of pounds. When BREXIT came along with the potential of using emerging technology to concentrate data (the new oil) into London, UK establishment institutions including its Government, apparently supported by several Big Four accounting firms, and the Association of Corporate Treasurers worked together to try to seize the opportunity. • Historically, the technology capability required to release supply chain data from millions of fragmented data silos did not exist, and so the data was not available for processing. However, technologies such as cloud are now making that data available. By some estimates, the value of the data is worth tens of trillions of dollars. Unless we have standards over how the value from that data is released and stored and to whom the value accrues, it will just be a stampede with governments and large corporations trampling the rights of people and small business owners. Our Social Contract was one of the casualties as authoritarian

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governments (some nominally democratic) try to force small businesses to give up their data to governments or large corporations controlled by a politically connected “Top End of Town” elite. One of the biggest risks is that the potential of data (FinTech, RegTech, AgTech, and other Tech) to deliver capacity building in vulnerable communities may be lost. • Historically, the technology capability required to usefully process vast amounts of data from supply chain transactions were not available, and so the legal precedents needed to govern rights over the ownership; control and use of that data have not yet been fully established. However, the technology is now available, and a geopolitical battle is currently taking place for control over data (the new oil) and for the value it contains. The risk is that nations will compromise their standards, including standards of ethics, accounting standards, legal standards and human rights standards to seize control of it. And that is a threat to all of us. The issue the Trump Administration has articulated with WeChat is an exa m ple (https://www.ft.com/content/a 7e1 d9 cf-9 d86 -4a 87-8 e0 337a6a2327390). It is a legitimate concern. Cowton and San-Jose go on to say “Delay (or, even worse, default, the possibility of which tends to increase with delay) in paying by customers, especially major ones, can have severe, if not fatal, financial consequences for suppliers, which in turn has repercussions for their own suppliers and other stakeholders, such as employees.” (Cowton and San-Jose 2017, p. 675). In my experience: • Buyers and suppliers have a range of responsibilities to each other and to the communities where they do business. These are unwritten conventions we call our Social Contract. • Given the risk to suppliers increases when buyers delay in payment, small suppliers should be entitled to outsource their credit risk management to capital markets where credit risks can be managed efficiently. That is achieved by making the confirmation that an invoice has been approved for payment available to suppliers on the same day the invoice has been submitted for approval. The technology is already available. FinTech can give suppliers the option, but not an obligation to take early payment, and competitive capital markets can give them the best pricing for the early payment and services such as management of their credit risk on outstanding invoices not yet paid by large buyers. • Digital integration technology now makes it possible for small- to medium-sized suppliers to efficiently outsource their credit risk management function to capital markets, not just for the money they are owed by large businesses, but at volume, even for the money they are owed by other small businesses. And capital markets can trade with small suppliers’ access to liquidity that is priced below small suppliers’ weighted average cost of capital and even below small suppliers’ cost of debt, so that allowing small suppliers to outsource their credit risk management function to capital markets can be very profitable for them indeed.

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• If it is done at scale, there may even be potential for suppliers in developing countries to outsource their credit risk management function for their trading activity with each other to capital markets and to obtain a short-term credit rating to better manage working capital and to enable capacity building and growth. Lack of a short-term credit rating and lack of access to liquidity are key constraints to growth for many small businesses in developing countries. • Capital Markets are a suitable match for any large business that might be contemplating using their market power to abuse their relationships with small to medium-sized suppliers. Capital Markets play an important role influencing the credit rating of large companies. If a large company default on its payment obligations to small suppliers who outsource their credit risk management to capital markets, the slap they receive from capital markets will hurt. A lot. Because Capital Markets calls late payment a “default,” even if the late payment is for a debt that was owed by the big corporation to a little family-owned business and then transferred to capital markets. Buffer systems can (and should) be built in to lessen the damage to a big business that can be caused by Capital Markets if they accidentally pay their trade payables late. The implication is late payment by big corporations to small suppliers and is far less likely if Capital Markets (or an associated agency) is the debt collector. And from a systems perspective, given the group treasurer is accustomed to dealing with Capital Markets and is treating suppliers like banks, closing the loop, and bringing capital markets in as the big corporation’s debt collector from hell, has a certain balance about it. 4. We Need Standards Because Conventional Teaching on Trade Credit Is Immoral Cowton and San-Jose state “Conventional wisdom regarding the taking of trade credit—as reflected in financial management texts, for example—is, at best, amoral, and perhaps immoral” (Cowton and San-Jose 2017, p. 676). • One does not need to be a socialist to make this case. It is entirely within the remit of traditional, conservative capitalism to make this judgment. The world’s rules are based on an international order that has been unbalanced by BREXIT and attempts by the UK to seize control over Data + Liquidity as it finds a place for itself outside the European Union. In relaxing its standards to increase its competitiveness as it positions for BREXIT, the UK has damaged the global economy. We need to get back to win-win outcomes for humanity. For those of us who believe in it, we need to reaffirm our commitment to freedom, democracy, and the Rule of Law, because humanity is facing an inflection point in the fight between democracy and authoritarianism, and the global digital economy will eventually deliver a decisive winner. • In 2014, President Obama announced the SupplierPay Pledge to a set of strict ethical standards that were consistent with the minimum standards proposed by Citibank for a transaction banking product to be promoted by the President.

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Around the same time, the UK Prime Minister, David Cameron, who was contemplating a BREXIT referendum, announced a similar promotion but at a much lower set of ethical standards. Off-balance-sheet finance transactions saw financial liabilities classified as trade creditors on balance sheets by CFO’s of large companies and signed off by their auditors. At least some of the Big Four accounting firms corrupted generally accepted accounting standards, conventions and our social contract and with enthusiastic support from Association of Corporate Treasurers (ACT) qualified Group Treasurers. Investors are being misled as to the true nature of the liabilities of large corporations. The relaxation of existing standards of disclosure has led to an explosion in cheap debt described as “off balance sheet finance” that is contributing systemic fragility to the global economy. Along the way, overleveraged companies such as Carillion Plc, BrightHouse, NMC Health, Agritrade, and Abengoa collapsed, harming communities and tens of thousands of small- to medium-sized businesses all over the world. We need existing standards, including those pertaining to financial reporting of balance sheet disclosures for investors and supply chain stakeholders, to be defended. That means, if trade credit is extended beyond the buyer’s cash cycle, the difference is accounted for as a financial liability. • Conventional teaching may refer to the idea of mandated 30-day (Australia) or 60-day (United Kingdom) payment terms. Both are immoral because neither of them bears any relationship with the purpose of trade credit. Both lack reason! Trade credit should be based upon the cash cycle required to convert production into cash receipt from sales. Thirty days is an approximation that is appropriate for most small business-trading activity with other small businesses. But in some industries – construction, for example, the cash cycle can be significantly longer. If politicians want to make a point about payment times, their focus should be on the time it takes a large buyer to approve an invoice for payment after it has been received. Technology advances including AI and an electronic three-way match (Purchase Order, Goods Received Note and Invoice) mean that approval time for an invoice should be same day unless an issue is identified. • Not only are some of the recent supply chain finance practices unethical, a breach of business convention, and a breach of our Social Contract at the microlevel of the individual supplier, but also when these practices are scaled up across a nation or at the global economy, it results in outcomes that are significantly against the public interest. For example, cheap debt scaled up to a macrolevel has made the global economy more fragile, and that is making it more difficult to recover from the current economic crisis. Parasitic business practices in breach of our Social Contract expose the world to greater systemic risk. 5. We need standards to protect rights and opportunities for participants in extended supply chains and for the communities where they live. Cowton and San-Jose point out: “The inappropriateness of suppliers acting as providers of financial capital is reinforced if stakeholders are considered. Given that a supplier’s stakeholders (such as employees, its own suppliers and local

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community) can be adversely affected if it has a major customer default or delay significantly on payments, then it can be argued, generally, that suppliers are under an obligation not to grant trade credit inappropriately” (Cowton and San-Jose 2017, p. 680). • So, the risk posed by Cowton and San-Jose is that if a supplier grants trade credit to its customers beyond the cash cycle and thus begins acting like a bank, then that might have knock-on effects and risks damaging the entire supply chain. In 2020, the risk became an issue because of the impact that excessive corporate debt is having on hindering the COVID-19 economic recovery. Cowton and San-Jose point out that in calculating the maximum ethical period for trade credit: “Thus suppliers can be seen as taking part in a joint enterprise with their business customers. Suppose the purchasing company/debtor is a supermarket that sells to the final consumer on a cash basis. The supplier provides goods to the retailer, whose role is to get the supplier’s product to market. Once the final consumer pays, then a sum of money becomes available to pay the supplier, with the balance remaining with the retailer to pay its other costs and generate a margin. Not only can this be seen as a joint enterprise, but imagine if the supplier were vertically integrated to the final consumer market—it would still have to wait until the final consumer paid before it had the money earned by its efforts. This scenario demonstrates that it is reasonable for the business customer to take trade credit while both it and its supplier wait for a sale to be made, and cash received, in the final product market (here, the supermarket). However, once the cash is received, the supplier should be paid immediately; there is no longer any justification for taking the trade credit, and to hold the money back is to forcibly borrow the money due to the supplier, with implications for financial positions within the supply chain. This analysis thus argues that the trade credit period can justifiably be as long as, but no longer than, the period taken to receive the money from the final consumer. At that point, the rewards of the joint enterprise should be shared between the collaborators in accordance with the terms of an appropriate agreement between them. If the supplier is not paid by that point, the position moves from one of real or “operating” trade credit to one of “financial” trade credit. Moreover, rather than there being a collaborative endeavour under way, the continued taking of trade credit can be viewed as exploitative; the business customer is hanging on to the supplier’s money simply because it can. If a trade debtor wishes to have more cash in its possession, it should go to a bank or similar source of funding” (Cowton and San-Jose 2017, p. 679). • The point about entire supply chains working together in a “joint enterprise” is crucial. It provides an explanation as to why businesses work together in a supply chain. Cowton and San-Jose state “If suppliers matter as a stakeholder group— either in themselves or as the embodiment of a network of indirect stakeholders—then

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trade credit matters, since it affects their ability to survive and flourish” (Cowton and San-Jose 2017, p. 676). • Governments are currently attempting to enable digital integration through topdown institutional pressure (market abuses of power, regulatory pressure, and procurement pressure) against small family-owned businesses. If top-down pressure fails, then the alternative is education and bottom-up democratic dialog and change. • The greatest value from Data + liquidity for people only arises if data currently sitting in silos within the same supply chain but in different countries is released. Data + liquidity information belonging to small business owners is most valuable when it can flow seamlessly across borders while simultaneously respecting the sovereign rights of people and nations. Standards are required so that the full value of released data can be enjoyed by humanity because the greatest value can only be created if Data + liquidity is able to flow across borders. That will only be possible if there is an agreement to enable international collaboration. Conditions are emerging for that type of agreement to be reached (@ 5th September 2020). • Small- to medium-sized family-owned businesses are core foundations of both democracy and capitalism. They represent resilient supply chains, prosperous communities, disruptive innovation, and endeavor. But they lack market power. So, that is where our focus for building a platform for prosperity from data should be. • A standardized, global digital working capital regime (digital supply chain finance) has the potential to connect small businesses to Capital Markets for liquidity for growth and for risk management services. Buffer systems can address capital markets’ requirements for standardization and volume. • Choice and win-win outcomes are important. There is a belief emerging among democracies that China’s authoritarian regime may be pursuing a win-lose strategy for humanity and for democracy, including by displacing our relationships with emerging markets that were once “colonies” of European countries. The large size of China’s economy means that its Data + liquidity flows will have greater critical mass than most developed nations and that is their competitive advantage. If our democratic model is going to survive the competition, we need international standards and teamwork on Data + Liquidity to regain our competitive advantage. In the digital economy, our relationships with former colonies are fragmented because they are based on “analogue” relationships. Teamwork on development and adherence to standards for the global digital economy will deliver the win-win outcomes needed for democracies to recover our competitive advantage over authoritarianism including removal of choice. The global growth potential from a market governance model that safeguards win-win outcomes is extraordinary. Note that while I am up for the competition, I have no issue with the Chinese people. When my Grandfather, who was my mentor, spoke to me about China, he emphasized the potential value of dairy to their food security. He

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believed top quality food security is mutual ground for anyone who has common sense. • Note, however, that authoritarian models can also emerge in democracies. In Australia, the implementation of the Modern-Day Slavery Act was followed by Australian Border Force raids on Rural Communities in search of undocumented workers, many of whom have lived in Australia for up to two decades. As at 5th September 2020, the Australian Federal Government is preferring to confront and criminalize family-owned farms for their use of undocumented workers, instead of bringing those workers into the regulated economy and then use the associated potential for supply chain transparency to close down horticulture as a channel for human trafficking into Australia and exploitation, while delivering an economic boom from demand from a productive newly legal workforce of 70,000 people who actually want to live with us in Rural Australia (most new immigrants want to go to the big cities). In the wrong hands, supply chain transparency can be a bad thing, even in democracies. We need standards so we can develop a Data + Liquidity solution that will compete with solutions from China and without using the resulting supply chain transparency to engage in human rights abuses ourselves. • Note that I am optimistic that the Australian Federal Government will eventually do the right thing; given my expert insights and ability to offer the government a better solution, I am giving them a particularly hard time on this point. It directly affects the community where I was born and grew up, and where my family have lived for more than a hundred years. 6. We Need Standards to Regulate the Mandate of Group Treasurers The liquidity flows and responsibilities for which the performance of a group treasurer of a large global multinational is assessed may be much larger than any bank. But the functions of a corporate treasury are only lightly regulated, if at all. And the changing potential of technology has transformed the group treasurer from an isolated figure in an ivory tower to core payment operations personnel. Treasury (FinTech) applications have become vastly more powerful than ever before, and for the first time in human history, global multinational treasury departments are plugging in Artificial Intelligence to screw as much value out of small businesses as they possibly can (think about that Authoritarian, top-down political philosophy). FinTech technologies have evolved from isolated spreadsheets on your computer to spreadsheets stored on a client server, to sophisticated client server corporate treasury technology workstations comprising a rich product feature set, to Internet-enabled technologies to ntier technology, to ERP solutions that connect global multinational corporations’ highvalue/low-volume “ivory tower” corporate treasury teams to their low-value/high-volume local procurement and accounts payable operations and payments departments all around the world, and then finally to cloud-based FinTech applications that also give the group treasurer overseer visibility of supply chain counterparty relationships

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everywhere. At each stage in the evolution of the technology, more and more datasets were released from enterprise silos and made available to increase shareholder value. However, now for many large corporations, the next stage in their evolution has been to try to gain access to counterparty data that at least belongs equally to their small, medium, and large suppliers, and it is that fight for control over data where major ethical issues in FinTech began to arise. And now that fight for access to and control over data is being scaled up to the macrolevel of nations, both the potential of the data for industry-wide digital transformation and the ethical-associated ethical issues have begun to become intense. On the website of regulator Australian Competition and Consumer Commission (ACCC), in a paper on misuse of market power, the ACCC states “a business with a substantial degree of power in a market is not allowed to engage in conduct that has the purpose, effect or likely effect of substantially lessening competition in a market” (https://www.accc.gov.au/business/anti-competitive-behaviour/misuse-of-marketpower). The ASBFEO’s Final Report demonstrates that the issue of misuse of market power in the global SCF industry is currently widespread. Big corporations are much more likely to be able to exercise misuse of market power over small suppliers. Misuse of market power may occur when a big buyer delays payment to suppliers, who are then offered a loan from a third-party vendor working with the big buyer, as a way of getting paid. The delay in payment is typically not being forced on the joint enterprise by a lengthening of the buyer’s cash cycle. The vendors involved are typically a lender and a supply chain finance FinTech with an eInvoicing system attached. They are employed by the buyer, and they exercise the buyer’s authority and market power. The buyer typically receives kickbacks in the form of money (or discounts) and data. In return for the “rent” the vendor pays the buyer, the vendor gets to exercise the buyer’s market strength, often in conjunction with the market strength of other big buyers. The implication is that these systems are capable of working for a network of buyers to yield enormous market power, forcing suppliers onto “top down” data integration solutions (abuses of market power against small businesses by big businesses working together via top-down eInvoicing/supply chain finance networks). There is another way to build the digital integration network: from the bottom up (or a combination of bottom-up and top-down).

President Obama’s SupplierPay Pledge In early 2010, I had just started a new role with Citibank Europe Plc in Dublin, Ireland. I was hired to help Citi deploy a new electronic transaction banking platform, like the one I had already deployed successfully to 56 countries around the world for Dutch bank ABN AMRO. However, shortly after I commenced work, Citi decided it had backed the wrong technology and would have to start the

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software development process again from scratch. I was told to “go find something useful to do.” My senior sponsor at Citi invited me and my personal mentor to dinner with a senior member of Citi’s Supply Chain Finance team (Banker X) and another guy, who helped create Kenya’s M-Pesa mobile payments solution. After dinner, we were treated to a performance by Banker X as he put on a solemn face and delivered his sales pitch for SCF – “it is good for large corporate buyers, it is good for their suppliers, it is good for their employees, it is good for communities, etc.” As I listened to the pitch I thought, hmmm, but if all of what I had heard is true, then why is not SCF being promoted as core government policy? I was thinking deeply about a pledge I gave my grandfather as a 14-year old, to dedicate my career to food security. In the months that followed, I began developing an idea that could scale supply chain finance up so that it could harness the trillions of dollars (https://www.irishfunds.ie/facts-figures/irish-domiciledfunds) including profits of global multinationals from the United States and other countries, concentrated into Ireland for its low taxes but then trapped there in enormous money market funds. The money is trapped in Ireland because if it is repatriated as dividends back to (say) the United States, it attracted corporate tax at the rate of the US-Ireland tax differential (22.5% at that time). I understood that if US multinationals simply paid their suppliers early, their trapped profits could be repatriated to the USA without having to pay tax on it. I also understood that self-funded supply chain finance is consistent with the fiduciary obligations of Clevel executives at listed corporations because they could earn a yield on their early payment. But how to get the CEOs of large corporations to prioritize SCF? Around that time, I had been introduced to an American lobbyist. She pointed out the Billionaires Pledge that Warren Buffett and Bill Gates had just announced. Why not call it a pledge? I loved the idea. It was entirely consistent with the pledge my grandfather had invited me to take and with the Social Contract that he had demonstrated to me when I was growing up in our small rural community back in Australia. In the heart of this corporate supply, chain finance pledge was the pledge I had given him during the Ethiopian Famine. The lobbyist said she believed she could position the idea with the White House to get an event hosted there with the CEOs of some of the USA’s largest companies for the purpose of getting them to prioritize SCF at the top of their to do list, to get liquidity flowing back through the US economy. And that is how the original concept for President Obama’s SupplierPay Pledge was born. I began socializing the idea for the SupplierPay Pledge among Citigroup’s leadership team. Some loved the idea, and others worried that it might be perceived by the market as Citigroup using its relationship with the US government to try to pressure the leaders of US companies to adopt a Citigroup transaction banking product. Citigroup had only recently been bailed out and was now largely owned by the US taxpayer. When bankers know they are backstopped by the taxpayer, they may take excessive risks in pursuit of bonuses because they know that if anything goes wrong taxpayers will foot the bill (moral hazard). From the perspective of those

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bankers in pursuit of bonuses, the bigger the risk the better. And here, Citi was prevaricating in the middle of a crisis that it could help to resolve. I became even more suspicious when Banker X told me that everyone senior at Citi knew that its corporate and social responsibility activities were just a function of its marketing activities and not serious. I began to lose trust in Banker X and some of the other bankers I had met at Citibank. I doubted their commitment to corporate and social responsibility after they described it to me as “just a marketing ploy,” and I feared they might somehow steal my idea. So quietly, I applied for a trademark for my working title “Supplier Finance Corporate Pledge” (https://trademarks.justia.com/851/32/supplierfinance-corporate-pledge-85132871.html). I then allowed my trademark application to fail because I wanted the indelible link, but I did not want to be accused of stealing Citigroup property. I decided to keep it as a “surprise” on the basis that if my concerns were unfounded it would not matter, and if my fears were real, it was better to stay quiet. Then the Irish economy went into its 2010 economic meltdown, and in the news, President Obama announced a call to arms to protect the US economy from a liquidity crisis with a $50 billion stimulus package. But the media said he was struggling to get his spending bill passed by the US Congress (https://www.nytimes.com/2010/09/07/ us/politics/07obama.html), and I had a realistic opportunity to respond to the President with an idea to help the US economy recover. Citi was prevaricating. I had an Irish contact with connections with a senior member of the US National Security Council. I asked for advice from my Citi sponsor and Banker X, and they both encouraged me to go to a meeting with the US NSC staff member (while both declined my invitation to join). At the meeting, after I pitched my idea, he said to me quietly, “Mr Crowe, that is the best idea I have ever heard from a banker.” In 2014, President Obama announced “the SupplierPay Pledge” (https:// obamawhitehouse.archives.gov/sites/default/files/docs/supplierpay_pledge.pdf). It became White House and US Government policy and got billions of dollars of new liquidity flowing through the American economy. It became one of the most successful Obama policy initiatives (https://www.commerce.gov/sites/default/files/ migrated/reports/supplierpayv25.pdf). I quietly received permission from the US National Security Council staff person to whom I first presented the Pledge to be allowed to say that I “responded to President Obama” following his call to arms to support the US economy during the 2010 liquidity crisis. However, the SupplierPay Pledge had significant weaknesses. It is an analogue solution, and I had an idea for a digital supply chain finance (data + liquidity) upgrade to the Pledge. I was made redundant by Citigroup, but a wealthy business associate and friend, Les Halpin, invested £500,000 to help me start up a UK-based FinTech to develop the upgrade. The way I saw it, the SupplierPay Pledge was like a bazooka against a liquidity crisis. But I was now starting work on something truly transformational for humanity – the solution to the pledge I gave my grandfather, way back when I was just a child during the Ethiopian Famine. And I had found a mechanism to do it that could deliver win-win outcomes for all stakeholders.

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President Obama’s SupplierPay Pledge (Circa 2015) (https://www. whitehouse.gov/copyright/)

Courtesy Barack Obama Presidential Library. https://obamawhitehouse.archives.gov/sites/default/ files/docs/supplierpay_pledge.pdf

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The SupplierPay Pledge got billions of dollars flowing through the US economy. However, as an analogue solution, it had some major weaknesses. For a start, it had no compliance monitoring capability. It was too easy for a large corporation to sign the Pledge even while systemic risks were rising because of noncompliance on a massive scale. Banker X resigned from Citi, partnered with the UK Prime Minister, David Cameron, and together they began promoting an unethical version of SCF to large UK Corporations, delaying payment to family-owned businesses in the UK, USA, and all over the world, forcing them to take out a loan with Banker X and to give up control over their data to get paid on time. At Citi, we had specifically precluded such tactics as “unethical,” particularly in terms of an endorsement by the President, so why was David Cameron using the Office of the Prime Minister to promote a solution that had already been ruled out as unethical? I watched as some of the Big Four accounting firms in the UK quietly dropped their responsibility for ensuring that balance sheets accurately depict the difference between trade finance and financial liabilities on the balance sheets of listed UK companies and then watched as large companies such as NMC Health (https://www.ft.com/content/4dbbe048-a426-45519c4f-3968235adcdb) (UAE) and Carillion Plc (https://www.nortonrosefulbright. com/en-us/knowledge/publications/f5497f95/supply-chain-finance) (UK) and Abengoa (https://www.theguardian.com/business/2015/nov/25/citi-criticisedinvestor-abengoa-collapse#:~:text¼Abengoa%20shares%20dropped%2070% 25%20in,of%20%E2%82%AC2.80%20a%20share) (Spain) and Agritrade (https://www.reuters.com/article/us-agritrade-international-banks/banks-accusesingapore-commodity-trader-agritrade-of-massive-fraud-idUSKBN20T1E4) (Singapore) and others collapsed with enormous off-balance sheet financial liabilities and allegations of fraud, wiping out tens of thousands of unsecured trade creditors. I watched as Banker X and the former Prime Minister lived a luxury lifestyle, all the while using delayed payment to force millions of suppliers all over the world to take out loans to the tune of hundreds of billions of dollars, just to get paid on time. Soon, their practices were being copied by other vendors, and misuse of market power by large corporations and even governments against small suppliers became acceptable behavior in the rush to seize control of the new gold. When I bumped into Banker X in Victoria Street near Westminster 1 day, he threatened me if I ever told anyone about my role creating the original concept for President Obama’s SupplierPay Pledge. And almost none of the senior people I worked with at Citibank stepped forward to point out that it was me who had developed the idea for the Pledge and then took the risk with my career to position it with the US Government. But only “almost.” Eventually, when the economic crisis following the COVID-19 pandemic came along, the global economy had been so weakened by the use of “balance sheet engineering” in the form of big corporations using small suppliers like banks, our economic recovery from this crisis has been made so much more difficult than it would otherwise have been without these unethical practices. There is now sufficient public interest for me to go public with the truth. There is still an opportunity for a model that defends win-win outcomes.

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Voluntary Codes Do Not Work The problem with the Pledge and with other voluntary codes is that they do not work. They have no effective monitoring mechanism. Per Cowton and San-Jose: “There have been multiple voluntary codes for dealing with late payment in the UK, but none have been successful at eliminating the scourge of late payment by big business of their debts to small suppliers (Cowton and San-Jose 2017, p. 676). • The Prompt Payers’ Code (1991), developed by the Confederation of British Industry (CBI) • The Better Payment Practice Code (1997), developed by the Dept of Trade and Industry (DTI) • Prompt Payment Code (2008) • Payontime initiative (2008)” Payment terms in an industry should reflect the cash cycle for that industry. The most important thing is how fast a buyer communicates to a supplier that their invoice has been approved for payment – technology means that same day approval is now possible. In terms of supply chain finance, the key to a successful solution is something that is consistent with a CEO’s fiduciary obligations to shareholders and to the Social Contract, and that gives suppliers an opportunity to exercise fully informed choice.

Obillex and the Ethical Digital Supply Chain Finance Product Suite After I was told I was being made redundant by Citigroup, I met with a friend and former business associate, Les Halpin, who had been the CEO of a corporate treasury technology company (Integrity Treasury Solutions) when I was a corporate treasury systems expert at PwC UK. I told him about an idea I had, to use paper bills of exchange legislation on the books of almost every Commonwealth country in the world. I believed we could develop an open and tradeable, quasi-sovereign dematerialized (digital) version of the bill of exchange and use it with a strategy to overcome the shortcomings of the SupplierPay Pledge. Paper bills of exchange had fallen away in their use in the 1980s following the Big Bang deregulation of the UK financial services industry because at that time, the technology did not exist to read all of the data attached to paper bills of exchange. But since then, I knew that the capacity for technology to usefully process massive amounts of data had improved. I had not appreciated it at the time, but Les was a wealthy man, and during our very first meeting over lunch, he asked me how much of an investment I was looking for. I told him £500,000. He said “Damian, you can stop looking.” And then and there, he became the first investor in the business I founded to overcome the weaknesses of President Obama’s SupplierPay Pledge. And that is how my FinTech startup Obillex Limited began.

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In the following years as President Obama announced the SupplierPay Pledge, I was working away quietly on the Obillex product suite. Les had been diagnosed with motor neurone disease and had stepped down as Chairman of Obillex and was replaced by a former McKinsey partner, Alan Morgan. When I told Alan about my encounter with Banker X in Westminster, he advised me to just stay quiet about my role creating the original concept for the SupplierPay Pledge. I understood that I was working on a major upgrade, and at the time I felt there was no real public interest in me stepping forward because I did not understand that large numbers of small, family-owned suppliers were already being harmed by the practices being promoted by Prime Minister David Cameron and Banker X. That is how I rationalized Alan Morgan’s advice to me, and I trusted him at the time. Instead, I focused on developing the Obillex product suite, which comprises the following: • O-Bill™ – the digital bill of exchange • FLOW-Bill™ – a version of the digital bill of exchange that allows digital liquidity to flow down a supply chain and simultaneously, for data to flow back up it • P-Bill™ – a purchase order finance solution • I-Bill™ – a Shariah-compliant solution for Islamic finance

© Obillex 2020, US Patent 8,423,460

The unique selling point that distinguishes the Obillex Solution from other supply chain finance solutions is that it allows liquidity and data to be transferred digitally,

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through extended supply chains, and the legal framework has been validated under English law with leading British institutions. Recently, during the COVID-19 pandemic and its accompanying global economic crisis, EY Germany and Switzerland and geopolitical strategic affairs specialist, Heiko Borchert, together with a EY German corporate treasury partner, published a joint paper based upon the Obillex “Liquidity + Data” product suite that highlights the importance of cooperation between democracies on standards for supply chain transparency. Their paper describes the Obillex product suite as “the solution to Europe’s economic recovery from the pandemic,” by specifically referencing the FLOW-Bill (https://www.ey.com/en_ch/supply-chain/the-europeanway-how-to-advance-europes-strategic-autonomy (p. 7)). The EY paper was followed up by a much shorter paper written by Heiko Borchert, which was published in the East Asia Forum, and highlights the economic and strategic security value of an effective supply chain transparency regime (https:// www.eastasiaforum.org/2020/06/29/supply-chain-management-and-economic-state craft-a-five-point-agenda/).

The Importance of Defending Ecosystems A crucial point regarding the ethics of trade credit is that buyers and suppliers are participants in an ecosystem for trading relationships that depend on the primacy of win-win outcomes for trading relationships based on choice to work. According to Cowton and San-Jose, “It might be contended that the granting of trade credit and the payment of trade debts is simply a matter between the two contracting parties; it is open to the supplier and purchaser to agree mutually acceptable terms of trade and equally open to them to seek legal redress in civil, rather than criminal, law if the other party does not perform according to the contract. However, it will be argued below that there are two respects in which ethical, and not only legal, considerations should be brought to bear: first, because of the nature of the relationship between the two parties; and second, because of the possible impact of their relationship on third parties” (Cowton and San-Jose 2017, p. 676). • Nature of the relationship (impacts of misuse of market power). • Possible impacts of their relationship on third parties (ecosystem) – Justification for the FLOW-Bill. • The systemic issue is not when poor ethical behavior by a large company affects one or a handful of small- to medium-sized suppliers. The systemic issue arises when those poor business practices are scaled up to the size of a national or the global economy . . . our experience is that the impact seriously damages the economy, undermines investor confidence, damages capital, and can result in a cascading series of bankruptcies in a regional or even national economy.

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• Made worse by the issue of emerging data and digital systems integration, including rights over ownership to and control over information that will have a fundamental impact on democracy and the future prosperity of humanity. According to Cowton and San-Jose, “A supply chain can have many links. However, the principle argued for remains the same. Once money enters the supply chain, it should pass quickly back along it, assuming payment has not already been made and received according to “standard” terms.” (Cowton and San-Jose 2017, p. 681). Perhaps, though, following our analysis, there should, in principle, be no need to set a period of credit since, as explained, cash would simply be received and a share passed on promptly, back through the supply chain. It would thus appear that we are suggesting that money received is “earmarked” and must be paid the minute it is received. That might be possible in some special situations, but, being more pragmatic, a suitable alternative would be to set the credit period with some regard to the underlying business process. (Cowton and San-Jose 2017, p. 681)

• This is particularly important in public sector projects, where the government typically wants to minimize the cost associated with managing large numbers of suppliers by working with a managed service provider or prime contractor but needs to support as many local subcontractors as possible. Digital working capital provides a monitoring capability along the lines of “earmarked.” Ultimate buyers can ensure local small suppliers are paid on time. It would help to reverse the issue in Australia, with large prime contractors bidding for contracts at below the cost of delivery and then trying to recover a profit margin via exceptions and via screwing subcontractors (supply chain transparency).

Philosophy of Trading • Win-Win outcomes because that is why trading exists (and it is why we have a Social Contract). It is when one or more actors in the ecosystem harness misuse of market power to target win-lose outcomes that everyone may end up losing. • The potential to use data to turn compliance into a profit center for suppliers. • The challenge of supply chain transparency in the private sector (top down red tape and regulation vs. explaining options for digital integration to small businesses and bringing them onboard enthusiastically and voluntarily because they are the big winners from the value created when data is released from silos). • Top down versus bottom up digital supply chain finance. Who owns the data? Who gets the value)?

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• Why an ethical trading philosophy is so important to supply chain finance trading strategy? – The potential of digital working capital to entrench democracy in the battle for supremacy – both authoritarian communism and authoritarian populism – Rise of the machines – how to use bottom up digital supply chain finance as a defense against the risk of disintermediation of humanity by advanced artificial intelligence – Focus on deployment of data for the advantage of small businesses and communities as opposed to big institutions and big business

Issues to Consider This section, “issues to consider,” is drawn upon my experience of the issues I encountered as the founder of a FinTech. • The problem of data silos (fragmentation of markets) • Scaling mechanism – communities are where people live (not enterprises or central government department) • Operations – Supplier onboarding strategy – mandate versus opt out versus make aware. – Supplier onboarding strategy – DPO extension. – The importance of leadership (senior sponsorship). – The importance of teamwork (Procurement, Technology, and Finance) in supply chain finance. – What does an ethical working capital pricing strategy look like? – How does ethical pricing of supply chain finance relate to ethical trade credit terms? – How to track the flow of liquidity down a supply chain? – KYC at scale. – Risk weighted systems audit. • Ecosystem – Bottom-up versus top-down digital integration, the ownership of data released from silos, and how stakeholders should be rewarded for their data – The role of accounting firms and regulators – When accounting firms and regulators screw up – When eMarketplaces fail (e.g., construction industry – when builders and plumbers quote for work at below the cost of delivery) – The crucial role of Capital Markets – New high-yield cash-equivalent assets class (course of money) – Outsource credit risk – Competitive market for pricing trade credits – The role of central banks – The role of local banks

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– The issue of abuse of market power – when eInvoicing vendors lock in finance • Model of a Supply Chain Finance FinTech

© Obillex 2020

Australian Small Business and Family Enterprise Ombudsman (ASBFEO): Supply Chain Finance Review, Final Report (https:// www.asbfeo.gov.au/sites/default/files/Final%20Report%202.pdf) Source: The Australian Small Business and Family Enterprise Ombudsman The ASBFEO conducted a review of payment terms, times, and practices in March 2019 (https://www.asbfeo.gov.au/sites/default/files/documents/ASBFEOpayment-times-report-2019.pdf). One of the recommendations of that review was for a further review into the impact (including ethics) of supply chain financing (SCF) options on small and family businesses. This next section looks closely at the findings in the ASBFEO’s final report, particularly insofar as they are relevant to the ethics of FinTech and Trading. 1. Ethical Issue: Politicians Have a Responsibility for Ensuring Small Business Owners Understand Their Choices Small businesses also need to be clear about the ability for firms to collect data on them and manipulate the platforms to their detriment, as highlighted in this report. (ASBFEO SCF Review, Final Report, p. 3)

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Comments: Yes. But given digital integration is happening anyway, and given it releases data and thus enormous amounts of value, politicians have a responsibility for ensuring small business owners understand the options for digital integration including the pros and cons of each option from their perspective. Governments have not done enough to educate small business owners on their options. When I spoke to an Australian politician pointing out that horticulture farmers should adopt “bottom up” digital integration of the food supply chain, his response was “but Damian, the farmers don’t want it.” I thought, how could they not want the bulk of the benefits released from digital integration flow to them, their workers, and their communities at the bottom of the supply chain instead of to the big supermarkets and category managers at the top of the supply chain? How could they prefer topdown red tape over bottom-up benefits flow to farmers? Digital integration is happening anyway, either through legislation such as the Modern-Day Slavery Act, the way Plant Breeders Rights, and the various quality platforms which are stripping data from family-owned farms, or through competitive pressures in the industry, such as e-invoicing. Then it occurred to me: The only possible reason that farmers do not favor “bottom up” over “top down” is because (a) this is actually all very new and hardly anyone understands the opportunity; and (b) government and politicians have not yet addressed their obligation to small, family-owned businesses to explain to them their options in the digital integration of their industries; or (c) they do understand, but the top end of town is busy trying to secure the opportunity for themselves. This is so important, because once digital integration is complete, it will set the future course of humanity for many years, perhaps even centuries. It is crucial that small business owners understand now, before it is too late. The world’s most valuable commodity is no longer oil, but data (https://www. economist.com/leaders/2017/05/06/the-worlds-most-valuable-resource-is-no-lon ger-oil-but-data). So, I decided to explain the opportunity to the farmers in my region, and now they would like a payroll FinTech in a Federal regulatory sandbox. They now understand their farm best practices are potentially products that could be distribted via global AgTech. In my experience as a treasury systems consultant with PwC London, when a large corporation is evaluating its strategy with a view to a possible change of IT systems, all of the key stakeholders in the system are interviewed so that their requirements can be gathered. The process includes sharing with all key stakeholders of a range of strategy options for addressing both the needs of both the corporate head office as well as those of the subsidiaries and pros and cons of each option relative to the business requirements that have been gathered. The process is open and objective and helps to build buy-in from stakeholders, bottom-up as well as topdown. If I now take this back to the responsibility of our politicians: Humanity has reached an inflection point. We can choose between top-down digital integration, bottom-up digital integration (defense of freedom, small businesses, communities, democracies, and widespread prosperity), or a combination of the two. If we do not make a decision, the default is top-down, such as China (misuse of market power). That also is Australia’s current destiny (top-down) unless our politicians learn to distinguish between leadership and authoritarian domination. Bottom-up digital integration releases the bulk of the value from digital integration to small business

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owners and communities. But leaders need to explain to stakeholders (small business owners) so they can make an informed choice. Comments: The length of the cash cycle for each industry is already calculated, down to each major business. Digital technologies can manage the data interchange. Digital supply chain technology will allow suppliers to take payment at any point in the cash cycle, if capital markets are able to price the transaction. 2. Public Sector Immediate Payment Terms Can Be Unethical “The Department of Defence has moved to paying suppliers in 2 business days, ensuring money enters the supply chain at record rates.” And: “I would also like to particularly commend businesses who have implemented immediate payment options for their small suppliers.” (ASBFEO SCF Review, Final Report, p. 3)

Comments: The Department of Defense early payment solution misses the Department of Defense supply chain other than prime contractors. This presents ethical issues, including: • The DoD supplier payment policy allows prime contractors to the DoD to hoard cash while delaying payment to subcontractors. The ASBFEO writes that “business and communities operate in an ecosystem.” But the ASBFEO’s recommendations ignore the potential of digital supply chain integration and the possibility that FinTech presents for deep tier supply chain finance. • It is possible to build a zero-knowledge SCF application that maintains the secrecy of the DoD’s suppliers, so security risks can be mitigated. • It is more likely that subcontractors and subsubcontractors are small- to mediumsized Australian family-owned businesses than prime contractors, so the DoD policy is like a lot of Australian Government policies – biased against Australia’s small, family-owned businesses. • The DoD supplier payment policy is inconsistent with business convention and thus represents a hidden subsidy for suppliers to the public sector. • The DoD supplier policy undermines the potential for a business model that would allow Australian FinTechs to accelerate payment to suppliers by leveraging the Australian Federal Government’s A1+/P1 short-term credit rating. That then locks suppliers out of the additional capacity building and profit potential from the more effective use of Data + Liquidity. There is a massive growing global market in FinTech. It is a key infrastructure of the emerging global digital economy. Australia’s DoD payment terms lock opportunities for Australian small, medium, and large businesses out of a closer funding relationship with capital markets and our FinTechs out of the rapidly growing global digital working capital market.

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3. The ASBFEO’s Ethical Judgments on Buyer Behavior During a Crisis Are Wrong Because It Was Misguided on the Mathematical Relationship Between Trade Credit and the Cash Cycle I have been extremely disappointed to receive numerous reports of large businesses extending payment times, or even suspending payments to small businesses in a time of significant pressure for the business community. (ASBFEO SCF Review, Final Report, p. 3)

Comment: The ASBFEO has missed the point of the purpose of trade credit and working capital. Payment terms should match the cash cycle. During a recession, the time it takes to turn a supplier’s inputs in a product and then sell it increases. The ASBFEO should not expect large buyers to finance the working capital of small- to medium-sized businesses during a crisis. Capital markets is better equipped to do that. The report overlooks the potential for capital markets to manage debt collection. Capital markets prices the credit ratings of large businesses and is equipped to professionally evaluate large corporations’ credit risk. Data from digital supply chain finance can help capital markets do a better job. Small businesses should be able to outsource credit risk management to capital markets. Digital SCF offers that possibility. Per Cowton and San-Jose: “Indeed, in certain circumstances, perhaps where there is some unforeseeable change of severe or catastrophic proportion, late payment might even be justified or at least defensible. Such a situation might include a sudden downturn in the economy, collapse of demand for a particular product or the trade debtor, if it supplies businesses in turn, having difficulty collecting payments due from a major trade customer” (Cowton and San-Jose 2017, p. 677). Sorell and Hendry (1994) make the point, though, that “this should also tend to entail the creditor firm acknowledging its ability and willingness to withstand the delay, rather than such delay being merely presumed by the trade debtor and not communicated. Such a decision might entail actions on the part of the trade debtor, such as the provision of appropriate information on its financial position and prospects.” This is what should happen. But because of the power imbalance between buyer and supplier, it does not. Digital supply chain finance (data & liquidity) enables small businesses to outsource credit risk management to capital markets. That is a particularly valuable option for small businesses during an economic crisis. 4. Ethics of Delaying Payment to Force Suppliers Onboard a Supply Chain Finance Solution Companies such as CIMIC Group, which are responsible for building much of this country, are in many ways working to undermine our strong foundations by extending payment terms to their small suppliers and pushing supply chain financing on those suppliers, to sure up their cash flow at the expense of those down the supply chain. (ASBFEO SCF Review, Final Report, p. 4)

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Comment: Give thought to the fact that we are in a recession. To some extent, the actions of CIMIC Group may be reasonable, given the current economic environment. However, to the extent that CIMIC Group’s DPO extension does not reconcile with its cash cycle, and instead is a strategy to force suppliers onboard to a supply chain finance solution, point to the poor leadership of politicians such as former UK PM, David Cameron. How did he get involved in promoting DPO extension (delayed payment) as a means of removing suppliers’ choice and forcing them to act as bankers to large corporations, giving up control over their data in the process? It is a solution specifically precluded by the SupplierPay Pledge because it is unethical. 5. Voluntary Codes of Conduct Do Not Work “I recognise this will be a significant shift in business practice for some entities, but the evidence from Australia and overseas shows that voluntary codes and gentle encouragement simply do not work.” And “While those businesses that believe in supporting their small business ecosystem are already choosing to do the right thing, those that see their suppliers as expendable will not change their behaviour until they are legally required to.” (ASBFEO SCF Review, Final Report, p. 5)

Comment: This is true with analogue supply chains. But digital supply chain finance can provide a monitoring and policy reporting capability (supply chain transparency). All supply chains will eventually be digital. If the public sector wishes, it can then weed those corporations out via public sector procurement processes. This is already how it works in the private sector, and it is how it should work in the public sector too rather than more unnecessary regulatory red tape. 6. Ethical Issue: Definition of “Small Business” May Be Inappropriate Recommendation 1: Unfair contract terms regulations – $10 million definition of small business. (ASBFEO SCF Review, Final Report, p. 5). Comment: Where does this $10 million definition come from? A business typically cannot afford to hire a dedicated corporate treasurer until their turnover is $500 million or more per annum. What assumptions is the ASBFEO making about the financial competence of small businesses with turnover of more than $10 million that warrants their lower protections? Beware the risk that lobbyists for big corporations have influenced politicians’ thinking on a definition as important as this. 7. Ethical Issue: Top-Down Red Tape Versus Bottom-Up Compliance as a Profit Center Recommendation 2: Transparent payment times: The Commonwealth Government’s Payment Times Reporting Framework (PTRF) be promptly implemented with

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that Framework being administered and enforced by an appropriately funded, empowered and proactive entity. (ASBFEO SCF Review, Final Report, p. 5) More costly bureaucratic red tape, hitting small businesses as costly overheads. A bottom-up model will deliver better compliance. Why not leave it to the auditors to do it? But note risks arising from political alignment of audit firms. 8. Mandated Payment Terms Are Unethical Recommendation 3: 30-day payment standard: Maximum payment terms of 30 days from receipt of invoice from small businesses should be legislated. Businesses should be encouraged to pay all suppliers within 30 days, however no legislated outcome should be imposed for businesses falling outside of the small business definition (ASBFEO SCF Review, Final Report, p. 5). Comments: This is not an objective measure (neither the 30 days, nor the arbitrary definition of “small supplier”). It is CSR/ESG marketing spin but not reality. The objective, ethical measure is the length of the cash cycle. Anything longer than that is treating suppliers as a bank, and that should be regulated. Elsewhere, the ASBFEO acknowledges that after 60-day payment terms were introduced into the UK and Europe, some suppliers waited even longer to get paid! The important point is not how quickly the supplier gets paid by the buyer, but rather how quickly the buyer approves the supplier’s invoice for payment and shares that information with the supplier. Given modern technology, approval should be on the same day, unless there is an exception. At that point, Capital Markets can price the buyer’s payable and deliver early payment to the supplier on the same day. 9. Ethical Issue: Financial Reporting Disclosures Recommendation 5: Appropriate coverage by accounting standards: The accounting standards need to provide greater clarity and properly cover SCF to ensure that accounts cannot be manipulated, particularly to mask cash flow issues and insolvency (ASBFEO SCF Review, Final Report, p. 5). Comments: Yes. Accounting firms have not been working up to standards of professionalism we would expect. The Big 4 firms’ independence and objectivity may have been compromised because they need to win government contracts to survive. 10. Ethical Issue: Managing Artificial Intelligence Risks Recommendation 6: Further review from competition perspective: The ACCC should review SCF provider activity from an Australian Competition Law viewpoint, including how data is applied through using artificial intelligence and algorithms (ASBFEO SCF Review, Final Report, p. 5).

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Comments: Yes, look at it from the “bottom up” perspective. Enable suppliers’ direct access to capital markets. Allow capital markets to manage the relationship with large buyers, on behalf of small suppliers – a fitting match. Digital integration technologies mean that small businesses can extract value from their own aggregated data (as an industry). So, data and value can be released from digital integration from the bottom up so that small, family-owned businesses and communities accrue the bulk/a fair share of the value of their data. One day, all the data from trading transactions all over the world will be analyzed in real time by artificial intelligence. At that point, it might be too late to implement the internal control systems that are necessary. So, a good way to build this type of digital network is from the bottom up, starting with small businesses. A data bank with a consent engine guards access to small businesses’ data. In a future with artificial intelligence mining our data, it will be important for us to be able to turn data access rights off. It may be a way of preserving democracy and sovereignty. And it would be unbeatable against an authoritarian dictatorship of any kind. Government should be educating small- to medium-sized suppliers on their strategy options for digital integration. Staying silent on such an important matter risks digital integration driven from the top down because some governments find it easier to act as an authoritarian dictator rather than as government for the sovereign (people). 11. Inconsistent Application of Ethical Standards in Developing Countries A prominent player in the SCF market and CEO of London-based Greensill Capital, Lex Greensill, has stated ‘The focus of people like Kate Carnell has caused us to pause and say we actually need to think about the way that our capital is being delivered . . . We’re in the process of formulating a position on eligibility for our products moving forward that is consistent with the view that Kate . . . has espoused.’ Following the release of our position paper, Greensill Capital have announced that they will not allow their product to be used by large businesses that push out payment terms to SME suppliers beyond 30 days. (ASBFEO SCF Review, Final Report, p. 7)

Comments: Why do we accept levels of exploitation by a UK/Australian FinTech in overseas communities that we say we would not tolerate in Australian communities? 12. Ethics of Immediate Payment The New Zealand Government also holds the view that current technology means 60 or even 30-day payment terms are no longer reasonable. Technology gives businesses the ability to process invoices almost immediately. (ASBFEO SCF Review, Final Report, p. 16)

Comments: Yes, instant payment is possible. But the purpose of trade credit is not because technology and the ability to process a payment quickly did not previously exist . . . it is a factor of the cash cycle and the joint endeavors of a supply chain. Rather than speed-up payment to suppliers, we should ask buyers to speed up communication confirmation the supplier’s invoice has been approved for payment.

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That will allow capital markets to deliver immediate payment. It also avoids the risks associated with damaging Australia’s embryonic FinTech ecosystem from an inefficient policy on early payment. 13. Data + Liquidity Can Support a Compliance Monitoring Mechanism Specifically, the evaluation sought to assess if the directive is fit-for-purpose in terms of effectiveness, efficiency, relevance, coherence and EU added value. This was a challenging task for several reasons, not least of which was the lack of a compulsory and common monitoring system across Member States. (ASBFEO SCF Review, Final Report, p. 20)

Comments: A digital working capital solution such as the Obillex Mechanism can provide a monitoring and reporting capability, as a deep tier supply chain finance and transparency solution all the way up and down the supply chain and as a capacity building mechanism horizontally across the supply chain. A foundation can manage the implications of different interpretations of the Social Contract between Members States. 14. Appropriate Regulation Can Deliver Efficient Markets and Prosperous Communities One negative outcome that surfaced was the fact that in some Member States that have traditionally had a prompt payment culture, the directive is perceived to have normalised longer payment periods. Other industry sources alleged that some public entities known for being ‘good payers’ have extended their payment terms to reach the maximum allowed under the directive. (ASBFEO SCF Review, Final Report, p. 21)

Comments: Supplier payment terms should be based upon the cash cycle of the buyer. Some businesses will be cash businesses (e.g., supermarkets’ sales of fresh produce) which means their payment terms should be less than a week. Others such as the construction industry or manufacturing might have a cash cycle that is longer than 60 days. The secret is not how fast the buyer pays the supplier but rather how fast the buyer confirms they have approved the supplier’s invoice for payment. With modern technology, the buyer should be able to approve the supplier’s invoice on the same day it is received. Capital markets can then pay the supplier’s invoice, also on the same day, at a market discount rate that is below the supplier’s weighted average cost of capital (“WACC”) and possibly even below the supplier’s cost of debt. It is thus profitable for the supplier to take immediate payment (albeit at a tiny discount). 15. Our Social Contract Needs to Be Defended with Coordinated International Action It is widely acknowledged that these objectives could not have been achieved by Member States acting individually. (ASBFEO SCF Review, Final Report, p. 21)

Comments: Most nations lack sufficient critical mass in their transaction flows to interest capital markets. Numbers must be vast for capital markets because the

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margins are typically slim. It is an important point. We need for coordination within government and between governments on definition of digital working capital and on the sharing of business capacity/data across borders. The greatest value can be created if data is traded seamlessly (within the context of the Social Contract) across borders. Bills of exchange legislation provide a common definition and existing regulatory framework. Case law provides further interpretation. 16. Compliance Monitoring Can Defend Our Right to Choose During the course of the Inquiry, we heard from one subcontractor to a state government project who alleged that he was not given a choice but to accept SCF or he would not be awarded the contract. The contractor, when questioned, denied that this was the case. (ASBFEO SCF Review, Final Report, p. 24)

A digital bills of exchange regime would enable transparency in SCF programs. If tied to trade credit that is limited to the length of the cash cycle, they would be a powerful combination. Suppliers receive the option but not the obligation to be paid early with pricing provided competitively via capital markets. The value of their data is held in trust and safeguarded by guarantee. 17. Project Bank Accounts Project Bank Accounts: Both Queensland and Western Australia have implemented and extended PBAs which are put in place by the Head Contractor and protect the next level subcontractor. The legislation in both States indicates that the head contractor must pay the progress payment to the subcontractor entity named in the contract. This appears to exclude a financier in an SCF arrangement receiving the payment from the head contractor. (ASBFEO SCF Review, Final Report, p. 24)

Comments: Project Bank Accounts are an attempt at addressing the late payment issue for extended supply chains. However, they are inefficient compared to a combination of Liquidity + Data. Project Bank Accounts cannot link suppliers to Capital Markets, for example. They have a very limited capability to move data up and down supply chains. O-Bills, FLOW-Bills, and P-Bills were developed under the governance of a nonexecutive board member who was the senior UK public sector procurement professional who led the introduction of Project Bank Accounts into the UK public sector. He told me the Obillex product suite is superior to Project Bank Accounts in every way. 18. Fully Informed Consent: A Technology Strategy for Digital Integration A key principle in the use of algorithms and AI is that of transparency. Companies and people should be informed when an algorithm impacts them, particularly when data they are providing may be used to manipulate outcomes against them in the future. Ensuring that small businesses are providing fully informed consent is difficult for a number of reasons, including: • Power asymmetries, where the small business has little choice but to consent to the use of their data. For example, where a small business joins a SCF program. Clarity is required around what a business owner is consenting to, and how that data will be used.

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• Information asymmetries, where a small business owner may consent to their data being stored and used without properly understanding the nature of this use. • Secondary uses of data, where data that is collected for a given purpose may be put to additional or new uses at a later stage. It is imperative that the conditions under which such uses are appropriate are made clear. While the Privacy Act indicates that consent be “current and specific,” it is difficult for a small business to assert whatever rights they may have due to the cost and knowledge required to pursue legal action. (ASBFEO SCF Review, Final Report, p. 29)

People and small business owners have a right to an informed choice. As a PwCtrained expert on the selection and implementation of complex FinTech systems, I learned that there is a right way and a wrong to select and implement systems that may have profound implications for the lives and livelihoods of stakeholders. A robust methodology should be followed, including awareness briefings to mobilize stakeholders, requirements gathering, strategy selection, system selection, and implication. Digital supply chain integration technologies such as FinTech can be implemented in multiple ways. At present, governments and large corporations are using top-down red tape, elimination of freedom of choice, procurement strategy, and intimidation to drive top-down digital integration models where the bulk of the benefits from the data that is released from silos flows to the government, institutions, and huge corporate buyers. But Government has an obligation to engage small business stakeholders properly in this process, to ensure they understand their options so that they can make informed choices. In Australia, a rural politician confidently asserted that horticulture growers are not interested in bottom-up digital integration. Really? Because digital integration is happening anyway and at the moment it is being driven by top-down red tape (such as the Modern-Day Slavery Act) and intimidation by supermarkets and their category managers. The fact is the digital economy is genuinely a new paradigm, and critical choices and options together with the pros and cons of each option have not been explained to voters and small business owners. If the government remains silent on this optionality, then by virtue of the government’s silence, small business owners are being condemned to the “top down” solutions promoted by Big Business because that is the model that serves them best. The solution is bottom-up digital integration with a data bank with a consent engine that is consistent with informed choice because it allows small, medium, and large businesses to retain control over how their data assets are being used and ensures they can receive a fair share of the value their aggregated assets create. Governments should not be enabling coercion via FinTech to drive digital integration. If it cannot do it top-down based upon freedom to choose based on the economic benefits being offered, then the alternative is bottom-up. Key is to explain to small business owners their strategy options and then give them a choice. The world’s BREXIT experience so far includes plummeting standards in the UK (accounting and auditing standards, off-balance-sheet financing, and misuse of market power (e.g., removal of full informed choice) to try to force small suppliers to take out loans using a mechanism that concentrates their data into London). They are not standards the world should embrace. There is an important role for English law to play if unwritten conventions and a Rules Based International Order are

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upheld. Otherwise, Data + Liquidity global financial markets need to bypass the UK so that value creation from the global digital economy can be optimized. There is an opportunity to harness a set of converging factors to extract the socio-economic development potential of the data that FinTech (Liquidity + Data) releases from silos and to ensure its owners understand its value. These are just some of the emerging factors driving the need for a minimum set of standards from FinTech and Trading: • Free trade agreement negotiations • Need to recover from the socio-economic catastrophe from the COVID-19 pandemic • Need for resilient supply chains • Geopolitical tensions • Need for resilient supply chains • An attack on democracy from China • Need to be able to extract the value of aggregated data while preserving data ownership and personal privacy • Need to preserve freedom, informed choice, democracy, and property rights • Need for truth telling and reconciliation in recognition that Black Lives Matter We need standards because politicians everywhere are often in pursuit of money and power more than they are great outcomes for communities. Data + Liquidity (FinTech) is a source of power (information) that should be kept out of politicians hands to the extent needed to ensure the interests of small business owners all over the world are not sacrificed for authoritarian oppression. Fully informed choice is a key.

Concluding Remarks and Future Predictions The COVID-19 pandemic has demonstrated the fragility of nations that overly depend upon globalization. The pandemic has reminded politicians that resilient supply chains are important to national security. That has led to a focus on the importance of Data + Liquidity for enabling resilient supply chains. And the pandemic led to recognition there is a geopolitical struggle for control between authoritarian regimes and democracy, and so standards for sharing data within and between democracies are important for defending freedom. The issues that have arisen because of BREXIT will pass. English Law and its institutions have significant value in the deployment of global standards for supply chain transparency. England has more to lose than perhaps any other nation from an international loss of respect for conventions. While some English politicians may have forgotten the importance of our Social Contract, I am confident that emerging leaders will not make the same mistakes. Scotland might be an excellent place to govern the UK’s Social Contract as data, and there is likely to be hundreds of billions, if not trillions of pounds worth of

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value for people and small business owners from the value of data released from silos in its domestic market. I am hopeful that this may help to hold the Union together. I am watching UK Chancellor Rishi Sunak – I think he is future UK Prime Minister material. Opposition leader Sir Keir Starmer is also looking more capable than his predecessor. The fight against authoritarianism will only be won if democracies work together, so I am hopeful that someone such as Mr. Sunak can turn the UK’s relationship with Europe around. English law and the Commonwealth of Nations are exciting channels for rapidly deploying the benefits of Data + Liquidity to developing countries. I predict that eventually there will be agreement between the UK/Commonwealth, Europe, USA, and other nations on a model for sharing the value to be released by digital working capital. The unparalleled potential of win-win model for creating value and widespread prosperity will eventually succeed over win-lose models. To the extent that there is uncertainty over the ownership of the data released by digital working capital from silos, I propose a foundation to defend the rights of small- to medium-sized business owners in the data and the opportunity for developing countries to build capacity. I think it is important to defend the rights of families and communities to prosperity. I believe that a solution that delivers widespread prosperity for developing nations can deliver even greater prosperity for developed nations. The foundation may also hold the intellectual property rights for Data + Liquidity supply chain transparency solutions. It may enable a global digital economy in multiple interpretations of the Social Contract that be supported. We have a Social Contract to guide and enable win-win outcomes. The Black Lives Matter movement has articulated a compelling case for change in the way the global economy works to address systemic racism that is leading to Win-Lose and Lose-Lose outcomes. Emerging Data + Liquidity solutions will help to defend winwin outcomes that lead to widespread prosperity. I have only just discovered a hidden message (https://trove.nla.gov.au/newspaper/article/173678236) that may have been left by my ancestors in the legislation that created the State of Victoria’s first National Park – I am still trying to understand what it all means, but it appears to me to be an acknowledgment by Irish-Australian colonial settlers of a debt owed to indigenous Australians that can never be fully repaid. I believe there may be a relationship between that hidden message and the pledge my grandfather invited me to take during the Ethiopian Famine. Food security will be treated as a “special case.” If we have food security, humanity can beat most crises we might face. It is common ground with China and every other nation. Food security will be recognized as an overriding output needed from the global economy. The pandemic will lead us to reevaluate risks to food security. Redundancy will be built back into supply chains so that food security can be assured during any crisis. International standards are needed between democracies for sharing data (supply chain transparency) and defending and promoting the interests of small businesses in data including its value on an individual and aggregated basis.

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Cross-References ▶ A Virtue Ethics Approach in Finance ▶ Applying Ethics ▶ Corporate Government as a Structure for Control and Promotion of Ethics in Banks ▶ Ethical Considerations About the Implications of Artificial Intelligence in Finance ▶ Ethical Orientation in Banks ▶ Ethical Responsibility of Financiers ▶ Ethics for Automated Financial Markets ▶ Ethics in the Independent Audits of Financial Statements ▶ Financial Institutions and Codes of Ethics ▶ Stakeholder Accounting for Sustainability Applied to Nonfinancial Information in Banking

References Australian Small Business and Family Enterprise Ombudsman (2020) Supply chain finance review. Final report Cowton CJ, San-Jose L (2017) On the ethics of trade credit: understanding good payment practice in the supply chain. J Bus Ethics 140(4):673–685 Donaldson T, Dunfee TW (1994) Toward a unified conception of business ethics: integrative social contracts theory. Acad Manag Rev 19(2):252–284 Herath G (2015) Supply-chain finance: the emergence of a new competitive landscape. McKinsey Paym 8(22):10–16. McKinsey & Company Mckinsey on Payments (2015) Volume 8, Number 22, p11 https://www.mckinsey.com/~/media/ mckinsey/dotcom/client_service/financial%20services/latest%20thinking/payments/mop22_ supply_chain_finance_emergence_of_a_new_competitive_landscape_2015.ashx Rousseau J-J (1762) Du contrat social; ou Principes du droit politique Sorell T, Hendry J (1994) Business ethics. Oxford: Butterworth Heinemann

Moral Education for Sustainable Financial Services Japanese Approach in Practice Jutaro Kaneko

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Necessary Mindsets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-Termism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Altruism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Moral Education in Japanese Schools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics Class as a Mandatory Subject . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Some Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Linkage with ESG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Moral Education in Japanese Financial Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cross-References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

This chapter analyzes Japanese moral education in the context of our global agenda of SDGs. The author broadly explained in a different chapter of this handbook about the Japanese approach in comparison with the European approach. This chapter is more focused on the practical aspects of how to promote moral education to support realizing sustainable societies and economies. Japan has upgraded moral education at schools from an ungraded activity to a mandatory subject. Financial education orchestrated by a council in the central bank explicitly incorporated ethical notions to address environmental and social issues in its guidelines for school teachers. It is worthwhile to observe and assess in coming years if the attempts will turn out to be effective to bring about expected

J. Kaneko (*) Japan Center for International Finance, Tokyo, Japan Institute for International Trade and Investment, Tokyo, Japan e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_36

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behavioral changes on the part of the citizens. Depending on the outcome, they may be able to provide some policy implications for the other countries. Keywords

Financial education · Ethics · Long-termism · Sustainable finance · Altruism · ESG · SDGs · Moral education · Climate neutraliztion · Ethical use of AI

Introduction Issues concerning environment (E), social (S), and corporate governance (G) which are being called “ESG” collectively have become the most pressing challenge in the global community. The United Nations advocates sustainable development goals (SDGs). ESG is regarded as a major criterion to assess implementation of SDGs. Against the backdrop, general interests in ESG compatible investments is growing in international society. Most notably, incorporation of SDGs into financial services is being considered through two channels. These are the combat against climate change as an example of “E” element and the ethical digitalization (e.g., ethical use of artificial intelligence/AI) as an example of “S” element.1 The two pillars can conceptually be classified under ESG/ SDGs as Table 1 shows. As for the first pillar of climate neutralization, it is remarkable that the public concern on global warming is rising sharply in the last couple of years across the European Union/EU (see Fig. 1). According to the opinion poll conducted by the European Commission in fall of 2019, this issue was ranked to be the most important issue second to immigration and higher than economic situation. Reducing emission of greenhouse gas essentially means accepting degree of convenience and comfortability in different aspects of daily life, including transportation and nutrition, and/or higher costs to pay for substitute energy (e.g., renewable energy). It is painful but this short-term pain can lead to long-term gain. In this respect, climate neutralization is the policy area where long-term perspective is most necessary. Table 1 Conceptual map Objective Policy goals Examples

Sustainability of economy E (environment protection) Climate neutralization

Water and soil quality retention, etc.

S (human rights protection, etc.) Ethical use of Al, etc.

Also regarding “G,” Europe is considering how to accommodate it in its flagship Green Deal policy framework.

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Fig. 1 Development of concern on climate change among EU citizens Note: Figures are aggregated ratio of responses to the question “What do you think are the two most important issues facing the EU at the moment?” Source: European Commission (Standard Eurobarometer)

Also regarding the second pillar of digitalization, due to development of technologies, not only countries and big firms but also ordinary citizens have become able to disseminate information globally. While this is a major advantage of digitalization, there arises a situation that unethical arguments cause serious impacts, unless the recipient can examine the appropriateness of each information. Therefore, it can be regarded also as a new risk in terms of sustainability. In the area of financial services, including fintech, global expectation for potential benefit of utilizing AI, besides distributed ledger technologies (DLT) such as blockchain, is rapidly and massively growing. AI has huge potential to streamline operational process and to mitigate shortage of labor forces through its functions, including projection, automation, data analysis, and user customization. At the same time, concerns on the negative aspects of AI are growing from ethical standpoints, most notably in Europe. It is worthwhile noting that the citizens in the EU member states are relatively cautious about AI and robotics in comparison with the people in the other areas, especially in Asia. As you can see in Fig. 2, according to a survey conducted by Oracle, an US IT giant, concerning use of AI in workplaces in ten countries all over the world, the ratio of those who expressed that they trust AI and robots more than human managers is generally higher in Asia, while it is lower in Europe (Oracle & Future Workplace 2019:11). Similarly, according to the result of an opinion poll targeted to the EU citizens by the European Commission, 88% of the respondents find it necessary to be careful about control and management over AI and robots(European Commission 2017).

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Fig. 2 Confidence in Al in workplaces Note: The figures are ratio of the respondents who answered that they trusted Al and robots more than human managers Source: Oracle & Future Workplace (2019)

An experts group on AI named High-Level Expert Group on Artificial Intelligence (AI HLEG hereafter), which the European Commission had launched, published a report entitled “Ethics Guidelines for Trustworthy AI” (EU’s AI Guidelines hereafter) in April 2019. EU’s AI guideline presents seven requirements for “trustworthy AI” which include “privacy and data governance,” “diversity, non-discrimination and fairness,” and “accountability.” EU’s AI Guidelines can be applied across sectors, but it especially fits financial services. For instance, there is risk that biased algorithm causes unacceptable discrimination in the process of underwriting by an insurer and credit assessment by a bank. Should financial institutions fail to exploit AI appropriately and bring about equal treatment of its clients (e.g., insurance policy holders and credit applicants) and financial exclusion, they can be condemned. AI HLEG’s report stresses that education plays an important role, both to ensure that knowledge of the potential impact of AI systems is widespread, and to make people aware that they can participate in shaping the societal development. A prerequisite for educating the public is to ensure the proper skills and training of ethicists in this space. EU’s AI guideline points out the importance of education in a modest tone that it can prevail public understanding on potential impacts of AI and that it plays key role to let the citizens realize possibility to participate in development of society. It also mentions that to ensure adequate skills and training is the prerequisite for that (AI HLEG 2019).

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In Japan, Council for Social Principles of Human-centric AI (AI CSPH) published “Social Principles of Human-Centric AI”(Japan’s AI Principles hereafter)in March 2019, preceding the EU’s AI Guidelines. Japan’s AI Principles clarify that policy makers and managers of businesses involved in AI must have an ethics permitting appropriate use of AI in society. They should take into account the complexity of AI and appreciate the possibility that AI could be intentionally misused. At the same time, it is important for developers to learn business models for how AI can be used in society, as well as to master a wide range of liberal arts such as social sciences and ethics including normative consciousness (AI CSPH 2019: 7–8). Japan’s AI Principles explicitly connect ethics and education by emphasizing importance of letting the people acquire firm understanding on ethics as an academic area and of establishing a new academic ground which accommodate a wide range of existing ones related to ethics (AI CSPH 2019). While EU’s AI Guidelines also refer to importance of education, it does not go beyond necessity of improvement of technological literacy. Given that, it may not be too much to say that Japan’s AI Principles take on clearer and more unique message. Japan is a front runner to tackle many social issues confronting a mature society, such as labor shortage, rural depopulation, and increased fiscal spending against the backdrop of declining birthrate and aging population. AI is considered as a key technology to rescue society from these problems, to achieve SDGs, and to build a sustainable world. Finance can significantly contribute to sustainable development. The main task of the finance system is to allocate funding to its most productive use. Investors can exert influence on the corporates in which they invest (Schoenmaker and Schramade 2019: 3–4). Other types of consumers of financial services (e.g., depositors, loan takers) can also wield influence over strategies of financial institutions. Sustainable finance is thus becoming a most important policy area. We have seen important policy developments in a new area of sustainable finance which support ESG/SDGs through financial market.2 The idea beneath is to raise enough fund from private sector through financial markets for various projects to promote sustainable development, since public funds available for governments are not sufficient in volume. Discussions on sustainable finance among countries are still focused on climate neutralization. However, Europe explicitly plans to expand the scope of its work to other environmental issues, including protection of water and soil. In addition, under the current situation where COVID-19 is deteriorating the global economy, the need to address social issues (e.g., human rights and equality of those who are most affected by the Corona virus such as social minorities) is also significantly growing. The most vocal venue of sustainable finance is probably Europe. Today’s financial system based on excessive liberalism and capitalism, however, has difficulty to justify ESG-oriented investments which are often less profitable than traditional

Sustainable finance includes basic ideas of the UN’s Principles of Responsible Investment (PRI) and the corporate social responsibility (CSR).

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investment at least in a short term.3 Therefore, we need to have ethical way of thinking to achieve these environmental and social goals. Education takes on important role to implement the reform. Of the 17 SDGs, the fourth goal is “Quality Education.” It maintains that obtaining a quality education is the foundation to creating sustainable development. In addition to improving quality of life, access to inclusive education can help equip locals with the tools required to develop innovative solutions to the world’s greatest problems. In November 2013, 37th UNESCO Assembly adopted Global Action Program on Education for Sustainable Development (ESD), which 69th UN Assembly endorsed in 2014. This program aims to maximize potential of ESD and provide global citizens with opportunity to learn sustainable development (UNESCO 2013). ESD is education that fosters the leadership needed to build a sustainable society. The world faces a number of problems related to the environment, poverty, human rights, peace, and development. ESD views these challenges of modern society as one’s own and shows how to approach them at a grassroots level (“think globally, act locally”), thereby creating new values and behaviors that contribute to solutions for those problems and, by extension, to the creation of a sustainable society. The Japanese ministry responsible for education, “Ministry of Education, Culture, Sports, Science and Technology (MEXT)” is incorporating ESD in the Japanese education system. In order to implement ESD, it is necessary to develop humanity (MEXT 2016). Japan has promoted energy saving and recycling since it experienced so-called oil shock in the 1970s. She is ranked as one of the top countries in terms of energy efficiency (see Fig. 3). However, the Japanese people do not necessarily seem to be conscious of ESG issues as compared with the Europeans. Climate change has not been the most important policy agenda. Also as for “S” element, Japan accepted mere 28 refugees in 2016 when the UNHCR says that an unprecedented 65.6 million people around the world have been displaced by civil wars, conflict, or persecution, while the UK granted asylum to 9,975 refugees and the USA did so to 84,994 (Hoffman 2017). The author estimates that there are two reasons for that in comparison with Europe. First, the Japanese people may not yet be so acutely conscious of ESG issues such as climate change as the Europeans, which is actually rather ironical and mysterious for a country that suffers severe natural disasters (e.g., earthquake, tsunami, typhoon, flood) more often than not. Secondly, important power and bureaucratic jurisdiction are fragmented among several ministries and agencies in Japan and the collaboration across the authorities is not always easy since they are independent of each other, unlike the European Commission where different general directorates are closely coordinated under high-level Commissioners. But there is a new interesting policy development emerging in Japan. It is about moral education. Since 2018,4 the MEXT has upgraded classes on ethics from just an

Iwai points out that capitalism lays ethical elements such as fiducially relationships based on duty of loyalty in its essence (Iwai 2019: 57–60). 4 It applies from 2018 with elementary schools and 2019 with secondary schools, respectively. Prior to the formal application, the transitional period started in 2015. 3

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Fig. 3 Energy efficiency by country (Primary energy supply per GDP) Note: Data is an of year 2016 Source: International Energy Agency

activity where no grade is given and no official textbook is provided to a mandatory class (subject) which will be assessed objectively and taught based on textbooks authorized by MEXT.5 In the following sections, the author will explore to connect this new development with potential reform of Japanese mindset toward ESG/SDGs. The author described in another chapter of this handbook theoretical connection between ESG-oriented policy framework and financial education (i.e., question of whether ethics needs to be considered in promoting sustainable development through financial education based on experiences in Europe and Japan). He clarified a strong linkage between them. Therefore, in this chapter, he will focus more on practical aspect of this issue, namely, implementation of financial education which contributes to realization of sustainable economy and society. This chapter consists of five sections. In the second section, the author specifies what needs to be incorporated in the civic mindset, attempting to specify philosophical grounds of this issue. The third section explains the new moral education in Japan. The fourth section presents moral education in financial services in Japan. Lastly, in the fifth section, the author concludes this chapter with some universally applicable policy implications in today’s international context which can be derived from the Japanese experiences.

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Normally, a school subject needs to (1) be taught by a specially licensed teacher, (2) be taught with a textbook authorized by MEXT, and (3) assess students’ performance with numerical grades. However, the new moral education does not meet the first and third requirements, as explained in section “Moral Education in Japanese Schools” of this chapter. Therefore, it is defined as a “special subject.”

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Necessary Mindsets Some of social issues may not be commonly recognized in all corners of the world, and it may be future generations who will seriously be affected by environmental deterioration. Thus, it is not easy to induce the people to change their behaviors right now in order to solve or mitigate the problems. To address ESG and to achieve SGDs effectively, the author believes that there are two required mindsets: long-termism and altruism. This section deals with fundamental elements to develop moral sentiments among the citizens, without imposing a certain ideal. What is tricky about it is that many challenges are economically rational at least from a short-term perspective. Various cost and pains such as reduction of convenience and comfortability and even subordination in global competition might be inevitable to overcome them, unless universally collective actions were taken. From a simplified standpoint of utilitarianism which essentially aims to maximize utility as an entirety, such prices and sacrifices could not be justified. Still, climate change and digitalization are phenomena taking place at a global level. Thus, the effect would be confined, even if only limited number of stakeholders deal with them. It is a must to make a difference that every citizen should grow altruism and rationally overcome apathy to act to realize what he/she believes need to be done.

Long-Termism Long-termism is one of key concepts of the EU’s sustainable finance policy framework. The underlying philosophy is generally advocated as “intergenerational equity” or “intergenerational justice.” The EU has been most vocal policy maker in this area since 2018. Green Deal and digitalization are two policy pillars of the current European Commission under Ms. von der Leyen. They are designed mindful of ESG and SDGs. European initiative on the basis of sustainable finance aims at funding projects to develop technology and infrastructure for conversion of our society and economy into more sustainable ones. The underlying belief seems to be that non-ESG-compatible activities are not sustainable and it is not wise to invest in them in a long run. The High-Level Expert Group on Sustainable Finance (SF HLEG hereafter) which was formed under the auspice of the European Commission published its final report in January 2018. The report reads that “the culture of the financial sector needs to be aligned more closely with long-term perspectives and the promise of a sustainable financial system that is useful to society” and “citizens with savings to invest should be empowered to invest in portfolios that reflect their sustainability and ethical preferences” (SF HLEG 2018: 13 and 27). European Commission’s Action Plan on Sustainable Finance which was published two months after the SF HLEG’s report clarifies that the action plan

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aims to foster transparency and long-termism in financial and economic activity (European Commission 2018).6 SF HELG’s report also emphasizes importance of financial education to increase demand for sustainable financial products. “Today’s barriers in financial education and transparency limit the ability to deliver this vision. The Commission has been paying particular attention to financial literacy. Yet further efforts are needed to empower citizens to choose the financial products and services that best suit their needs. This, in fact, is necessary for sustainable finance literacy efforts to translate into increased demand for sustainable financial products.” The High-Level Expert Group clarified long-termism as a key for promoting sustainability. It also expects citizens to invest to reflect their ethical preferences. Long-termism is fundamentally compatible with utilitarianism in the sense to go for maximizing total benefit and happiness of all parties, irrespective of time and location of them. It, in its ultimate form, requires consideration on the people of future generations and those living in distant places beyond visible scope, based on firm ability to imagine pains they are or will be suffering from. Climate change, for instance, has different impacts over the nations, depending on geographical characteristics. Some lower-altitude countries are and will be harder hit by the rise of sea surface, while others affluent in woods by forest fire. Imagination is a prerequisite to take these issues seriously and to understand the pain of the people suffering beyond visible scope. Similarly, global actions to address S and G elements of ESG (e.g., illegal child labor) require solid ability to imagine the social costs on loss of studying opportunities of the young and future generations in poor countries which can be far away from the eyes of citizens in advanced economy. As Adam Smith writes, sympathy to the others is based on rich imagination (Smith 2018). To foster ability to imagine what is not directly observable is what education is expected to offer. In Japan, there has been a management philosophy of “Sanpo-yoshi” among merchants in Ohmi; an old name of Shiga prefecture which is east of Kyoto since the seventeenth century (Edo era). Sanpo-yoshi is a Japanese phrase for three-way satisfaction, which means “good for the seller, good for the buyer, good for the society.” Ohmi merchants were very active and successful in other provinces and countries, and considered a third-person perspective by operating their business as members of the relevant society. It was essential for Ohmi merchants to build the intangible asset of trust with the people in the regions they visited. Itinerant trading was not a business of one-time sales, but instead required the merchant to depart every year to regions and provinces where they sensed success, and develop customers in places On the other hand, the action plan does not mention financial education, and the author assumes that it is because of the limitation of the European institution based on principle of subsidiarity. The current EU’s highest law named Lisbon Treaty stipulates that the EU can act in the only areas where it can achieve the objectives better than the member states, if it does not have exclusive mandates (article 5). Yet, the situation has been changing gradually, so that the EU increases its involvement in financial education (chapter “Ethics in Education for Sustainable Finance”).

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where they had neither roots nor relatives to expand their territory. Long-term sustainability, rather than the pursuit of profit, forms the very essence of Japanese business (Suenaga 2019). As such, long-termism has been rooted in Japanese commercial culture and behaviors since centuries ago.

Altruism J.S. Mill further developed Bentham’s theory of utilitarianism. Mill introduced an idea that wishing happiness of the others is a higher pleasure than wishing happiness of him/herself. According to Mill, human actions are driven by remorse or “internal sanctions” that he/she would feel out of conscience when he/she leaves the others in an unhappy state (Mill 1861).7 Auguste Comte, a French sociologist, defines altruism as something contrary to egoism. He captured it as concrete expressions of attachment, veneration, and benevolence (Comte 2017). Joseph Butler, an English theologist, named satisfying human relationship as a condition to live a happy life (Butler 2011). David Hume, a Scottish philosopher, explains that affection and sympathy are the motivation for a person to help the others (Hume 1739). In recent literatures, Jeffries explains that generosity, benevolence, forgiveness, volunteering, unlimited love, virtue, philanthropy, and altruistic love are terms used to indicate specific manifestations of generalized orientation of altruism (Jeffries 2014: 6). According to Weiss and Peres, altruism in a strict sense necessarily involves sacrificial behavior, ranging from self-abnegation to self-destruction. In a society where all individuals were purely altruistic, altruism would be impossible because no ego would exist to be the receiver. On the other hand, altruism in a softer sense includes actions that do not necessarily imply self-annihilation, but only self-donation gestures, such as mutual care, reciprocity, and cooperation. Soft altruism shelters so many phenomena that it paradoxically includes egoism (Weiss and Peres 2014: 72–73). The scope and degree of altruism has not been agreed yet after a long-time discussion among philosophers. Altruism is not compatible with short-term utility. It may be interpreted in today’s context as a willingness to accept the cost of transition to sustainable world. Long-termism and altruism share overall commonalities. Depending on degrees of purity, their motivations both can be egoistic and hypocritic. A slight difference between them may be that altruism aims at absolute interest of others, while longtermism does not exclude return to oneself in the long run. Altruism is based on the concept of “gift” which is motivated mainly by a sense of debt or guilt, while long-termism is more like a pure voluntary will. A gift is in its

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Mill thought morality experience. On the other hand, Immanuel Kant thought it is generated by reason, which means that moral principles are a priori – generated outside of, or prior to, experience. Kant concludes that it is rational for the people to help each other and denies necessity of philanthropic sentiment (Kant 1998).

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essence anonymous at the time of its occurring and reproductive. If a gift is not anonymous at the time of its occurring, it is an exchange because the recipient feels obliged to return something equivalent. (Yet, if it is anonymous forever, no one can recognize it as a gift.) If a gift is not reproductive, it is a self-sacrifice which is not sustainable. Therefore, a gift requires the donor to be ethical and the recipient to be intellectual (Chikauchi 2020). In the context of ESG, altruism interprets that the existing natural environment is inherited from the ancestors and thus must be inherited to future generations as it is. The point is that the willingness needs to come from each citizen’s own decision. It should not be a blind obedience of what is taught or “slave morality” based on “Ressentiment” by Nietzsche’s definition (Nietzsche 1887). Moral sentiment is not something to be inflicted. According to a modern Japanese philosopher named Kitaro Nishida, a truly good conduct which brings the society forward is to realize one’s individuality. Therefore, each one has different mandates and needs to ponder what to do (Nishida 1923). In this sense, just serving to the society through self-sacrifice does not necessarily mean contributing to the society. As Michael Sandel, a contemporary US political philosopher, points out, there are limits with what money can buy such as self-sacrifice and free service based on good will. But, in the mainstream modern economics, there is no such thing as a free lunch and the notion of gift does not fit well (Sandel 2010). As the result, motivations to do something good for the others based on morality is sometimes attempted to be rewarded by remuneration. Financial incentives and penalties rather frustrate such pure motivations. Samuel Bowles places values on cooperative and generous existence of altruistic citizens. He argues that such tools as incentive and punishment which control capitalism have limits as motivations for intangible sentiments, including professionalism and fulfillment (Bowles 2016). A prominent Japanese thinker in Edo era named Sontoku Ninomiya combined Shinto, a traditional religion inherent in Japan, Confucianism, and Buddhism. Being a farmer himself, Ninomiya established a unique agricultural philosophy named “Hotoku (rewarding ethics).” He encouraged peasants to be altruistic as a means to be happy and harmonious with the nature which is essentially irresistible and uncontrollable by teaching from practical and tangible standpoints. His precept consists keeping economic temperance (Bundo) and sharing economic surplus with the others (Suijo) (Yamauchi 2018). Ninomiya placed evident value on financial independence, so that even the weak group of the people in the then society could build and maintain sense of self-esteem, while he regarded excess capital as a threat to natural way of life.

Moral Education in Japanese Schools According to Richard Dawkins, an evolutionary biologist, genes are “selfish” and are biologically designed to perpetuate their own survival and replication. This genetic programming manifests in human behavior. Humans are not a global species,

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not even at a collective, local group level, but at the level of individual beings, along with our kin (i.e., those carrying our genes). We cooperate when it satisfies our own self-interest (McDonald 2019: 9–10). Then, how can we incorporate altruism in practice of education to bring about human behavioral change? Key element is to let citizens, including students, think and empower to make our economy and society sustainable, beyond getting aware of issues and the associated arguments. As such, an approach of “moral dilemma” can be named.8 A moral dilemma raises ethical questions which do not seem to have one-size-fits-all answers like the famous “trolley problem.”9 In general, moral dilemma is interpreted as a dilemma which results in a failure by making a choice itself, since no alternative can be discarded under an ultimate circumstance. With this approach, students can learn life skills to find realistic solutions to difficult conflicts of interests which take place in daily lives. To teach a uniform justice or good to deal with situations where damage is inevitable by making whatever choice through education could bring about inappropriate outcome. There is nothing like an absolute good, and different judgments can be drawn from different viewpoints on religion, philosophy (e.g., libertarianism, utilitarianism), as well as from different historical and cultural backgrounds. Apart from moral dilemma mentioned above, there are interesting new approaches, including Structured Group Encounter10 and Moral Skill Training11 which facilitate deep thinking and provoking discussions. These approaches may contribute to conversion of our society and economic system into sustainable ones through financial channel. They are being tested in actual school classes. Utmost importance is for each individual to think thoroughly him/herself. However, thinking by him/herself has a limit and can even lead to a self-righteousness or a shallow conviction. It is likewise important to polish one’s idea through discussion with those who have different viewpoints and senses of value, based on dialectic approaches. The essence of education is to provide opportunities to deepen one’s own thoughts and to sophisticate them through discussions. School is an optimal place to examine and improve their own ideas through discussions with the others with various backgrounds and thoughts. To repeat a 8

Lawrence Kohlberg developed this approach based on Jean Piaget’s theory of moral development. Kohlberg told people stories involving moral dilemmas followed by democratic dialogues. In each case, he presented a choice to be considered, for example, between the rights of some authority and the needs of some deserving individual who is being unfairly treated. One of the best-known stories concerns a man called Heinz who is poor and unable to buy medicine for his dying wife (McLeod 2013). 9 This is the crux of the classic thought experiment developed by philosopher Philippa Foot in 1967 and adapted by Judith Jarvis Thomson in 1985 (D'Olimpio 2016). 10 This is an approach developed by Yasutaka Kokubu, a Japanese psychologist. It aims at enabling students to understand ethical values more effectively through simulated experiences than through just reading stories (Morotomi 2017: 36–41). 11 This is an approach exploits “role playing” not only to help students understand others’ feelings but also to train them to find solutions to concrete problems (Hayashi 2017: 50–55). Role-playing is a form of psychological treatments developed by Jacob Levy Moreno.

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Table 2 Ethical thinking Thick ! Discuss ! Rethink ! Discuss ! Rethink ... from from more (Repetition) diverted diverted viewpoints viewpoints

Reach something close to a universal answer

process of 1) think him/herself, then 2) discuss with the others, and 3) revisit and improve the original thoughts from different angles is effective. Education can provide citizens necessary tools to think and empower. Conceptually, it can be expressed as a continuation of (1) know/get aware, (2) think and discuss, and then (3) act (see Table 2). There are fundamental questions such as “is it possible to train ethics through education?” and “is ethics not something to be better taught at home and in the community than at school?” To give straightforward answers to them is difficult. That said, regional communities’ role to play seems shrinking due to growing dependency on internet as channel to get information. Home is also becoming difficult to function as an educational venue against the backdrop of increase of nuclear families and unmarried couples. School is a place where pupils and students spend quite long time of their daily lives. For example, a pupil averagely spends between six and seven hours in his/her elementary school in Japan. Therefore, school is an important venue for them and can help develop their character and ability.12 School is also unique in its ability to provide venue to exchange views and discuss problems and issues with different people. In Japan, Revised Basic Act on Education (RBAE) was enacted in 2006. Article 2 of RBAE stipulates following five objectives of education which include: (1) cultivating rich sensibility and sense of morality; (2) developing individuals’ abilities and fostering a spirit of autonomy and independence; (3) fostering the values of respect for justice, responsibility, and equality, and the value of actively participating in building our society; (4) fostering the values of respecting life, caring about nature, and desiring to contribute to the preservation of the environment; and (5) fostering the value of respect for tradition and culture and love of the country and regions that have nurtured us, as well as the value of respect for other countries and the desire to contribute to world peace and the development of the international community. Based on RBAE, the curriculum guidelines (Course of Study/CS) for elementary schools and secondary schools were also revised in 2008. CSs stipulate that the objective of the moral education is to nurture ethical judgment and sentiment, and willingness to practice them by thinking from wide perspectives based on

12

Moral education must have its foundation in the home. All parents have the responsibility of having it take root in their children. But it is unrealistic to expect for it if a child is at home only in the late afternoon or evening. Schools have a primary role to play in this education (Jones 2017).

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understanding regarding ethical values (MEXT 2017a, b). Behind it, there is a basic policy to cultivate rich and wholesome hearts through solid moral education. In accordance with CS, educational contents were revised to enhance moral education. Ethical elements are notable in the CS. The Japanese education system has a particular affinity for moral education. The students and pupils clean their class rooms by themselves in the Japanese schools. They are taught to be ethical before being wise and smart. In this context, the MEXT places emphasis on the importance of making schools an “open environment” where students can form connections with various people in society, so that the students can gain confidence that they are able to change the world through their activities (Japan Times 2015). There has been an ethics class in the last six decades in the school curriculum. Recently, they were upgraded to be obligatory both at elementary and secondary schools. In my understanding, the basic motivation behind the reform is increase of suicides among children who suffered bullying at schools. It has been pointed out that the traditional moral education was not practical to address such complicated problems in their daily lives because it is nothing more than a passive learning which consists merely listening to teachers telling stories or reading teaching materials to understand feelings of those who appear in the materials, as well as asking simple questions to which students know desired answers without thinking (Yaginuma 2017: 39–40). It is too early to assess the effect of the reform. However, I am hopeful that it will be useful also from the viewpoint of steadily prevailing altruism and sense of ownership on sustainability among the citizens. In Japan, a weekly moral class has been incorporated in the elementary and secondly schools as an ungraded school activity since 1950s.13 Moral classes are upgraded to a full-fledged subject at elementary schools in school year (SY)14 2018 and at secondly schools in SY 2019. As a result, official textbooks and evaluation requirements were introduced to the moral education. The new ministerial guidelines which include strengthening of moral education are being implemented from SY 2020 at elementary schools and from SY 2021 at secondly schools after two years transition periods, respectively. The new ministerial guidelines for elementary schools declare that moral education aims at nurturing ethics as a basis to think about how to live well, to act based on one’s own decisions, and to live in harmony with the others as independent individuals. There exist certain concerns as those described in the following section. Notwithstanding, the author thinks that the new moral education is promising if it can be implemented well. Despite technical difficulties in implementing these ideas and concerns which are reasonable and sound, the author maintains that the new

13

Like the USA, France, and other countries, Japan prohibits religious instruction in public school. Moral education is, thus, not religious teaching in these schools (Jones 2017). 14 A school year starts at the beginning of April in Japan.

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Japanese moral education is a good challenge with enormous potential on the condition that it is designed and implemented carefully.

Ethics Class as a Mandatory Subject After the upgrading of moral education, the textbooks for the subject are standardized and subject to authorization by the MEXT, different from the past when only the supplementary textbooks and materials devised by teachers were used at the classes. Each child has been graded but been assessed subjectively by the teachers who make comments on his/her performance. The biggest challenge for the new mandatory subject is how to overcome egoistic way of thinking and apathy to the others. In short, it is expected for everyone to consider, if not prioritize, interests of the others at the same degree as the interests of one’s own and the closest people. Even if not being conscious, those who are of apathy tend to behave selfishly and egoistically without feeling remorse by not taking into due account the interests of the other. MEXT stresses that the focus of moral education should change from reading of related materials to teachings that encourage thinking and discussion by schoolchildren. MEXT explains that the aim is to nurture children’s ability to face diverse and sometimes conflicting values, to think autonomously and to engage in dialogue and to cooperate with others for the betterment of individuals’ lives and society. It also argues that imposing certain values on students or teaching them to blindly follow what others have told them without thinking independently is irreconcilable with the goal of moral education (The Japan Times 2014). Importance of “active learning” which means autonomous and cooperation-based education method aimed at identifying and solving problems by taking them personally is emphasized. There can be dilemmas, for example, between tolerance to forgive a misconduct by the others and respect for rules which does not allow selfish acts, as well as between trust or friendship and fairness or justice. It will be a useful training to take those dilemmas personally and yield imagination to solve the conflicts from as many viewpoints and standpoints as one can think of. The new educational system expects for ethics classes which stimulate students and pupils into contemplation and in-depth discussion to reach essence of complicated issues and to find one’s own answers to philosophical questions, including justice and good. In Japan, the underlying motivation of upgrading moral education was bullying at schools which resulted in suicides by the targeted kids.15 Respect for human dignity is one of the most outstanding elements of the new system. It is too early to assess effectiveness of the Japan’s new moral education given that it has been only a couple of years since it was introduced. More data and social statistics, including that on development of bullying cases, are yet to be available for doing it.

15

Terawaki (2018) points out limit of teaching ethics in class room, arguing that it is totally absurd to think that bullying will reduce if the moral education becomes a mandatory subject.

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Some Concerns Besides the respect for human dignity, there are some controversial elements such as “respect for tradition and culture and love of the country” which reminds the neighboring nations of the Japan’s militaristic mentality during the Second World War. Japan has a bitter experience of having abused education during the last war time. Glorification of the militarist state based on emperor warship and patriotism favored by the government might be instilled into children. Countries around Japan may be concerned about the possibility that the upgraded moral education will be used to exonerate and glorify narrative of Japan’s colonial and wartime actions.16 It is indispensable to face the risk of imposing certain values on children through the new moral education. It is the risk of slave morality. Japan finds itself under influence of climate change and is also hit frequently by the other natural disasters such as earthquakes and tsunamis. Under a crisis, it is absolutely a must for the people to get united and cooperate in a regional community. Thus, it justifies higher evaluation to following decisions made at the community level than to being individualistic. The fact that the nation used to make living more by farming and agriculture than hunting may also explain the Japanese loyalty and obedience to the group they belong to. Because of the strong peer pressure or pressure to conform, the ability to think on one’s own can be less appreciated and left untrained. Conflicts between social values and personal values are common in the daily lives of the nation. Dilemma between self-sacrificing devotion to the group and desire to self-realization, “death with dignity” can be named as such. They remain taboo, and Japan has not addressed these issues seriously (Jones 2017). With these in mind, three potential problems can be specified: assessment methodology, textbooks authorized by MEXT, and teaching burden.

Assessment Methodology Under the new system, students and pupils are not graded as they are in other mandatory subjects, including mathematics and Japanese language, where numbers are given from 1 (worst) to 5 (best) in accordance with evaluation vis-à-vis the other students. Teachers write notes to describe what each student has accomplished in classes and how much developments the student has made. This is called an absolute individual assessment. No single method for this type of evaluation methodology is established yet. There are various elements, including observation, interview, questionnaire, composition, and performance (e.g., speech, illustration, physical expression). Each of them has advantages and disadvantages. Therefore, they need to be combined appropriately (Tomioka 2017: 140–144).

16

The ministerial guidelines state that loving one’s country is meant to lead the nation not to biased and exclusive patriotism but to the attitude willing to contribute to international society with the sense of responsibility as a member of the country (MEXI 2017b).

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Ministerial guidelines for both elementary schools and secondly schools emphasize the importance of that teachers continuously observe the process of development of moral sentiments of individual pupils and reflect the findings in teaching (MEXI 2017a). However, it is ambiguous about what to be regarded as development in case of moral education. Thus, it is fair to be concerned about the risk that relative evaluation will be made, despite the guidelines. Some even argue that teachers will give better grades to the students who understand the purposes of the ethics classes and that the classes are designed to create robotic students who never question and challenge authority. On the other hand, some children may just attempt to express views that teachers expect to hear with an aim to obtain good evaluation, instead of sharing their own opinions.

Textbooks Authorized by MEXT Although more values are placed on interactive communications under the new system, textbooks remain to be influential and in the center of the classes as a means to present issues at the beginning of each lesson. Notwithstanding, some of the episodes commonly accommodated in textbooks are controversial. These are “A Two Bases Hit by Boy Hoshino”17 and “A Magician”18 for instance. Evaluations on them have not been established yet. Nonetheless, even world-famous literatures can be misinterpreted, if they are partially extracted and incorporated in textbooks. As the textbooks for moral education are subject to authorization by the government, it is rational to induce that the publishers of the textbooks are tempted to live up to the expectation of the government to avoid rejection by the competent ministry: MEXT, which poses risk of slave morality. With the introduction of government-authorized textbooks, some experts worry about possibility that teachers lose their creative freedom (Maruko 2014). Teaching Burden Unlike mathematics and chemistry, ethics has no single universal answer. Instead, students are expected to reach the best solution one can think of at the point of time, even if they cannot get to certain. To teach abstract values and difficult concepts such as justice, sincerity, and fairness requires high expertise and integrity. Notwithstanding, teachers are required to combine different materials other than stories in the textbooks. Evaluating each of around 40 students/pupils in nonnumerical manner is

17

This is a story written by Kinetaro Yoshida. It deals with dilemma between desire to do one’s best and self-sacrifice for the interest of a group the one belongs to. A boy who made a hit in a baseball game is scolded by his team director because he neglected an instruction by the director not to aim at doing so for the sake of the team. 18 This is a story written by Teruo Ebata. It deals with dilemma between desire to be successful and virtue of keeping words. An unsuccessful magician chooses to perform for a boy based on a promise with him, discarding an unexpectedly offered opportunity to perform in a big theater which arose after the promise.

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quite demanding and burdensome, too. The workload of teachers responsible for ethics is said to rise sharply from before. As moral education had been an informal school activity until recently, teachers in charge of homeroom used to teach it in general. There are still little teachers equipped with enough experiences and know-hows on the new requirements, because licensing courses for teaching ethics are not well in place in universities. Not by relying on relative evaluation through tests, teachers have greater discretion. Quality of classes varies, depending on qualities of teachers. Not only through textbooks but also through teachers, there exists risk that specific and biased beliefs are enforced in the moral education.

Linkage with ESG To address ESG issues to achieve SDGs, confrontation with difficult problems such as how to strike good balances between egoism and altruism as well as between present interests and future interests is unavoidable. In the context of environment protection for example, there can be a conflict between freedom of individuals and total utility of the society or religious sense of good. These ambivalent challenges are becoming evident today when different values collide more frequently against the backdrop of globalization and digitalization.19 In relation with ESG, the MEXT plan refers to “sustainable development of society,” although it does not go far yet to include global challenges such as climate change,20 and “relationship between progress of science and bioethics.” Surrounding SDGs, there are various contemporary issues, including environment protection, poverty reduction, human rights protection, peace keeping, and development. They are closely related to each other, sometimes consisting dilemmas and conflicts (MEXT 2017a:99). International pressure could force certain countries to reduce its emission of greenhouse gas and to accommodate refugees. Yet, such measures are not sustainable in the long run if the countries are not convinced. Every national must think by him/herself. Otherwise, even greatest ideas and policies will never be rooted in such countries. Moral education has potential to play important roles not only in helping children realize a better life for themselves but also in ensuring sustainable development of states and societies. Unlike “love of one’s country,” the above two orientations are less problematic.

19

For example, one of the authorized textbooks for high schools/upper secondary schools covers a wide range of contemporary issues, including those related to bioethics (e.g., human clone, surrogate birth, euthanasia), environmental problems (e.g., aggravation of ecosystem, industrial waste, global warming), family and social challenges (e.g., externalization of family functions, gender equality), and negative aspects of technology development (e.g., invasion of privacy, digital divide)(Satoh et al. 2018: 190–220). 20 For example, Mark Sagoff maintains that if developing countries do not join in efforts to control greenhouse pollution, these efforts will be futile (Sagoff 2003).

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Overall, discussions on environmental factors of ESG are more active in Europe, while discussions on social factors (e.g., violation of human rights, inequality, and disrespect of human dignity) have been the main concerns among the Japanese citizens. As for corporate governance factors, some important rules developed by international standard setters, including OECD and BCBS are already in place, and the both jurisdictions are adopting the international standards in their respective legal and regulatory regimes, although education on corporate governance is still seldom discussed in either of them chapter “Ethics in Education for Sustainable Finance”. In Japan, the philosophy of ESD is incorporated mainly in classes of social studies and science, respectively, both at elementary school and secondly school, based on RBAE and CS (MEXT 2016). By teaching ethics also in class of science, it is expected that students think about issues related to technology (e.g., risk of discrimination caused by misuse of AI) in the context of ESD.

Moral Education in Japanese Financial Industry OECD advocates that, while financial education concerns all ages, the education of the younger generations on financial issues is all the more important and including financial education in the formal school curriculum is one of the most efficient and fair ways to reach a whole generation on a broad scale (OECD 2014: 9). In Japan, financial education is a part of home economics class. Influences of individual citizens per se are limited, but, if effectively collected, their financial actions can change societies as an entirety. As such, it is important that everyone uses the power, being mindful of the potential. In the traditional context, financial education has been regarded important as a tool for consumer protection and financial inclusion. Of course, those demands remain legitimate today, given the current social challenges like digital divide and cyber fraud in the rapid progress of aging demography and IT development. Basic understanding and knowledge on investment, saving, insurance, and pension among citizens are a premise for sustainable finance to develop. However, education to promote sustainable finance is fundamentally a new policy area, because it requires the people to consider interests of others, while conventional financial education was mainly aimed to provide the consumers and investors financial literacy to protect themselves from unexpected losses and financial crimes. Yet, ethics is also very important and may be even more important than literacy, because long-termism requires dramatic change of citizen’s mindsets in the sense that they need not only be wise to protect themselves but also be nice to the others beyond visible scope. This is why the author maintains that long-termism and altruism is a new ingredient for financial education. Even in the EU, the center of discussions on sustainable finance, the methodology for education for sustainable finance has not been established and seems not to be incorporated in school education. For the lack of the EU level initiative due to the constraint of the regional community, collaboration among relevant entities (e.g., authorities, industries, schools) is underdeveloped at the member states’ level, too.

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OECD’s highlights the need to ensure a suitable level of involvement of public authorities, educational system and other important stakeholders (OECD 2014: 10). In Japan, financial education is a joint task among authorities, schools, and industries. There is a hub for financial education named Central Council for Financial Services Information (CCFSI) which was established in 2001. CCFSI consists of various stakeholders (e.g., government agencies, representatives from the financial industry, consumer fora, and academia). The central bank serves as the secretariat. CCFSI develops guidelines on financial education. Its “Financial Education Program” for high-school students as of September 2015 stipulates that financial education aims to urge them to think about and do what is needed to realize a sustainable and better society and to use money for the purpose (CCFSI 2015). Another CCFSI’s guideline entitled “Teaching Guide for Secondary Schools” as of March 2018 encourages teachers to teach the concept of “ethical consumption” which considers impact of one’s financial activities and on environment and consumers’ responsibility (CCFSI 2018). Also important is awareness that the daily life of each individual is linked to society. Financial education in Japan tries to encourage students to incorporate environment-friendly products and attempts. It can be regarded as an advanced aspect that Japan has introduced the essence of ESD to its financial education. CCFSI dispatches lecturers to schools and communities, organizes seminars and forums, and develops Teaching Guide for Secondary Schools on Financial Education. Considerations on ESG and SDGs are already reflected in the guide. For example, they prescribe that teachers are advised to let the students think about the meaning of the term “ethics” and notice that there are financial products around themselves which are designed to deal with environmental issues. This approach would be effective to develop the general mindset necessary for promotion of sustainable finance.

Conclusion The global economy is currently in a severe downturn due to COVID-19. It is already said that the damage will surpass that of the previous worldwide financial crisis which was triggered by the Lehman Shock. Today’s crisis is forcing us to face the vulnerabilities of our economies and societies, and consider how we can make our system more robust than the pre-crisis time. Thus, this can be an opportunity for structural reforms toward a sustainable recovery. From environmental perspectives, there are biological findings on causalities between human activities and pandemics. Human habitat has been so expanded that the margin between that of human and that of wild lives is getting scarce, which increases risk of contagions between them (Johnson et al. 2020). From social perspectives, the crisis has reportedly excluded the minorities (e.g., immigrants, single mothers, LGBTs) from community safety nets and put them in more difficult circumstances. Altruistic supports for them are even more needed to rectify inequality and to ensure human rights protection.

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Japan has a long history of having tackled with today’s global challenges through energy saving and recycling of natural resources, backed by the traditional spirit such as of the Ohmi merchants. Nonetheless, public sentiments toward COP21’s Paris Agreement are not so enthusiastic as in Europe, and discussions over protection of refugees remain relatively sluggish. There can be some explanations for it. Lack or insufficiency of long-termism among the Japanese mindset may be one of them. Hopefully, the upgraded moral education will activate national discussions on environmental and social issues with global perspectives and bring about behavioral changes among the Japanese citizens. Toward this goal, the relevant guidelines should be revised as appropriate. In this regard, it may be noteworthy that the current CSs merely mention sustainable development of the “Japanese state and society,” which the author believes can be made more ambitious. In order to support grass-rooted developments toward SDGs from financial education channel, CCFSI has initiated its attempts to empower the Japanese retail investors and financial consumers. Both channels can contribute to each other by sharing feedbacks and insights out of the respective future developments. The discussion in Japan is still at an early stage, but seems evolving in an intriguing direction. It may provide some useful policy implications for the other countries and jurisdictions.

Cross-References ▶ A Virtue Ethics Approach in Finance ▶ Digital Financial Inclusion of Women: An Ethical Appraisal ▶ Ethical Considerations About the Implications of Artificial Intelligence in Finance ▶ Ethics and Digital Innovation in Finance ▶ Ethics in Education for Sustainable Finance

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for secondary schools). Available at https://www.mext.go.jp/component/a_menu/education/ micro_detail/__icsFiles/afieldfile/2019/03/18/1387018_011.pdf. Accessed 13 July 2020 Morotomi Y (2017) 考え、議論する道徳科授業の新しいアプローチ10 (Ten new approaches to ethics classes with thinking and discussion). Meiji Tosho Shuppan Nietzsche F (1887) Zur Genealogie der Moral. Eine Streitschrift Nishida K (1923) Zen no Kenkyu (An inquiry into the good) Iwanami Shoten OECD (2014) Financial education for youth: the role of schools. Available at https://www.oecd.org/ education/financial-education-for-youth.htm. Accessed 13 July 2020 Oracle & Future Workplace (2019) From fear to enthusiasm: artificial intelligence is winning more hearts and minds in the workplace. Available at https://www.oracle.com/webfolder/s/assets/ ebook/ai-work/index.html. Accessed 14 July 2020 Sagoff M (2003) Controlling global climate: the debate over pollution trading. Philosophical dimensions of public policy. Routledge Sandel MJ (2010) Justice: what’s the right thing to do? Farrar, Straus and Giroux Satoh M et al (2018) 改定版 倫理 (Ethics (revised version)) Suken Publishing Schoenmaker D, Schramade W (2019) Principles of sustainable finance. Oxford University Press, Oxford Smith A (2018) The Theory of Moral Sentiments. Logos Books, Los Angeles Suenaga K (2019) The story of Japan’s Ohmi merchants: the precept of Sanpo-yoshi. Japan Publishing Industry Foundation for Culture. Terawaki K (2018) 危ない「道徳教科書」(Risky “Ethics Textbook”) Takarajima Sha. The Japan Times (2014) Moral education’s slippery slope. An editorial appeared on 26th October 2014. Available at https://www.japantimes.co.jp/opinion/2014/10/26/editorials/moral-educa tions-slippery-slope/. Accessed 14 July 2020 The Japan Times (2015) Much potential in new courses. An editorial appeared on 22nd October 2015. Available at https://www.japantimes.co.jp/opinion/2015/08/22/editorials/much-potentialnew-courses/. Accessed 14 July 2020 Tomioka S (2017) 「考え、議論する道徳」の評価とは(What is “moral education to think and discuss”?)考え、議論する道徳を実現する!(Realizing Moral Education with Thinking and Discussion). (ed) Kangae Giron suru Doutoku wo Jitsugen suru Kai. Tosho Bunka Sha UNESCO (2013) Global action programme on education for sustainable development as follow-up to the United Nations decade of education for sustainable development after 2014 Yaginuma R (2017) 「考え、議論する道徳」の誕生と形成 (Birth and formation of “Moral education to think and discuss”)考え、議論する道徳を実現する! (Realizing moral education with thinking and discussion). (ed) Kangae Giron suru Doutoku wo Jitsugen suru Kai. Tosho Bunka Sha Yamauchi T (2018) The agricultural ethics of Ninomiya Sontoku. Agricultural ethics in East Asian perspective. In: Thompson P, Thompson K (eds) The international library of environmental, agricultural and food ethics, vol 27. Springer, Cham. https://doi.org/10.1007/978-3-319-92603-2_3 Weiss R, Peres P (2014) Beyond the altruism-egoism dichotomy: a new typology to capture morality as a complex phenomenon. In: Vincent J (ed), The Palgrave handbook of altruism, Morality, and social solidarity. Palgrave Macmillan, New York

Poverty Alleviation Through Financial Practices: The Importance of Microfinance The importance of microfonance Osmar Arandia and Saskia Hepp

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Main Text . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stakeholders of a Microfinance Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Status Quo of Microfinance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shortcomings and Inducing Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reconciling Sustainability and Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Creating Efficient Business Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Measuring Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Defining the Relevant Stakeholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The MFIs Goals and Possibilities for Action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Client’s Goals and Possibilities for Action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Donors’ and Creditors’ Goals and Possibilities for Action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Government and Regulatory Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Framework for a Successful Microfinance Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

Unfortunately, poverty is still a largely unsolved problem in many societies, especially in developing countries. Therefore, it is crucial to analyze and determine possible measures to improve the well-being of the poor and thus diminish social marginalization. Microcredit was once discovered to be the long-desired development tool, which should eradicate poverty, but during the last 40 years it increasingly transformed into a profitable business with the poor. Therefore, the purpose of this chapter is to establish a framework, to understand the benefits of all the stakeholders involved and provide a guide for institutions to similarly O. Arandia (*) · S. Hepp Universidad de Monterrey, San Pedro Garza García, Nuevo León, Mexico e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_38

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achieve social and financial goals by clearly defining the structures of a successful microfinance program. Based on past investigations on the achievements, shortcomings, and challenges of microfinance programs, this chapter sought to define the central stakeholders in a program, their goals and possibilities for action with the purpose to develop a theoretical model, which can serve as a basis for the analysis of microfinance programs. The result is a model for the microfinance industry, which includes a set of influencing factors that should be considered and actions that can be taken by financial institutions, clients, donors and creditors, the government, or regulatory entities. It serves as a theoretical proposal for the microfinance industry and aims to provide a guide to follow for the key players to create economic and social value. Ideally, this would improve the performance of the respective program by encouraging the reconsideration of roles and responsibilities evoked by a global view on its shortcomings. In this way, the framework can be considered as a first step in counteracting the pervasive mission drift of microfinance. Keywords

Status quo of the microfinance industry · Mission drift · Microfinance programs · Stakeholder’s goals and responsibilities · Framework for a successful Microfinance Program

Introduction Give a man a fish, he’ll eat for a day. Give a woman microcredit, she, her husband, her children and her extended family will eat for a lifetime. – Bono (2017)

In accordance with this quote, financial empowerment, not charity, appears to be the solution for the world’s poverty issues. The context transmitted is the widespread idea people have when thinking about microfinance. Small loans are given to poor women to unleash their entrepreneurial skills and thus enable them to generate considerable income for their family apparently an effective and easy way to help the poor end their miserable situation. The hype about microfinance reached its peak 2005, which the UN declared as the year of microcredit (Sinclair 2012, p. 10). One year later, Muhammad Yunus, commonly known as the godfather of microcredit, was awarded the Nobel Peace Prize jointly with Grameen Bank “for their efforts to create economic and social development from below” (Nobel Media AB 2018). Therewith, microfinance was officially recognized as a crucial tool for development. Microcredit is a financial practice that dates back as far as to the colonization of Indonesia by the Dutch, who founded the banking institution Bank Rakyat Indonesia (BRI) in 1895, which is still one of the largest microfinance banks worldwide today (Sinclair 2012, p. 9). Nevertheless, the most widely recognized roots of microfinance activities can be found in Bangladesh. In 1976, the Bangladeshi economist

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Muhammad Yunus proclaimed to have discovered a measure to end world poverty – the solution he provided was microcredit. With the foundation of the Grameen Bank that provided small, low-cost loans to the poor, which were meant to enable them to start businesses and generate income, Yunus revolutionized the banking system with the mission to establish an effective means to escape poverty (Sinclair 2012). The Grameen Bank institutionalized features that would later provide a model for other microfinance providers and changed the assumption of the poor as not being bankable into recognizing the possibility of cost-effective financial services offered to them (Islam 2007). Other early microfinance activities were mainly set by nongovernmental organizations (NGOs) with a philanthropic mission and date back to the 1970s to many places, primarily in Asia and Latin America (Chu and García Cuéllar 2008). Although there is no internationally recognized definition of microfinance, the term describes a wide range of financial services and products, such as credits, savings, insurance, and payment services dedicated to low-income or nonbankable customers, as well as microenterprises, who are usually rejected by traditional banking institutions (Leone and Porretta 2014). Tazul Islam, with respect to the lending conditions and the kind of clients addressed, defines microcredit as “a hybrid of a development tool and a financial service” (Islam 2007, p. 72). In accordance with its proclaimed objectives to alleviate poverty and to grant broader access to financial services, microfinance is largely associated with developing countries, where a huge proportion of the population is dependent on an alternative for traditional banking institutions. Despite its initial mission marked by honorable intentions and optimism, until today, staggering effects of microfinance could not be verified. A major study by the Department for International Development (DFID) of the UK funded a systematic research on the impact of microfinance on the well-being of poor people and found no strong evidence indicating that microfinance benefits the poor or empowers women. Instead, they affirmed that it consumed a compelling proportion of development resources, both in terms of finances and people, which probably could have been invested in other development activities with a higher guarantee of success (Duvendack et al. 2011). Microfinance has become a critical and widely discussed topic in the field of economics and development studies in recent years. Armendáriz de Aghion and Morduch (2005) describe microfinance as “a series of exciting possibilities for extending markets, reducing poverty, and fostering social change,” but they also acknowledge that it is “a series of puzzles, many of which have not yet been widely discussed.” Although they are convinced that microfinance can bring along positive impact, they emphasize that so far there is no clear statistical proof for its success in poverty reduction and gender empowerment (2005). As Copestake et al. (2016) point out in their analysis on the history of microfinance, two opposing views prevail – one being the neoclassical economics interpretation, which accredits the expansion of financial market opportunities to microfinance and the contrasting political economy critique, which detects increasing opportunities of exploitation.

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In the last 40 years, “Microcredit” has grown from being a purely philanthropic ambition by NGOs providing small loans to the poor, to be a profitable financial service for many institutions and is now designated as “Microfinance.” The founder of microcredit himself states that “one of [his] goals was to eliminate the presence of loan sharks who grow rich by preying on the poor [. . .] At that time, [he] never imagined that one day, microcredit would give rise to its own breed of loan sharks. But it has” (Yunus 2011). In 2016, microfinance institutions (MFIs) served 132 million low-income clients with the total loan portfolio worth 102 billion dollars (Convergences 2017). This raises the question of in how far the initial philanthropic motivation that underlies microfinance’s function as a development tool is consistent with its status quo as profitable financial service. Philanthropist Rahmi Koç states that recognizing the fact that a business should always strive for profitability does not conclude that it must abandon its social aspirations. However, it is essential to analyze the relationship between the two (Cattaui 2001). Although most institutions engaging in microfinance programs might have the same promise, which is to increase the access to financial services for people of lower social classes and therefore positively influence their socioeconomic situation, their motivation certainly varies. All the institutions involved offer a service to the poor which traditional banking institutions cannot provide to them and ask high interest rates in return. However, while some have the intention to create social value and economic change, others might only want to take advantage of a profitable business, exploiting the vulnerability of the poor. Certainly, with the aim to achieve a well-working system, it is essential to create value on both sides. Many institutions would not offer microfinance services if it was not a profitable business for them and in this case, a sufficient supply of financial services for the poor probably could not be guaranteed. Then again, microfinance can only be recognized as an effective development tool if it succeeds in reaching the poor and having a positive impact on their wellbeing. According to the OECD Better Life Initiative material living conditions and quality of life are indicators for current well-being. Future well-being is determined by observing some of the crucial resources that encourage well-being over time and that are constantly influenced by today’s actions. These driving forces can be assessed by using indicators of various types of “capital,” such as economic, natural, human, and social capital (Durand 2015). The trade-offs and synergies between financial sustainability and outreach to the poor have been discussed extensively by many investigators in the field of microfinance, such as Morduch and Haley (2002) or Peck Christen (2013). Other studies include the dimension of impact, such as Zeller and Meyer (2002), which present The Triangle of Microfinance with the three primary goals: financial sustainability, outreach, and impact and discuss the interrelation of the latter. Several investigators talk about the importance of microfinance governance and debate the relevance and influence of the different stakeholders involved on a microfinance board (Mori and Mersland 2014) (Mori 2010).

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The increasing critiques on the profitable business with the poor clearly underline the need to disclose the practices of the institutions involved and to extensively study the effects on its recipients. Due to the largely controversial mission drift observed in many MFIs, it is crucial to determine the status quo of the industry and to define challenges that must be overcome. Hence, this chapter seeks to provide a solution to the current discrepancy in institutional goals by bringing together all the aspects mentioned above. On that basis, a theoretical model for the microfinance industry including the most important stakeholders and the crucial elements of a microfinance program, their central goals, responsibilities, and their scope of action to accomplish their aspirations shall be derived. The focus hereby especially lies on the possibilities of the stakeholders to reach their proposed goals, provided that the beneficiaries of the program are reached by its services and profit from a positive effect on their socioeconomic well-being. Simultaneously, the elements determined should ideally be applicable as a guide for MFIs to adapt their business model toward a more sustainable and socially responsible approach and to help the other actors to contribute successfully to the desired outcome. The resulted model includes the core purpose that should be achieved by a microfinance program, which is defined as creating social and economic value. The literature review presented sets the basis to understand the structure of microfinance programs and presents the key stakeholders involved. Furthermore, it discusses the status quo of microfinance by alluding to investigations on achievements and shortcomings of the industry. The chapter concludes with the definition of current challenges and possible solutions.

Main Text To provide a comprehensive insight into the concept of microfinance and to determine the areas already investigated, the following section gives an overview of the microfinance business and incorporates the relevant studies on microfinance’s achievements and shortcomings as well as the challenges it has to overcome. MFIs clearly differ from regular banking organizations. Not only because operations are made on a smaller scale, but also due to the difference in the underlying business model. Whereas traditional banks generally borrow money from clients in the form of savings and lend them to other clients with collateral, MFIs usually do not offer savings accounts and loans are not secured by collateral. Instead, the capital of MFIs typically comes from investors, multilateral organizations or lenders, such as microfinance funds, which supply them with cash for long periods charging moderate interest rates. This capital enables the MFI to lend small quantities on shorter terms and with significantly higher interest rates to its poor clients. The surplus of the additional interest rate charged to clients minus the coverage of

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non-repaying clients, operating costs, salaries, etc., is the profit which remains for the MFI (2012). Muhammad Yunus initially came up with the microcredit concept when he interacted with women in a rural area of Bangladesh, which were not able to buy the raw materials they needed to produce the products they were selling and therefore were dependent on local exploitative moneylenders. To make the Grameen banks’ loans sustainable, Yunus established a system of solidary group arrangements to create a joint liability in case of defaults and in this way replaced traditional loan collateral by peer pressure (Armendáriz de Aghion and Morduch 2005). More specifically, joint liability means that small groups of borrowers are mutually responsible for the repayment of their loans and the default of one group member is equivalent to the default of the whole group and results in denial of successive loans. Therefore, co-borrowers screen and monitor each other, which decrease agency problems between the MFI and its borrowers. Still, joint liability entails some disadvantages, such as the time that must be spent on repayment meetings and the social pressure affecting clients, which resulted in some MFIs starting to shift from joint to individual lending (Attanasio et al. 2015). Regularly, the MFI system also includes loan officers, which acquire clients, explain the conditions, collect payments, and pressurize clients if they do not repay.

Stakeholders of a Microfinance Program Considering Freeman’s (1984) broad definition of a stakeholder “any group or individual that can affect or is affected by the achievement of the organization’s objectives,” the establishment of a successful microfinance program entails the clear definition of the key stakeholders involved as well as their particular roles and responsibilities. Defining the stakeholders with the aspiration to adopt Freeman’s definition, the following stakeholders can be identified for a microfinance program: the MFI and its internal stakeholders (owners, managers, and employees); the clients and their families; donors (development organizations, NGOs, etc.); creditors (banks, financial institutions); the government; any entity in charge of the regulation or supervision of the system; companies linked to microfinance operations; investigators in the microfinance field; the local community; and society as a whole. The present literature on stakeholders in microfinance programs is centered on the governance of MFIs and primarily discusses the significance of stakeholders on board of the organization. Mori (2010) identifies six, either local or international stakeholders, that may influence the decision making of MFIs through their inclusion on the board of the organization. Solely local stakeholders are clients (customers), employees, and the government. Donors (development organizations, international NGOs) or technical assistance providers (international NGOs, consultants) are considered as international stakeholders. Investors (owners) and creditors (banks,

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debt holders, other financial institutions, or international loan providers) can be classified as national or international stakeholders. Subsequently, Mori also attributes roles to each of the stakeholders defined. She argues that clients serve as information providers to the institution in terms of product demand, ways of delivery, and means of attracting and retaining clients and thus enable organizations to adequately design their products and services. Employees are usually in direct contact with the clients and therefore deliver relevant information on the improvement and innovation of services and a suitable delivery process, which allows the creation of competitive strategies. The government’s responsibility mainly revolves around the implementation of policies and regulations for the microfinance industry, whereby the local government especially assumes an important role if it was involved in the foundation of the MFI or is the owner of the organization. International stakeholders, such as donors and technical assistance providers, transfer funds and international expertise to the organization, measure processes, or encourage good practices and therefore strengthen the institution. Creditors also provide funds to organizations. Owners usually are shareholders and/or investors and are the main actors on the board of the organization. Nedunchezian and Sivasankaran (2009) define poor households as the main stakeholders of a microfinance program. Also, they include MFIs, affinity groups (SHGs or Grameen); mainstream financial institutions and funding agencies including donor organizations; government bodies; and companies linked to the microfinance industry (e.g., general insurance companies).

Status Quo of Microfinance It is essential to provide an overview of the achievements and shortcomings of microfinance programs to identify successful examples. Their approach to the provision of services to clients can be used to derive best practices for the industry. Early microfinance initiatives started with the ambitious aim of lifting the poor out of poverty. Even though, so far, it did not reach its full potential as a development tool, microfinance clearly brought along some positive changes. Some of the advantages of microcredit over traditional banking are its orientation toward markets which are not targeted by formal banks and the elimination of obstacles to utilization for poor people, such as the use of sophisticated technology and the application of unfavorable monetary and taxation policy or regulation which restrict or affect regular banks. Besides, especially in developing countries, politics often interfere in the credit markets and investments are misdirected, which corroborates the need for alternative institutions (Buss 1999). Women’s World Banking (2006) defined the most important accomplishments of microfinance in the previous 10 years as the following: Poor people proved to be bankable, attractive clients for financial institutions; leading institutions showed that

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microfinance business can be profitable and sustainable; outreach increased dramatically; the microfinance network enlarged; microcredit expanded its scope of services to microfinance; microfinance became a part of the financial system; and key performance indicators and standards have been set and awareness of microfinance increased significantly. In previous investigations, the evaluation of the performance of MFIs has often been based on outreach and sustainability. Navajas et al. (2000) define outreach as “the social value of the output of a microfinance organization in terms of depth (how poor are the clients), worth to users (willingness to pay), cost to users (sum of price costs and transaction costs), breadth (number of clients), length (time frame of the supply), and scope (number of types of financial contracts supplied).” A MFI can be operationally sustainable, which means that operating costs (e.g., paying loan supervisors, opening branch offices) are covered by revenue of the business, whereas the issuing or covering of defaulted loans can still be subsidized, or it can be financially sustainable (Sengupta and Aubuchon 2008). Financial sustainability is reached when an institution becomes independent of continuing inputs from governments, international agencies, or charitable organizations and instead the MFI acquires money through its lending operations (Christen et al. 1995) (Sengupta and Aubuchon 2008). In this regard, it has to be recognized that, through microfinance, millions of people formerly excluded from formal financial services now have access to loans, savings, insurance, and other offerings (Roodman 2013; Zeller and Meyer 2002). Christen et al. (1995) assessed the performance of 11 programs that deliver financial services to microenterprises in Asia, Latin America, and Africa considering their outreach and the self-sustainability of the involved MFIs. They found that a significant outreach could be achieved in all analyzed cases, hereby scale, not only focus was essential to reach the poorest. Prior and Argandona (2009) approve that public policies that encourage the needed scale for MFIs are necessary to massively deliver financial services to the population. All the analyzed programs offered mainly short-term working capital loans and ensured repayment by group loans, social pressure, and the guarantee of ongoing access to increased credit supply. Another common factor was services close to the clients’ home or work, which altogether created a positive and strong client response. Also, they observed that 10 out of the 11 examined institutions were able to fully cover the nonfinancial costs of their operations with revenues. Five of the 11 were profitable, generating positive returns on assets. Furthermore, they identified only two factors that explained the differences in financial viability: salary levels of program staff relative to local gross domestic product (GDP) and the effective real rate of interest. Another interesting point of many scholars is the impact of microfinance on the socioeconomic lives of clients. In this idea, Attanasio et al. (2015) found that a joint liability program including women in rural Mongolia had a positive impact on female entrepreneurship and household food consumption. In contrast, they could not detect a significant impact of a simultaneously introduced individual liability program and trace this back to the fact that joint liability may prevent the use of loans for noninvestment purposes.

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Similarly, a study by Hietalahti and Linden (2006) showed that microcredits in South Africa managed to release some of the poorest women from deepest poverty or enabled others to diversify and improve their businesses. The study focused on two microcredit village programs and found that the one, which was dedicated to more educated clients with more experience in business, often not solely reliant on the loan itself and with access to larger loan sizes when joining the program, was more successful. However, a study on outreach of microfinance programs by Christen et al. (1995) could not prove the same effect of increased loan size on financial sustainability. They found that programs with larger loan size did not promote financial viability. An investigation on socioeconomic benefits through MFIs in Rajasthan, India, by Joshi and Giri (2016) confirmed that microfinance programs improved the socioeconomic conditions of the poor people in the district. Hereby, they found that access to various sources of financing (including savings and insurance) as well as education had a positive impact on the household’s income. Besides, income was also found to increase with the number of occupations plied. Garikipati (2017) confirms that credit directed to the very poor has to be combined with other microfinance services such as savings and insurance and adds that clients that remain longer in the program achieve more profitable businesses. In a same path, Mutengezanwa et al. (2011) proved the positive relationship between microcredit and the socioeconomic situation of borrowers, showing that the activities of MFIs increased social interaction and socioeconomic sustainability, including improved access to decent food, education, better housing, and healthcare. Taking into account the above-mentioned investigations, one can conclude that the main achievement of microfinance is the inclusion of poor people into the financial system. However, a strong positive impact on the social well-being of the very poor through the access to financial services cannot be verified by the studies included. Factors that seem to encourage a positive outcome for the recipients of a microfinance program appear to be the accessibility to a broader range of financial services, joint liability lending paired with the guarantee of ongoing access to funds and higher levels of education. The financial viability of a MFI is found to be largely dependent on the effective rate of interest.

Shortcomings and Inducing Factors Muhammad Yunus considers the shift of interest by lenders from their status as nonprofit organizations to commercial enterprises in search of profits as the starting point of troubles with microcredit. Due to the commitment to their shareholders, public MFIs started to raise interest rates, engaged in offensive marketing and loan collection to generate profits and lost their former sense of empathy with borrowers. He suggested that a fair interest rate should not surpass the cost of the fund for the bank with an additional 15% of the fund, which serves to cover operational costs and contributes to profit. The optimum spread between the cost of the fund and the interest rate charged should be about 10% (Yunus 2011).

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Hugh Sinclair, who has worked for a decade in the sector, across three continents and in several institutions, is probably one of the most prominent representatives of a profound critique on the microfinance system, describing it as a corrupted business focused on maximizing profits and exploiting the poor. He acknowledges that there are successful programs, but those tend to be rather uncommon. Thus, he exhorts the industry to consider the lessons of the last decades and to apply them to the benefit of the poor (Sinclair 2012). Moreover, he criticizes that seemingly, microfinance does not need any other proof for its functioning than the fact that the poor are able to repay loans, which is generally regarded as one of the greatest achievements of microfinance. Repayment rates are usually greater than 90%, but this perception neglects the persistence of extreme poverty in many countries (Sengupta and Aubuchon 2008) (Sinclair 2012). Sinclair also overturns the idealized perception of the “female microfinance client living in the hut with the sewing machine” (Sinclair 2012) by alluding to the fact that such cases are rare and frequently women are sent by men to ask for a credit; loans very often are spent on consumption, which only creates temporary profit and long-term debt for the clients; interest rates above 100% are common and the small businesses are rarely able to cover these payments; the impact on poverty alleviation is minimal or even negative; the recipients are not automatically successful entrepreneurs; it can encourage child labor and jeopardize their proper education; most clients do not belong to the “extremely poor”; regulatory protection of clients is missing; and group lending can destroy personal relationships between peers (Sinclair 2012). In the same idea, Bateman (2014) even states that the microcredit model has been one of the most harmful interventions in the recent economic and development policy history. He especially criticized the extent of greed and willingness to make profits by actors in the microfinance sector, which particularly came to light in 2007, when the first MFI went public, but led to the further disclosure of exploitative behavior by owners, shareholders, investors, and advisors in the sector. According to Bateman, the real problem of microfinance programs is not supply, but rather a lack of demand for more local suppliers of simple goods and services dedicated to the local poor. Therefore, he claims that microfinance does not establish an important additional source of income for the purchase of the increased local supply (Bateman 2014). Similarly, Aneel Karnani (2008) claims that microcredit does not significantly contribute to poverty alleviation and therefore is not a suitable tool to eradicate poverty. Instead he sees the creation of jobs and increasing productivity as the major goals to cause a change. As a matter of fact, several studies based on different investigation methods, such as systematic reviews or meta-analysis show that microfinance has no considerable effect on economic outcomes, thus providing no evidence for a beneficial effect on the well-being of the poor and their businesses (Awaworyi 2014) (Duvendack et al. 2011). Despite the formerly mentioned achievement of microfinance to provide financial services to a wider range of society, many investigators criticize an insufficient

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penetration of the poorest classes of society. In their analysis of the effects of microfinance on poverty reduction, Morduch and Haley (2002) describe microfinance as an effective and powerful tool in alleviating poverty that, assuming favorable conditions, suits the needs of a broad range of the population, but they condemn the limited outreach of such programs. Another general problem of MFIs is that they are rather small and therefore more vulnerable due to resource constraints. Moreover, the tendency to focus on a specific group of clients, often restricted to few areas leads to an undiversified loan portfolio, makes them sensitive for systemic risks (Zeller and Meyer 2002). While some institutions limit their service to providing loans, others include educational or nutrition programs. Besides, prerequisites for potential clients vary significantly as some institutions demand savings before granting a loan. Most institutions try to overcome the increased risk of lending to the poor and insufficient information following the initial approach of group lending introduced by Yunus in the 1970s (Zeller and Meyer 2002). Another frequent problem faced by financial institutions dealing with the poor is the relatively high transaction costs. The financial transactions are very small but require the same administrative effort as larger loans and generate significantly lower revenue (Zeller and Meyer 2002). The result is an inefficient banking system. Moreover, various researchers in the field of microfinance, such as Shakya and Rankin (2008), who studied microfinance programs in Nepal and Vietnam, proved that beneficiaries of such programs regularly fail to comply with their regulations and especially do not achieve the entrepreneurial purpose they aim to promote. Likewise, et al. (2006) detected repayment problems among borrowers that revealed some unresolved disadvantages in the programs. However, the most threatening development is the mission drift of many institutions, which set the goal of growing a profitable business over the purpose of creating social value. It is easy to take advantage of the poor, which often have no other choice than simply accepting the immense interest rates in a desperate attempt to escape poverty and often end up indebted because of failing businesses and the inability to pay back their loans. The included studies cannot find a considerable positive effect on economic outcomes; neither do they attest a sufficient penetration of the very poor classes of society. Regarding institutional sustainability, relevant barriers are the vulnerable, undiversified, and inefficient banking systems underlying microfinance programs and a lack of information on their clients.

Reconciling Sustainability and Social Responsibility Many authors agree on the fact that a crucial task for microfinance programs is the creation of a microfinance market which is both economically sustainable and socially responsible. Woller et al. (1999) adopt the definition of a sustainable microfinance business as “the ability of a program to produce outputs that are valued sufficiently by beneficiaries and other stakeholders that the program receives enough

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resources and inputs to continue production.” This means that an MFI would be considered feasible although it depends on donor funding. Also, they criticize that donors are the only economic actors that are not considered as being rational but as unstable, whimsical, and unreliable and claim that they are in fact rational. Hietalahti and Linden (2006) question if self-sustainability should even be a target of MFIs if there exists the opportunity of financing by donors, as it is a very ambitious goal when trying to reach the poorest. They argue that the fundamental goal to reach self- sustainability is to increase cost-effectiveness, which might be at the cost of the poorest as they require increased monitoring and business training. According to the idea of a social responsible finance, Prior and Argandona (2009) define the social responsibility of financial institutions in developing countries as granting access to financial services. This includes among others the admission to current or savings accounts, loans, payment and transfer methods, financial advice under the best possible terms of return, cost, and risk. In the same idea, Rhyne (1998) notes that if microfinance would simply be regarded as a mathematics problem, it would be a problem of dual maximization with the two objectives outreach to the very poor and achievement of financial sustainability. These kinds of problems do not provide one single solution, but a curve of multiple possible trade-offs called production possibility frontier that depend on preferences for one or the other objective. Therefore, the author argues that we need to ascertain how close we are to this frontier to see if there exists a trade-off between outreach and sustainability or if there still is capacity to increase both factors. Besides, she recognizes that pricing seems to be determining the financial viability of a program, as sustainable programs were found to set interest rates at a percentage that fully recovers costs, whereas others with lower interest rates opted for the dependency on subsidies. Therefore, in her opinion, the debate finally is about the willingness to subsidize interest rates. Nevertheless, she admits that this model of constraint maximization does not include social, political, or moral dimensions and argues that a model that sees reaching the poor and sustainability as largely complementary objectives with sustainability to achieve the desired outreach is more appropriate. Zeller and Meyer (2002) introduce the concept of The Triangle of Microfinance facing its main challenges, which they define as (1) a sufficient outreach of microfinance programs, (2) a positive impact of microfinance programs on the poor, and (3) the creation of sustainable financial institutions. Furthermore, they argue that most MFIs particularly focus on one of the three targets, although they generally try to accord to all of them and state that there might be a potential trade-off between depth of outreach and financial sustainability as well as impact and financial sustainability. The extensive review of the literature on the impact of microfinance on poverty alleviation by Morduch and Haley (2002) contributes to the question whether those three challenges are reconcilable. They found the following interrelations: (1) Excellent financial performance of a MFI does not guarantee reaching the poor but in turn, excellent outreach does not preclude financial sustainability of the institution. However, the outreach of a program improves significantly if the institution

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explicitly aims at poverty reduction instead of focusing on financial goals. (2) Appropriate product design and targeting are crucial to reach the poorest as well as entrepreneurial skills and ability are indispensable characteristics of clients to successfully manage a microenterprise. To improve the outreach of microfinance programs, Women’s World Banking (2006) suggests increasing retail capacity by strengthening high-potential MFIs and encouraging traditional banks to enter the business. Joshi and Giri (2016) argue that possible solutions for the improvement of the impact of microfinance programs on economic development in rural areas could be to offer training in financial education, loan management, and asset accumulation as well as population control. Frisancho et al. (2008) assessed the impact of a business training program for female microentrepreneur clients of a group banking program in Peru and found that offering this nonfinancial service was not only beneficial for clients, resulting in better business practices and increased revenues and profits but also positively affect repayment rates and client retention.

Creating Efficient Business Models Women’s World Banking (2006) identifies the expansion of the microfinance product range and the establishment of more efficient processes as an essential challenge to tackle. Prior and Argandona (2009) mention the persistent lack of access to financial services in some areas as a result of insufficient and inefficient business models followed by financial institutions, which are not appropriate for low-income segments. They claim that supply factors are more important than demand factors (e.g., lack of confidence in financial system), as the demand for financial services exists regardless of the population’s profile. The authors argue that the main reasons for the supply discrepancy are unreasonably high costs and prices for financial services, geographical location of potential customers and their proximity to branch offices, unfavorable risk methodologies for developing countries, and inadequate regulatory frameworks. This creates the need for effective business models of microfinancial services that can handle those segments. González Vega (1998) backs this claim, arguing that there are many businesses of poor households that demand credit but lack supply and that the demand for other financial services such as deposit facilities and payment services is not satisfied. The demanding task therefore is to provide financial services that suit the respective demand of the population. Roodman (2013) recommends integrating digital technologies to enhance the flexibility of institutions on their path to self-sufficiency by allowing them to diversify their services and lower their costs. In the same idea, Peck Christen (2013) alludes to the issue of high transaction costs, which limit financial sustainability and he presents mobile money as a possible solution. This service permits the transmission of money over mobile phones through an extensive network of agents,

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mostly airtime resellers, which are allocated across the country including poorer neighborhoods and rural villages. This kind of system was already introduced in Kenya in 2007 under the name M-Pesa and has been used by 15 million Kenyans to send money to someone else. The method showed positive effects on consumption, especially on food consumption when facing negative income shocks. Furthermore, it stimulates local consumption as payments are received and therefore also spent locally. This system, among others, covers money transfers to savings accounts, loan payments, and sale of micro-insurance as well as offering a prepaid VISA Card and a prepaid smart card, which is used to receive medical treatment at certain hospitals at a low per-visit cost. Lapenu (2002) argues that a preexistent banking sector in rural areas facilitates the development of MFIs in these regions due to reduced transaction costs. Besides, she claims that MFIs alone, especially with the premise to be sustainable, cannot achieve a significant impact on the poorest of the poor. Instead, there is the necessity of complementary services, such as education, infrastructure, or health care, which must be provided independently from financial services by the government or NGOs. According to Women’s World Banking (2006), the development of the domestic financial market and its instruments; the definition of broad strategies and policies for all parties involved; the optimization of competitive dynamics; knowledge about the industry and its customers; and ensuring public and private support are crucial areas for action. Cotler and Aguilar (2013) determine among others minimized dependency on subsidies and propose the utilization of its pool of savings as key features of an effective and sustainable microfinance system that benefits the poor instead.

Measuring Performance Another challenge to address is to establish a suitable measurement of microfinance programs to define the success of the social mission of the institutions involved. Many studies have been realized on their financial performance and financial sustainability, but thereby missed to assess the social impact of these programs, and the effectiveness for their clients. Roodman (2013) considers meticulous academic studies on the impact of microcredit as one of the main challenges of the industry. Austin et al. (2006) argue that performance measurement for a social purpose is more complex than evaluating performance in commercial contexts, which is easily achieved through tangible and quantifiable factors. Typically, the combination of financial and nonfinancial stakeholders creates intricate relationships that are hard to manage. In this way, nonquantifiability, multicausality, temporal dimensions, and perceptive differences of the social impact achieved present a great challenge. Since 2012, the Universal Standards for Social Performance Management serve financial service

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providers to comply with their social goals and by May 2017, more than 300 institutions in almost 90 countries had used the audit tool. This objective framework helps to benchmark social performance in the sector and allows MFIs the comparison to peers and offers insights into sector trends and gaps as well as social risks (Convergences 2017). This development is undoubtedly an achievement in drawing the focus on the institution’s social mission; however, it is insufficient in gaining an encompassing view on the accomplishment of microfinance social goals. The standards include the definition of social goals, the commitment to these goals, the development of products and services that can meet the clients’ needs and preferences, a responsible treatment of clients and staff as well as a balance between financial and social performance (Social Performance Task Force 2018). The effectiveness of this tool certainly depends on how the standards are measured, especially when referring to the client. Also, of the more than 2,200 MFIs, only 300 already used the tool.

The Model With the objective to provide a comprehensive overview of the current issues and the status quo of the microfinance industry, the underlying principles and stakeholders involved, as well as the challenges, we built up a comprehensive model after an extensive literature review and a hermeneutic analysis of the work gathered. In the case of this chapter, these texts were provided in the form of books, journal articles, reviews, and newspaper articles published between 1995 and 2018. Hereby, first of all, relevant studies were defined and used as a basis to establish themes for the different chapters, which include the findings on the topic under investigation (Byrne 2001). Some often-cited literature and important investigations on the topic of microfinance from earlier studies are included to show the evolution of the system. The focus is set on work published after 2007, the year which marks the “mission drift” of MFIs to better identify the current state and needs of development for the industry. The studies included are not restricted on any particular region but analyze issues and the impact of microfinance programs in various countries, stretching from Latin America to South Africa and Asia. The amalgamation and interpretation of the author’s findings form the basis for the developed model. The resulting scheme strives to incorporate all the elements identified as essential for the well-functioning of a microfinance program, which beforehand have been identified in the literature review.

Results The result of the previously conducted extensive literature research is a model for the microfinance industry, which entails the most important stakeholders, their

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respective goals and possible actions, which contribute to the overall purpose of a microfinance program: the creation of social and economic value for all the stakeholders.

Defining the Relevant Stakeholders As discussed beforehand, multiple stakeholders can be determined for the microfinance industry. The following limitation carried out with the aspiration to create a simplified model, is based on the categorization suggested by Mitchell et al. (1997). The proposed model includes the following key stakeholders: The MFI, the target clients of these institutions, donors (typically development organizations or international NGOs), and creditors (e.g., banks or international loan providers) as well as the governments and a regulatory entity. Hereby, the institution itself, which includes owners, managers, and employees is defined as one unit and classified as a definite stakeholder with power, legitimacy, and urgency for the program. As a matter of fact, the institution is the core of the microfinance program as it provides the services that the system is based on and has the strongest influence on the characteristics of the program. Also, the government and an independently established regulatory entity hold all the three characteristics as they provide a framework of laws and regulations and act as supervisors of the institutions and defenders of the clients. Clients, creditors, and donors evidently have legitimacy in the program as well as they are urgent stakeholders given that the system without these actors would not be able to function. Although it is arguable if one single client, creditor, or donor possesses a position of power in the system, each group as a whole certainly does.

The MFIs Goals and Possibilities for Action The central part of the Model is referring explicitly to the MFI and is inspired by The Triangle of Microfinance presented by Zeller and Meyer (2002). The authors establish their model based on a conceptual framework, which defines three primary objectives of microfinance: Financial sustainability, outreach, and impact (2002). The model proposed in this chapter takes the same three institutional goals as the basis for a well- functioning system, but rather than focusing on their interrelation, it defines concrete factors and fields of action that can lead to the achievement of these goals. The central triangle connects the subordinate goals for the MFI, which are necessary to achieve the fulfillment of the overall purpose. Those are financial sustainability, outreach, and impact. Especially the first two are objectives repeatedly made a subject of discussion by many different authors and investigations, such as Christen et al. (1995), Morduch and Haley (2002), Navajas et al. (2000), and Rhyne (1998). Outreach is defined as the social value of the output of a microfinance organization in terms of depth, worth to users, cost to users, breadth, length, and scope, which

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stems from Navajas et al. (2000). Simply put, it describes an expanded financial inclusion of poor people formerly excluded from the access to banking services (Zeller and Meyer 2002). As far as financial sustainability is concerned, ambiguous opinions are prevalent. Some authors define it as an essential premise for an MFI to operate (Rhyne 1998; Zeller and Meyer 2002), while others doubt if it should even be a goal to achieve (Hietalahti and Linden 2006). Woller et al. (1999) adopt a different definition of financial sustainability, which does not preclude donor funding as long as the outputs of the program are valued sufficiently by clients and other stakeholders and the program receives sufficient resources and inputs for its operations. The model treated in this chapter takes a middle course. Financial sustainability is not and should not be the most important goal for a microfinance program, but it certainly has positive spillover effects on outreach and impact. Therefore, it is desirable that in the long run, but especially in the beginning of operations, institutions should be considered as sustainable following the abovementioned assumption of Woller et al. Subsidization and dependency on donors is not reprehensible considering that microfinance ultimately is a development tool. The third goal, which is impact, is located at the top of the pyramid, as here, it is still considered as the most important aim, considering that public investments in microfinance can only be justified if it proves to be a beneficial tool for its recipients and succeeds in alleviating poverty. Thus, impact is defined as the change in wellbeing (Durand 2015) of the poor clients evoked by the participation in a microfinance program. The arrows connecting the three targets symbolize potential synergies or tradeoffs between them. The achievement of a positive impact largely depends on the mission of an institution and its aspiration to operate sustainably (Social Performance Task Force 2018). The other way around, achieving a positive impact means that clients are able to improve their well-being, which includes successfully establishing a source of income, paying back their loans, building up savings, and taking out further loans, which in change benefits the institution. Impact certainly also depends on outreach; only if the poorest are targeted adequately, the desired impact can be achieved (Morduch and Haley 2002). Similarly, outreach can be increased by creating a positive impact, as people are more interested in participating in successful programs. Financial sustainability and outreach are often seen as largely complementary, assuming that institutions are striving for financial sustainability to encourage sufficient outreach (Rhyne 1998). Increased outreach amplifies the operational scale of an institution and therefore might enhance financial sustainability. On the other hand, a negative relationship between the depth of outreach and financial sustainability cannot be totally excluded. Reaching the poorest of the poor also implies a higher credit risk as lending to less poor clients. Each of the three objectives is surrounded by a smaller circle, which stands for the continuum of factors and possible fields of action enhancing the respective goal. In

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the following, the most important influencing factors shall be listed with reference to the proponents. 1. Factors that influence outreach: increased institutional scale (Christen et al. 1995); efficient targeting (Morduch and Haley 2002); proximity to clients (Christen et al. 1995); tailored products (Mori 2010); financial sustainability (Rhyne 1998); and proved impact on clients (Rhyne 1998). 2. Factors that influence financial sustainability: salary levels of staff in relation to local GDP (Christen et al. 1995); real effective interest rates (Christen et al. 1995); repayment incentives (Christen et al. 1995); clear social mission (Social Performance Task Force 2018); better risk analysis (Prior and Argandona 2009) (Zeller and Meyer 2002); diversification (Zeller and Meyer 2002); knowledge about industry and customers (Women’s World Banking 2006); efficient processes (Prior and Argandona 2009) (Women’s World Banking 2006) (Zeller and Meyer 2002); technological innovations to lower transaction costs (Peck Christen 2013) (Zeller and Meyer 2002); full financial product range (Garikipati 2017) (Joshi and Giri 2016); and support by government/donors (Hietalahti and Linden 2006) (Woller et al. 1999). 3. Factors that influence impact: fair interest rates (Yunus 2011); expansion of product range (Garikipati 2017) (Joshi and Giri 2016); purposefully deployed loans (Sinclair 2012); joint liability (Attanasio et al. 2015); ongoing access to credit (Christen et al. 1995); education as well as financial and entrepreneurial training and advisory (Joshi and Giri 2016) (Morduch and Haley 2002); and extensive studies on impact of programs (Roodman 2013).

The Client’s Goals and Possibilities for Action The clients in a microfinance program primarily strive for the access to financial services, which beforehand has been denied to them by traditional banking institutions. The motivation behind their demand for loans, savings, or other services should ideally be an improvement of their well-being as only with this underlying intention, the microfinance program can create a long-term positive impact (Sinclair 2012). Therefore, the two central goals of recipients of microfinance services are defined as Access to Financial Services and Impact. The access to financial services is closely related to several aspects of outreach. The depth of outreach determines if the very poor are reached by the offered program. Worth to users represents in how far the terms of the financial service match with the client’s demand and cost to users is essential as clients would only enter a program if they expect a net gain (Schreiner 2002). Impact can be defined as an improvement of the client’s well-being (Durand 2015). A positive impact can be reflected in the successful establishment of a new income source, the ability to pay back their loans, to accumulate savings, and to take out further loans (Morduch and Haley 2002).

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As the clients are the actors that should gain empowerment through the microfinance program, it is easy to realize that they do not have as many possibilities for action as the MFIs. Nevertheless, they have the potential to enhance the achievement of their goals. Again, the circle around the respective goal represents the scope of possible actions that can be undertaken. The most important factor for the recipients participating in a microfinance program is that they in fact strive for a long-term impact and honestly communicate their intentions to the institution. Still, it is very common that loans are misused for consumption, instead of investing them in a business (Sinclair 2012). Therefore, granting unlimited access to information on their financial situation and specific motivation of receiving the loan is crucial. To ensure the supply that matches their exact demand, clients must be aware of their own necessities and in this way encourage the institution to offer the products they need (Mori 2010). This should include the provision of customized products for novice users. Once the access to financial services is gained, the impact highly depends on the efforts of the client to establish a source of income. Hereby, the clients should make use of nonfinancial services offered by the lenders, such as financial and business education, which enable them to lead their business in a profitable way. Also, it has been shown that a longer participation in a credit program is more likely to achieve positive outcomes.

Donors’ and Creditors’ Goals and Possibilities for Action Donors and creditors usually donate or lend money to MFIs with the aim to support the microfinance program as an effective development tool and thus improve the well-being of the poor. Creditors expect a return on their money invested and thus also seek profit from their participation. Both share the goal impact, whereas creditors additionally strive for profit. Their main role to ensure a positive impact of the program certainly is to provide ongoing access to financial resources for the MFI. Apart from funds, international stakeholders, such as donors and technical assistance providers, transfer expertise to the organization, measure processes, or encourage good practices and therefore can strengthen the institution (Mori 2010). This positively influences the impact of the program as well as supports the institution in gaining financial sustainability, which in turn ensures the desired profit for its creditors.

The Government and Regulatory Entity The last two stakeholders to complete the proposed model and form the basis of the microfinance program are the government and a specifically established regulatory entity.

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There is a consensus in literature that contributes to the belief that governments still play an important role in the financial sector, which is to supervise, regulate, and build a financial structure as well as to provide macroeconomic stability, such as a stable currency and a moderate inflation rate, which ensures favorable conditions for the development of MFIs (Arora 2017) (Foschiatto and Stumpo 2006, pp. 28–29) (Yunus 2011). Specifically, it should aim at increasing competition (Cotler and Aguilar 2013), allocating subsidies when necessary (Arora 2017) (Mutengezanwa et al. 2011), establishing adequate consumer protection laws (Roodman 2013), and providing complementary services, such as education or food supply (Lapenu 2002). In addition, an already well-established general banking structure (Lapenu 2002) and the further encouragement of traditional banks to enter the microfinance business (Women’s World Banking 2006) are supporting factors for an increased outreach. Moreover, an independent regulatory entity should be in charge of the supervision of MFIs to guarantee transparency and fair treatment of clients, as well as protect the latter from exploitation, which raises trust among financial institutions and clients (Foschiatto and Stumpo 2006) (Roodman 2012). A framework of general rules and procedures and a definition of strategies and policies in accordance with the government and financial institutions should be set up (Mutengezanwa et al. 2011). This could include the establishment of a capacity building program dedicated to the microfinance sector, covering its entire operations and fitting the respective requirements of all its stakeholders and the definition of a benchmark rate of interest for microcredits (Nedunchezian and Sivasankaran 2009). Some authors suggest the foundation of an international credit bureau to monitor MFIs debt levels, rates of growth in borrowing, lending, and equity. This could provide accurate and up-to-date information on investment deals as well as the involved investors and enable the authority to publish credit ratings. A mandatory license for operating a MFI and a regular check on the performance could counteract the commercialization of the industry (Roodman 2012) (Nedunchezian and Sivasankaran 2009).

Framework for a Successful Microfinance Program The overall purpose of the microfinance program is placed at the top of the model and is defined as the creation of social and economic value for all the stakeholders involved. The model claims that this purpose can only be achieved if all the stakeholders seek to achieve their goals by trying to exploit their full action potential. The importance of a mutual benefit for the two key stakeholders, the institutions offering microfinance programs and the poor recipients of their financial services, has already been addressed at the beginning of this chapter and is therefore at the forefront of the model. It is necessary to ensure a sufficient supply and demand for microfinance services, thus making it an efficient and effective development tool.

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What stands out from the model is the fact that all the actors share the goal of impact, which emphasizes the importance to achieve this goal. As previously mentioned, a microfinance program, which is not provoking a positive impact on the well- being of its beneficiaries does not satisfy the fundamental demand underlying its function as a development tool (Fig. 1).

Conclusion A seemingly outstanding event in development economics was the discovery of microcredit as a potential solution to the world’s poverty problems by Muhammad Yunus in the 1970s. Even though microfinance has long been praised by NGOs and investigators in the field and has achieved official recognition as an essential tool for development by awarding the Grameen Bank and its founder Muhammad Yunus with the Nobel Peace Prize, the initial euphoria failed to stand up to rising criticism on the system. An ever-expanding number of investigators condemn the increasing shift of philanthropic institutions dedicated to the poor to profitable businesses striving for institutional and shareholder benefits. Although microfinance made a group formerly excluded from financial services bankable, there are many shortcomings in the current orientation of microfinance programs. Therefore, the purpose of this chapter was to establish a framework, which benefits all the stakeholders involved and provides a guide for institutions to similarly achieve social and financial goals by clearly defining the structures of a successful microfinance program. The result is a model for the microfinance industry, which clearly defines the key stakeholders, attributes them with responsibilities, and shows their capacity to act in favor of their individual goals. Specifically, the model relates the current challenges and the overall purpose to a set of influencing factors that should be considered and actions that can be taken by financial institutions, clients, donors, and creditors supported by the government or regulatory entities. It serves as a theoretical proposal for the microfinance industry and aims to provide a guide to follow for the key players to create economic and social value. Clearly, the model does not make a claim to be encompassing, as literature and investigation on the topic of microfinance programs and their success or failure are extensive and partly inconsistent. Especially when it comes to the spillover effects or potential trade-offs between the three central institutional goals, there have only been mentioned some of the potentially existing interrelations. Nevertheless, this chapter is a first step in determining significant factors to achieve the best possible economic and social outcome of a microfinance program and to establish a relationship between them. Presenting alternative business models that could evoke the reversal of the current mission drift in the microfinance sector is crucial, as only the reconsideration of microfinance’ initial purpose can ensure its validity as a development tool.

Fig. 1 Framework for a successful microfinance program. (Source: Created by the authors, 2020)

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Further research could focus on the application of the developed framework by applying it to various MFIs in a comparative performance study. Also, it could be used to identify the status quo of a program, to detect potential lacks, and to provide recommendations for the different stakeholders. This ideally would improve the performance of the respective program by encouraging the reconsideration of roles and responsibilities evoked by a global view on its shortcomings.

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Cotler P, Aguilar G (2013) The microfinance sectors in Peru and Mexico: why have they followed different paths? In: Manos R, Gueyié J-P, Yaron J (eds) Promoting microfinance: challenges and innovations in developing countries and countries in transition, 1st edn. Palgrave Macmillan, Houndmills, pp 39–55 Durand M (2015) The OECD better life initiative: how’s life? And the measurement of Well-being. Rev Income Wealth 61(1). https://doi.org/10.1111/roiw.12156 Duvendack M, Palmer-Jones R, Copestake J, Hooper L, Loke Y, Rao N (2011) What is the evidence of the impact of microfinance on the well-being of poor people? Institute of Education, University of London, Social Sience Research Unit. London: EPPI-Centre. Retrieved April 12, 2018, from https://assets.publishing.service.gov.uk/media/57a08aeeed915d622c0009bb/ Microfinance2011Duvendackreport.pdf Foschiatto P, Stumpo G (2006) Políticas municipales de microcrédito: Un instrumento para la dinamización de los sistemas productivos locales. Estudios de caso de América Latina. Naciones Unidas, Santiago de Chile Freeman RE (1984) Strategic management: a stakeholder approach. Pitman, Boston Frisancho V, Karlan D, Valdivia M (2008) Business training for microfinance clients: How it matters and for whom? (F. R. Louis, Ed.) Retrieved May 22, 2018, from https://ezproxy. udem.edu.mx:2119/docview/1698749722?accountid¼17236 Garikipati S (2017) The impact of microfinance on poverty alleviation: making sense of the evidence. In: Giorgioni G (ed) Development finance: challenged and opportunities. Springer, Cham, pp 189–206 González Vega C (1998) Microfinance: broader achievements and new challenges. Ohio State University. Department of Agricultural, Environmental, and Development Economics. Retrieved April 3, 2018, from http://hdl.handle.net/1811/66761 Hietalahti J, Linden M (2006) Socio-economic impacts of microfinance and repayment performance: a case study of the small enterprise foundation, South Africa. Prog Dev Stud 6(3):201– 210. Retrieved February 20, 2018, from https://ezproxy.udem.edu.mx:2119/docview/ 218128628?OpenUrlRefId¼info:xri/sid:primo&accountid¼17236 Islam T (2007) Microcredit and poverty alleviation. Ashgate, Hampshire Joshi P, Giri A (2016) Economic and social impact of micro finance programs: an empirical study of SHGs in Rajasthan, India. IPE J Manag 6(1):131–150. Retrieved February 20, 2018, from https:// ezproxy.udem.edu.mx:2119/docview/1828144103?rfr_id¼info%3Axri%2Fsid%3Aprimo Karnani A (2008) Employment, not microcredit, is the solution. J Corporate Citizenship (32):23– 28. Retrieved March 16, 2018, from https://ezproxy.udem.edu.mx:2119/docview/211906279? accountid¼17236 Lapenu C (2002) The Microfinance revolution: implications for the role of the State. In Zeller M, Meyer RL (eds) The triangle of microfinance: financial sustainability, outreach, and impact. Int Food Policy Res Inst, pp 297–320. Retrieved April 11, 2018, from Leone P, Porretta P (2014) Introduction. In: Microcredit guarantee funds in the Mediterranean. Palgrave Macmillan, London, pp 1–21. Retrieved February 16, 2018, from https://link.springer. com/chapter/10.1057/9781137452993_1 Mitchell RK, Agle BR, Wood DJ (1997) Toward a theory of stakeholder identification and salience: defining the principle of who and what really counts. Acad Manag Rev 22(4):853–886 Morduch J, Haley B (2002) Analysis of the effects of microfinance on poverty reduction. 1014. NYU Wagner Working Paper, New York. Retrieved April 9, 2018, from https://s3.amazonaws. com/academia.edu.documents/3470021/morduch_02_analysis_effects.pdf?AWSAccess KeyId¼AKIAIWOWYYGZ2Y53UL3A&Expires¼1523295880&Signature¼PU1KluziDEX %2Feeq3n8VU6D5OnKY%3D&response-content-disposition¼inline%3B%20filename% 3DAnalysis_of_the_e Mori N (2010) Roles of stakeholders in strategic decision-making of Microfinance organizations. Int Business Econ Res J 9:7. Retrieved May 22, 2018, from https://ezproxy.udem.edu.mx:2119/ docview/733705426?accountid¼17236 Mori N, Mersland R (2014) Boards in microfinance institutions: how do stakeholders matter? J Manag Govern 18(1):285–313. Retrieved May 22, 2018, from https://link.springer.com/content/ pdf/10.1007%2Fs10997-011-9191-4.pdf

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Mutengezanwa M, Gombarume FB, Njanike K, Charikinya A (2011) The impact of micro finance institutions on the socio- economic lives of people in Zimbabwe. Ann Univ Petrosani Econ 11 (1):161–170. Retrieved February 20, 2018, from http://www.upet.ro/annals/economics/pdf/ 2011/Mutengezanwa-Gombarume- Njanike.pdf Navajas S, Schreiner M, Meyer RL, Gonzalez-Vega C, Rodriguez-Meza J (2000). Microcredit and the poorest of the poor: theory and evidence from Bolivia. In Zeller M, Meyer RL (eds) The triangle of microfinance: financial sustainability, outreach and impact. Intl Food Policy Res Inst, pp 152–171. Retrieved April 11, 2018, from https://books.google. c o m . m x / b o o k s ? h l ¼d e & l r ¼& i d ¼h M U 4 Aw A A Q B A J & o i ¼f n d & p g ¼P P 1 & dq¼microfinance+development+tool&ots¼7ZBApVMqxc&sig¼DzJMS41FawLH KY52QVRGP78iM&redir_esc¼y#v¼onepage&q¼microfinance%20development% 20tool&f¼false Nedunchezian VR, Sivasankaran N (2009) Assessing the performance of the stakeholders of microfinance programs. IUP J Manag Res 8(1):60–74. Retrieved May 22, 2018, from https:// ezproxy.udem.edu.mx:2119/docview/199325477?accountid¼17236 Nobel Media AB (2018). The Nobel Peace Prize 2006. Retrieved April 13, 2018, from Nobelprize. org: https://www.nobelprize.org/nobel_prizes/peace/laureates/2006/ Peck Christen R (2013) Financial services that clients need: The 3.0 business models, reconciling outreach with sustainability. In: Köhn D (ed) Microfinance 3.0: reconciling sustainability with social outreach and responsible delivery. Springer, Cham, pp 105–122 Prior F, Argandona A (2009) Credit accessibility and corporate social responsibility in financial institutions: the case of microfinance. Business Ethics Eur Rev 18(4):349–363. Retrieved April 10, 2018, from https://onlinelibrary.wiley.com/doi/epdf/10.1111/j.1467-8608.2009.01568.x Rhyne E (1998) The yin and yang of microfinance: reaching the poor and sustainability. MicroBanking Bullet 2(1):6–8 Roodman D (2012) Due diligence: an impertinent inquiry into microfinance. CGD Books Roodman D (2013) Armageddon or adolescence? Making sense of microfinance’s recent travails. In: Köhn D (ed) Microfinance 3.0: reconciling sustainability with social outreach and responsible delivery. Springer, Cham, pp 13–40 Schreiner M (2002) Aspects of outreach: a framework for discussion of the social benefits of microfinance. J Int Dev 14(5):591–603. Retrieved May 25, 2018, from https://onlinelibrary. wiley.com/doi/pdf/10.1002/jid.908 Sengupta R, Aubuchon CP (2008) The microfinance revolution: an overview. Federal Reserve Bank of St.Louis. Retrieved April 25, 2018, from https://ezproxy.udem.edu.mx:2119/docview/ 227758644?accountid¼17236 Shakya YB, Rankin KN (2008) The politics of subversion in development practice: an exploration of microfinance in Nepal and Vietnam. J Dev Stud 44(8):1214–1235. Retrieved February 16, 2018, from http://ezproxy.udem.edu.mx:2943/ehost/pdfviewer/pdfviewer?vid¼1& sid¼e345ec7a-ff0e-4542-99dd-62d7dc21dd23%40sessionmgr4007 Sinclair H (2012) Confessions of a microfinance heretic: how microlending lost its way and betrayed the poor, 1st edn. Berrett-Koehler Publishers, San Francisco Social Performance Task Force (2018) The universal standards for social performance management. Retrieved April 6, 2018, from Social Performance Task Force: https://sptf.info/universal-stan dards-for-spm/universal-standards Woller GM, Dunford C, Woodworth W (1999) Where to microfinance. Int J Econ Dev 1(1):29–64. Retrieved April 23, 2018, from http://marriottschool.net/emp/WPW/pdf/class/Class_14Gender_Equity_and_Microenterprise_Continued.pdf Yunus M (2011) Sacrificing microcredit for megaprofits. The New York Times, A23. Retrieved April 4, 2018, from https://www.nytimes.com/2011/01/15/opinion/15yunus.html Zeller M, Meyer RL (2002) The triangle of microfinance: financial sustainability, outreach, and impact. Intl Food Pol Res Inst Retrieved April 5, 2018, from https://books.google.com.mx/ books?hl¼de&lr¼&id¼hMU4AwAAQBAJ&oi¼fnd&pg¼PP1&dq¼microfinance+develop ment+tool&ots¼7ZBApVMqxc&sig¼DzJMS41FawLHKY52QVRGP78iM&redir_ esc¼y#v¼onepage&q¼microfinance%20development%20tool&f¼false

Part III The Crisis in the Governance of Financial Institutions

Corporate Government as a Structure for Control and Promotion of Ethics in Banks Mariem Ghares and Eric Lamarque

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Role of Values in Governance-Level Decision-Making Processes . . . . . . . . . . . . . . . . . . . . . . . . The Role of Values as a Decision Filter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . How the Values Filter Is Activated? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conditions of a Real Consideration of the System of Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Role of Governance in Strengthening Strategic Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ensuring that Boards Are Able to Make a Real Impact in Terms of Referencing Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cross-References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

In this research we establish the link that exists between concepts of “values” and “corporate governance” which can explain the level of consideration of those values in modes of governance and strategic decisions. Our proposal confirms the fact that if values are really taken into account in the decision process through specific governance structure, it allows to support best practices by making values a key factor of success. With the crisis, the financial places, especially banks, are questioned on their conduct behavior what brings them to update their modes of governance in a more ethical way. The comparison between three types of governance model for banks will allow to perceive the importance and the structuring role of values in the governance. M. Ghares VALLOREM, IAE Tours, Tours University, Tours, France e-mail: [email protected] E. Lamarque (*) Sorbonne Research in Management-IAE, Management and Governance of Financial Cooperatives, Paris 1 Pantheon-Sorbonne University, Paris, France e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_7

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Keywords

Values · Governance · Banks

Introduction The analysis of the banking crisis starting with the US savings and loan crisis in the early 1980s up to the subprime crisis in 2007 reveals that the financial institutions adopted inappropriate practices or failed to prevent deviant and sometimes illegal behavior, thus are confronted with the question of how to systematically and effectively integrate references to values and ethics into decision-making processes in these institutions. To that end, we observed how some banks sought to systematically take into account principles relating to ethics or values associated with exemplary behavior. We specifically wanted to make a comparison between traditional banks, which are owned by shareholders, and banks under specific types of governance: cooperative banks and Islamic banks. In fact, these types of banks clearly refer to their respective value systems when making certain strategic and management decisions (communications, HR practices, commercial actions, etc.). Referencing these values allows them to differentiate their offerings from traditional private institutions by giving customers and staff the feeling that they are dealing with an organization that takes a different cultural and practical approach. However, we often find that stakeholders working within these organizations do not perceive any difference in practice and feel that they are dealing with a fairly traditional institution. This is particularly true in the banking sector, where services are mostly very similar, distribution strategies are fairly homogeneous, and the quality of customer relationships is essentially undifferentiated between institutions. Our proposals in this chapter are based on our observations of practices at the executive committee and board of directors’ levels and state that the values system, in order for it to have a real truly influence decisions, must clearly be supported by formal mechanisms within or close to the governance bodies. We also note the risk of a fairly significant gap between the concerns of the executive committees, in charge of the management of these organizations, and the boards of directors, who tend to be strongly attached to the purported values. In case of not observing that these values had influenced some decisions at the highest level, it is difficult to expect that operational players will be influenced by and they will make operational decisions based on them. In the report, we will discuss the actions and organization that can be implemented at the level of governance structures to strengthen the influence of the cooperative values system on strategic decisions and, beyond that, on the decisions under the power of the executive committee. Here we are thinking of investment decisions or decisions relating to compensation of directors. Based on a doctoral research (Ghares M. conducted a doctoral research which included an analysis of values in the banking sector comparing an Islamic bank and a traditional bank in order to determine the role that values can play in management

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practices, specifically strategic projects. A version of this chapter is also published in French in Deville A., Lamarque E., Michel G. editors, “Comment les valeurs coopératives impactent les pratiques de gestion,” EMS 2020.), an analysis of the way values is mobilized at the governance level sheds light on the conditions necessary for them to have a real impact on decisions in contexts where financial performance is usually considered the most important criteria. In the first part, we will analyze the decision-making process, looking at the level where that values become involved in banks with strong activist roots. In the second part, we will discuss the necessary conditions to increase the influence of values on decisionmaking.

The Role of Values in Governance-Level Decision-Making Processes Values are the cornerstone of ethical thinking. According to Bayle and Mercier (2008), an ethical identity is based not only on the recognition of values but above all on the identification of a link between the values of an organization and its actions and decisions. Jeavons (1992), Jurkiewicz and Massey (1998) claim that organizations which adopt ethical charters and claim values and then incorporate these into their activities receive more support from stakeholders because they create a climate of trust. Values are a new management process that is increasingly focused on the social aspects of business and rejects any attempt to violate ethics (Pesqueux and Biefnot 2002). More recently, questions linking values and governance in order to legitimize decisions have begun to interest researchers in corporate governance (Wirtz 2006; Wirtz and Laurent 2014). Thanks to works by Allport, Vernon and Lindzey (1960), Guth and Tagiuri (1965) and Wellhoff (2010), values have now been classified into different families (Table 1); they are as follows. In the banking sector, two governance model, cooperative banks and Islamic banks, make strong references to the values associated with the mode of governance and ownership. Since the 2008 crisis, we have seen this reference to values emerging clearly in their communications. Some French cooperative banks communicate regularly on “Your deposits here are reinvested here, in your territory” or “a bank owned by its customers that changes everything!”, as well as in their strategic plans and institutional signature (“bank and cooperative”). These include values, which are political (“democracy”), ethical (“solidarity”), and relational (“proximity”) (Lamarque and Alburaki 2007).

The Role of Values as a Decision Filter Observing strategic planning works in this environment led to an assessment to what extent these values had a significant and active role in the decision-making process. The challenge for cooperatives in general is to make these values visible in the main choices offered to the members, who are also customers. This is what

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Table 1 Types of values Values families Affective values Intellectual values Ethical values Aesthetic values Spiritual values Political values Performance values Psychological values Competency values Winning values Driving values Interpersonal values Moral values Societal values Fulfilment values Social values

Examples of values Friendship, belonging Open-mindedness, rationality, knowledge, expertise Solidarity, honesty, altruism, sharing Beauty, quality, attractiveness Brotherhood, social justice Sustainability, independence, democracy, equality, freedom, patriotism Professionalization, quality, excellence, efficiency Trust, ambition, boldness, perseverance, sincerity Satisfaction, confidentiality, team spirit, efficiency Enthusiasm, ambition, performance, innovation Authenticity, initiative, modernity, openness, simplicity Trust, friendship, respect, solidarity, team spirit Ethics, loyalty, justice, virtue Sustainable development, social responsibility Humanism, personal development, talent Democracy, goodwill, conformity

ensures that the model remains attractive and the values remain a differentiating factor. Otherwise, these organizations could be accused of using them solely for image and communications purposes. Therefore, the challenge is to develop decision-making models, specifically for strategic issues, which specifically integrate the values. Chédotel and Pujol (2012) believe that “strategic decision-making is seen as an activity shared between management and different stakeholders (members of the board of directors, middle managers, consultants, etc.) or in the context of a management team seen as a community of practice.” In this process, the research seeking to identify at what point values come into play at two levels: – As a contextual element upstream of the decision process In this case, the directors and executives who make the decisions keep these values in mind. As directors, they have an obligation to get all staff members on board with these ideals. The commitment of these directors to these values is deeply important (Whitman 2008). The adoption and integration of some values only reinforce the desire to legitimize facts and actions by raising awareness on the importance of the moralization in the state of business (Gabriel and Cadiou 2005; Aliouat and Nekka 2011). This legitimacy also requires a commitment to CSR and recognition from stakeholders. In order to strengthen this commitment for a company, it is advisable that they create a “community of values” for all players, who will be required to integrate these values into business activities and strategies (Tirole 2016).

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In a quest for legitimacy through values, a leader must know how to create harmony between two aspects of a business: the economic and the social. By operating in this way, the company subscribes to the normative aspect of stakeholder theory. (In studying stakeholder theory, Donaldson and Preston (1995) came to the conclusion that there are three aspects underlying this theory, namely, descriptive, instrumental, and normative.) This legitimacy, justified by a social and cultural influence in the organization, rooted in neo-institutional theory. The neo-institutional approach makes it possible to combine a “capitalist” model (Weber 1967; Boltanski and Chiapello 1999) with a “social” model (Suchman 1995; Capron and Quairel-Lanoizelé (2007). It is based on the principle that the organization operates within an institutional framework based on standards that legitimize their operating methods. This theory makes it possible to situate companies in an institutional environment featuring rules where the company must comply to establish its legitimacy (Meyer and Rowan 1977; Rouleau 2007) . In this type of decision-making process, we observed that values are generally taken into account informally, insofar as there is no specific time or place where values will be formally included in a strategic plan, nor certain choices will be explicitly eliminated due to non-compliance with the values. Just because a project in the plan is explicitly related to CSR issues does not mean that all decisions will involve taking values into account or be subject to an evaluation in line with these values. – A filter at the end of the decision-making process, in order to make the final decisions In this case, values can be seen as a mean of controlling decisions insofar as they help deciding what is feasible or not and can provide solutions during implementation (Simons 1995). Strategic management involves coordinating missions, visions, and values. Davies (2001) conducted an analysis on the importance of missions, visions, and values in a strategic plan development. This triptych, a sign of a strong corporate culture, represents a solid basis for a company’s strategic decision-making. These values are part of an organization’s “DNA” contributing to its strategic positioning (Pant and Lachman 1998; Bayle and Mercier 2008). Along with the idea of positioning values as a filter comes the hierarchy of values in decision-making. The fact is, cooperative banks operate in a competitive environment and therefore naturally pay attention to risks of financial performance. Thus, values will take precedence over more social or societal values. We observed that, depending on how the values are positioned in the decision-making process (informally or formally), the impact of the values could vary quite drastically. This issue is common to all companies but becomes more urgent for cooperative institutions. Therefore, the challenge is to ascertain to what extent choices with strong societal and cooperative values (supporting a struggling local company) would not be ruled out despite their negative economic consequences (high risk taken on by the bank). Conversely, choices motivated by financial performance should not be made without taking into account the cooperative stance presented by doing so.

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ABANDONED

STRATEGY

STRATEGY

STRATEGIC CHOICES SELECTED STRATEGY ECONOMIC FILTER

VALUES FILTER

Fig. 1 Classification of the two filters: economic filter and values filter

As suggested in Fig. 1, it is important for chosen or rejected strategies to be properly assessed through the cooperative lens. The research conducted to try to better understand the positioning of values in the decision-making processes and in relation to the performance requirements of any private institution confirmed the “filter” role. However, the “values” filter is activated in ways that can vary substantially depending on the organization.

How the Values Filter Is Activated? It follows from the above that the role of values in decision-making processes can be formal or informal, especially in the banking sector (Lamarque 2008; Ghares 2013). Informal does not mean that they are not involved in the decision-making processes, where we have not identified a space dedicated to their involvement. References to values are often most made at the governance level (general assemblies and boards of directors), but there is not always a formal space dedicated to discussing these values and checking whether the decisions are compliant with values. This is often the case at traditional shareholder banks. Our analysis has revealed that financial criteria are given much more emphasis and are prioritized. In the first place, economic rationales are adopted, followed by values rationales. This is clearly illustrated by the following comment made by a CEO: “We make strategic decisions which are in line with our values as much as possible. . . We make decisions according to a financial filter, and the reference to values comes after.” Values criteria are ranked below economic criteria. The values come at the end of the process. They get involved once all the other criteria are met. This failure to recall the values throughout the process is a major factor to justify their informal status. The absence of values at some steps of the decision-making process set a risk of

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losing certain values. Therefore, there is a risk of a perceptible difference between the stated values and the values in practice. In this case, the integration of values into the strategic decision-making process involves commitment by the management teams and for top management to start taking ownership. In contrast, observing a very specific case, Islamic banks, allows us to highlight a case where there is a minimal gap between the stated values and the values presented in practice. The main difference from shareholder banks is the presence of a Sharia (Muslim law, elaborated from the eighth to the eleventh century by the greatest scholars of the time) board, at the heart of the institution’s governance. The interviewed stakeholders confirm that Sharia board’s supervision protects the bank. Ethical monitoring is managed by the Sharia board, guarantying constant control at all stages of the process, reflecting an obligation to align values by reminding people of the existence of a filter of values which must not be transgressed and must be taken into account at all levels of the decision-making process. This monitoring is carried out at all levels: a pre-decision check, checks throughout the process, and a retrospective check (Ghares 2013). This very specific case, where a structure dedicated to the values and recognized by all players in the bank, suggesting an adoption of a system is necessary to ensure that values are taken into account. Cooperative banks can be described as an intermediate case between the formal and informal arrangements. Recently, Law No. 2014-856 of 31 July 2014 relating to the social and solidarity economy introduced the cooperative review system (Box 1) with the aim to verify that targeted organizations comply with certain cooperative principles, which are recognized by the representative bodies for this mode of governance. French-specific laws on cooperative sector have introduced the principle of “cooperative review.” It consists of, each 5 years, checking and auditing to ensure that the organization and operation of cooperative companies are compliant with cooperation’s principles and rules as well as the interests of its members. The aim is to screen all the legal, administrative, and governance aspects of cooperatives to check whether they meet cooperative status requirements. This review intends to meet the “best practices” requirements in terms of governance. The auditors are appointed at the general assembly, in charge of preparing an engagement letter including observations and recommendations, shared to the members at the general assembly. We have also observed the presence of mutualist committees within federations of cooperative banks representing regional institutions at the national level. To some extent, these federations counterbalance decisions made by the central bodies. Thus, federations are asked to decide on the approaches adopted at the group level. Observing the working methods of these cooperative groups shows that executive directors at regional institutions are generally in working groups of federations and they are the ones who have the power push through certain decisions. This is why we describe this governance model as an intermediate approach to taking values into account, because its effectiveness also depends on the ownership of cooperative

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values by the managers. Hence, the question is how to strengthen this ownership in order to achieve a balanced consideration, taking into account performance issues and cooperative and social principles.

Conditions of a Real Consideration of the System of Values Questions about respecting values to permeate an organization as a whole must begin at the highest level of governance. For instance, custodians of values systems who are above all the boards of directors must be the ones to guarantee the implementation of these systems. In a cooperative bank, the directors are customers. In other forms of cooperatives, they might be employees or producers who decided to pool resources and expertise in order to strengthen their positions in a competitive environment while remaining fundamentally attached to compliance with certain practices, not paying shareholder shares and implementing a greater degree of solidarity among themselves and with the rest of society. Like in Islamic banks, but also in shareholder banks where CSR is really a deep involvement through dedicated committee at the board level, it’s at the board of directors and executive committee level that dissemination of values takes place. Directors should strongly believe on the values of this model. However, they should also communicate this to executives; otherwise, there will ultimately be friction between the financial logic and the CSR logic, illustrated by the governance bodies’ failure to stick to operational decisions or an operational functioning that is not in line with fundamental concerns of the members of the cooperative. This gap is also amplified by the complexity of the banking business, in which directors with different levels of expertise put them on an equal footing with managers.

The Role of Governance in Strengthening Strategic Decisions The role of governance bodies, executive directors, and supervisory committees is central to the internal monitoring system implemented by institutions. The matter with the quality of governance is not solely related to monitoring issues, but also reinforces its influence on the contribution to strategic decisions and setting the level of risk-taking. This trend is the result of criticism from the authorities of the passivity of governance bodies (boards of directors and supervisory committees) with regard to controlling the risk-taking of the institutions where they were theoretically supposed to provide supervision. Although cooperative banks, particularly in France, will correctly point out that they are not responsible for the financial crisis and that they take fewer risks than conventional banks, the regulatory and supervisory authorities do not intend to put in place a framework on this specific case. The governance requirements are in regulators’ agenda for over 5 years and are fully in line with Basel 3. They have generally been taken up by the European Banking Authority (EBA) since 2012, which under CRD 4 (Art. 91-12) was officially appointed to suggest guidelines regarding competence, experience, and

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integrity of board members as well as main executives (management body). These guidelines are now known collectively as “fit and proper.” The authorities are also aware that administrators (the representative of owner customers in cooperative banks) have not always been able to perform their expected role due to a lack of financial skills, particularly in risk exposure. Risk policy is an area in which expression of values can be seen most clearly, but in a differentiated manner. • On one hand, cooperative banks are expected not to take undue risks in their financial activities involving retail debt or management of their own accounts. As a result, banks that used their own funds to make money caused lots of trouble during the crisis. • On the other hand, given their local commitments and their desire for proximity, one could expect them to take a credit from local players who might appear riskier. At the very least, if they do not take on greater risk than conventional banks, they expect to be more considerate when dealing with struggling borrowers. Assessing this type of situation requires that directors should have the ability to assess “financial/economic filter,” to evaluate manager’s decisions. We have already created conditions to develop this knowledge and an ability to challenge the managers on financial issues (Lamarque 2018). The proposal we made involves promoting the creation of boards that are “balanced” in terms of skills and expertise: the goal is to think of boards as collective structures, with complementary expertise and collective responsibility for the made decisions. This also calls for a diversity of expertise. Members of specialized committees (audit, risk, remuneration, etc.), even from different business sectors, have specific skills on in these areas. Having only specialists in banking and insurance or financial markets on boards is not desirable, nor is it explicitly required by regulators, and there is no guarantee of the quality of decision-making. However, regulators expect both “a rigorous process for identifying, evaluating, and selecting future directors” and “appropriate planning for the replacement of board members” (BCBS on Bank Corporate Governance, July 2015). The idea is to form boards bringing together varied expertise and experience with relevance to the governance of financial cooperative. The Basel texts also present a fairly long but not exhaustive inventory: capital markets, financial analysis, financial stability factors, financial reporting, IT, strategic planning, risk management, compensation, regulation, corporate governance, and managerial skills. With regard to cooperatives, we can add at least cooperative or CSR values and societal commitment, to cite relevant examples. From an educational and skills-building point of view, and in line with complexity and diversity of the addressed topics, efforts at education have had a limited impact. Admittedly, the board members have increased their knowledge on a range of subjects. They can access to educational materials, but the regulatory authority refers to the ability to “challenge” managers. Spending 2 days on a topic before returning to one’s usual affairs cannot produce that level of confidence or expertise.

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The directors have to spend an enormous amount of time going over training courses individually and should refer to them when it comes to assess documents. In the future, before even thinking to appointing a particular member as a director, we suggest establishing a standard board of directors or supervisory committee structure, which lists a diverse skills set required for its proper functioning and on which we would like to be able to refer to when it comes to helping cooperative meeting challenges and regulatory constraints. This should also consider other diverse sociodemographic factors. This proposal is based on the idea that the only way to balance discussions between boards and executive managers is to recognize the expertise of the boards in areas other than customer expectations or expression of cooperative and CSR values. Otherwise, the “gulf” which sometimes separates directors from executive managers will persist and continue to increase the risk of a discrepancy between observed practices and the stated values. This applies at all levels of the organization, starting with distribution channels, which often feel they have to reach required objectives that, and do not understand how they, can play on the cooperative dimension to differentiate themselves. (Practical suggestions were made in the context of a publication (Lamarque 2018). Some of the passages from this paragraph were developed in that chapter, published in English.)

Ensuring that Boards Are Able to Make a Real Impact in Terms of Referencing Values Besides the configuration of board members and directors’ profile, the question arises of the boards’ work, their effectiveness in monitoring decisions, and above all their ability to contribute and make decisions while asserting their cooperative convictions. Furthermore, in the most critical situations, executives are alert to accelerate their response to undertake necessary measures. After discussing the professionalization of directors, we are now targeting the professionalization of the board’s operations. The role of the chairman consists essentially of organizing discussions, speaking opportunities, and ensuring that everyone’s contribution is respected. The implementation of explicit processes around organizational methods (agendas, deadlines for documents submission, structure of documents, etc.) is an area of focus. In all these areas, we can see that professionalism has increased. However, is the values filter fully integrated into the processes? Is a board able to implement, at its level, both the financial filter and the values filter as described in the first part of this chapter? Where this is the case, a single structure can steer the two aspects of the decision-making process. Under pressure from regulators, boards who have made progress on increasing banking expertise are not on an equal footing with the operational managers, and discussions between equals cannot really take place. The perspective they can offer is more focused on cooperative values. These latter considerations lead to consider a final proposal with the aim to ensuring respect for the fundamental values of cooperatives and meeting requirements of professionalization of banks’ governance bodies. It supports the idea of

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implementing an instrument for monitoring compliance with values, as we have seen in other types of banks. This would entail the creation of a joint governance structure, featuring two types of boards: • A board of expert directors, possibly categorized as “banking,” based on the classic principles of a business in terms of the number of independent directors, profiles, and collective expertise. If professional certification of bank directors were ever to become the industry standard, this would no longer conflict with the rules and principles of cooperative status. The scope of responsibility would be clearly defined in terms of monitoring and the scope of proposals to be made in the areas of strategy or risk management, or any other subject defined as falling within its purview. The subjects over whom it will have final decision-making power and the subjects where it will have only the power to make proposals must be clearly established. – A cooperative/CSR board composed of member directors: a body that will ensure compliance with the cooperative/CSR principles and values before making the final decision. This will enable taking into account the customer shareholders concern, like the board members. The role and the scope of its powers in decision-making processes related to addressed subjects that should be clearly defined. We believe that such a mechanism is likely to ensure compliance with both technical requirements and cooperative/CSR principles and to genuinely give the governance structures the legitimacy, say in the decision-making process, the only way to make them accountable. The challenge is to upgrade the decision-making playing field, so that one aspect does not prevail over the other. We also seek to ensure that the two decision-making filters are balanced. We recognize the operational challenges of implementing such a mechanism, but we also note that some examples of this approach exist and involve a joint participation in decision-making processes. The Desjardins cooperative bank in Quebec, for example, had for long a board of directors and a supervisory committee, although they have similar purviews. (Desjardins is a movement of cooperative banks that had developed in Quebec in 1900 by Alphonse Desjardins. The aim was to facilitate access to saving and credit for an excluded population. The Desjardins caisses have their origins in approach motivated by the Christian religion.) Many cooperative banks have dedicated committees, separate from the boards, consulted during or involved in decision-making. At some like Islamic banks, they built strong identity and specific values, where coexistence of a board of directors and Sharia board is having real power over the made decisions. Furthermore, the increasing numbers of traditional banks have created committees within their boards of directors that specialize in corporate social responsibility (CSR committees). This also demonstrates a genuine or ostensible desire to show that directors are considering values associated to this positioning. However, if we want this to be more than a marketing campaign, it is important to set up a mechanism to monitor compliance with values.

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For a successful values approach that would attract the attention of senior managers and increase their willingness to integrate them into their work, a dedicated entity can be effective. This makes it possible to monitor references to values and penalize non-compliance, as non-compliance can damage the reputation of the company and its brand image. In our case study, the explanation for Islamic banks’ or cooperative banks’ apparent immunity to the 2008 crisis lies in their ongoing reference to their values and the strong power of the body that monitors compliance with said values. The fact is that the monitoring of values compliance at Islamic banks is stronger at the technical level. This must be combined with commitment of the management teams to bringing the values to life in their strategic practice. Finally, we observe that for a better integration of values into managerial actions, it is important to formalize these values. By comparing Islamic banks, cooperative banks, and traditional banks, we note that the Islamic bank gives values a central role because they are integrated into a formal structure and there exist an effective system for controlling and monitoring the application of these values.

Conclusion In addition to mentioning the role of values in strategic decision-making processes, we wanted to come up with proposals to be discussed and debated by stakeholders and by regulators, in the sector. While some aspects of their operational implementation have been mentioned, it is obvious that there exist real organizational and psychological obstacles. These proposed approaches in a context where the regulatory requirements of the banking profession and the strengthening of cooperative principles are clearly opposing forces. We believe that defending cooperative structures by simply asking the banking regulators to adapt the rules or even to exempt cooperatives from certain obligations is futile. It is more constructive to draw up proposals to change the cooperative governance model to preserve its fundamental values. Nevertheless, there is another area that should be considered besides the strong values we are discussing. This is the balance that the bank should maintain between mentioned values and its earning capacity, in the interest of all stakeholders. Islamic banks are subject to shareholder, partnership, and religious rules. Strategic decisions are defined and implemented by a joint body, board of directors and Sharia board, in order to meet the economic and socioreligious demands. The Sharia board must opt for decisions in line with the values, and the board of directors must opt for costeffective decisions; the director is subject to monitoring on both these levels when implementing strategies. The management method is designed around a participatory partnership seeking the best outcome for all stakeholders. These banks, focusing on the stakeholders, seek to ensure social well-being and development, which gives them moral, sociopolitical, and practical legitimacy. At cooperative banks, we sometimes observe that economic efficiency remains a major driving force, to the point where they risk deviating from the decisions that

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we would have expected to see they strictly complying with the model’s values. Few structures we assessed are prepared, in an objective and even controlled manner, to accept a drop in economic performance in exchange for better societal performance, given that this social performance is still broadly undefined. With regard to traditional banks, the board of directors is an essential mechanism of control for the director’s decision-making. It plays this role for managers, while simultaneously seeking to align their interests with the bank’s interests, which raises the question of the compatibility between the bank’s interests and the social legitimacy they would like to develop. This approach explains the practical legitimacy of implementing values committee for this type of bank, which would allow them to maintain other types of values that reinforce other types of legitimacy, such as social or moral legitimacy. Ultimately, values are a strategic element for organizations, and they inspire the principles of management; this reconciliation between values and strategic decisions eliminates any argument that values impede strategic decision-making. Although currently there exists a deep confusion around values due to the dominant focus on economic issues at the expense of social issues, financial crises generate a significant advance for values by stripping them of cultural frustrations, particularly when it comes to strategic management of banks. With this coexistence of financial and non-financial criteria, it becomes imperative to manage the contradictory processes. To deal with this type of situation, banks must demonstrate the flexibility and adaptability, necessary to manage certain contradictions. In addition we consider that it is at the governance level that people have to manage systematically the coexistence of financial and ethical objectives. Several analysis and proposal developed in many chapters of this book are directly related to the influence or decisions taken or able to be taken at the top of the bank. The application of code of ethics (chapter ▶ Financial Institutions and Codes of Ethics), the real influence on manager decisions and bank management (chapter ▶ Ethics as a Solution to Fraud in Commercial Banks in Uganda), or the official role to define and vote executive compensations (chapter ▶ Ethical Responsibility of Financiers) are decisions and practices in which member of board are directly involved or should be involved. In fact, the problem of many governance structures in banks comes from the poor influence, and sometimes the low implication, of board members in decision process. Often the power is in the hands of manager, and contribution of boards is very weak. So, our contributions, as many ideas proposed in this handbook, are all the more likely to occur if governance structure and board members really have the independence, the skills and the will to clearly consider ethic issues as fully part of financial decision.

Cross-References ▶ Ethical Orientation in Banks ▶ Financial Institutions and Codes of Ethics

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References Allport GW, Vernon PE and Lindzey (1960) A Study of Values: A Scale for Measuring the Dominant Interests in Personality. Houghton Mifflin Harcourt, Boston Aliouat B, Nekka H (2011) Identité, valeurs et légitimité au sein des pme algériennes: une approche conventionnaliste de leur réussite en milieu hostile. Bus Manage Rev 1(2):48-71 Basel Committee on Banking Supervision (2015, July) Guidelines Corporate Governance Principles for banks Bayle E, Mercier S (2008) Sport et éthique: enjeux et outils pour le marketing sportif. Rev Française Mark 219(4/5): 9–26 Boltanski L, Chiapello E (1999) Le nouvel esprit du capitalisme. Gallimard, Paris Capron M, Quairel-Lanoizelé F (2007) La responsabilité sociale de l’entreprise. Editions La Découverte, Paris Chédotel F, Pujol L (2012) L’influence de l’identité sur la compétence collective lors de prises de décision stratégiques – résultats d’études de cas. Rev Finance Contrôle Stratég 15(1/2) Davies G (2001) E-reputation: the role of mission and vision statements in positioning strategy. J Brand Manage 8(4):315–333 Donaldson T, Preston LE (1995) The stakeholder theory of the corporation: concepts, evidence and implications. Acad Manag Rev 20(1):65 European Banking Authority EBA (2012) Guidelines on the assessment of the suitability of members of the management body and key function holders:Article 91 (12) of Directive 2013/36/EU (CRD) and Article 9 of Directive 2014/65/EU: https://eba.europa.eu/eba-andesma-provide-guidance-to-assess-the-suitability-of-management-body-members-and-key-function-holders Gabriel P, Cadiou C (2005) Responsabilité sociale et environnementale et légitimité des entreprises: vers de nouveaux modes de gouvernance? La Revue des Sciences de Gestion 211–212: 127–142 Ghares M (2013) La place des valeurs dans la prise de décisions stratégiques: une étude comparative entre banque islamique et banque classique. Thèse de doctorat Guth WD, Tagiuri R (1965) Personal Values and Corporate Strategy. Harvard Business Review 43 (5):123–134 Jeavons TH (1992) When the management is the message: Relating values to management practice in nonprofit organizations. Nonprofit Management and Leadership 2(4):403–417 Jurkiewicz CL, Massey TK (1998) The influence of ethical reasoning on leader effectiveness: An empirical study of nonprofit executives. Nonprofit Management and Leadership 9(2):173–186 Jurkiewics CL, Massey TK, Brown RG (1998) Motivation in public and private organizations. Public Product Manage Rev 21(3):230–250 Lamarque E (2008) L’influence des valeurs liées à la RSE sur les décisions stratégiques des firmes: les cas des banques mutualistes. In: Dion M, Wolff D (eds) Le développement durable: théories et applications au management. Dunod, Paris Lamarque E (2018) The governance of cooperative banks: main features and new challenges. In: Migliorelli M (ed) New cooperative banking in Europe: strategies for adapting the business model post crisis. Springer, Cham Lamarque E, Alburaki S (2007) La place des valeurs dans la gouvernance de l’entreprise: le cas des banques mutualistes. Rev Française Gouvernance d’Entreprise (1):135–151 Meyer JW, Rowan B (1977) Institutionalized organizations: formal structure as myth and ceremony. Am J Sociol 83(2):340 Pant N, Lachman R (1998) Value incongruity and strategic choice. J Manag Stud 35(2):195–212 Pesqueux Y, Biefnot Y (2002) L’éthique des affaires, Management par les valeurs et responsabilité sociale. Editions d’Organisation, Paris Rouleau L (2007) Pour une approche globale des fondements des théories néo-institutionnelles. In: Théories des organisations. Presses de l’Université du Québec, Québec

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Ethics of Bankruptcy Creditor Unai Olabarrieta, Andre´s Araujo, and Leire San-Jose

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Main Text . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Problem of Corporate Insolvency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Problem of the Efficiency in Insolvency Resolution Methods . . . . . . . . . . . . . . . . . . . . . . . . The Debtor’s Delay in Facing the Solution to Their Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses Caused by This Circumstance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proposals from a Business Ethics Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

The quality of insolvency regulatory frameworks is a determinant of a country’s economic competitiveness, achieving an efficient restructuring framework is a constant concern of those responsible for economic matters. Despite this, there are no statistical data to help elucidate the phenomenon, and we are unable to accurately determine the degree of efficiency of bankruptcy proceedings. Twenty-nine changes in bankruptcy legislation have occurred in Spain since 2003. However, the judicial process is still seen as inefficient and its use is marginal. As we will analyze throughout the chapter, the number of insolvency proceedings is significantly less in Spain than in neighboring countries. Analyzing the efficiency of our bankruptcy processes and how to improve the system is an urgent need. The companies that U. Olabarrieta (*) · A. Araujo Universidad del Pais Vasco UPV/EHU, Leioa, Spain e-mail: [email protected]; [email protected] L. San-Jose Universidad del Pais Vasco, Leioa, Spain ECRI Ethics in Finance and Social Value Research Group, University of the Basque Country UPV/ EHU, Bilbao, Spain e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_16

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declare themselves insolvent in the judicial framework come late, a circumstance that is observed due to the patrimonial situation in which they go to the process, with negative own funds. We must approach the problem with ingenuity and new perspectives, analyzing the ethical repercussions of this delay and proposing solutions not from legal duty, but from ethical duty. Keywords

Bankruptcy · Business ethics · Zombie companies · Business crisis · Business failure

Introduction When a debtor realizes that it is impossible or complicated for him/her to face his/her payment obligations regularly or imminently, legislation provides for a series of mechanisms to solve this situation. The legal mechanisms for resolving the debtor’s insolvency have two sides. On the one hand, they constitute a right that the debtor has to resort to this mechanism as a way of sustaining the activity while addressing the solution to their situation through an agreement with their creditors to negotiate the new payment conditions for their debts. On the other hand, they constitute an obligation for the debtor since they are not the only one affected by the debtor’s insolvency. In the proper insolvency resolution, there are many affected persons who are interested in its efficient resolution: employees, financial creditors, commercial creditors, the public administration, among others. We can point out here that from the perspective that the organization is constituted not only by the shareholders but by a set of stakeholders, the legitimacy, and therefore, the duty and responsibility should be given to all stakeholders. The Spanish bankruptcy system (Gómez and Sánchez 2018); Paule-Vianez et al. (2019) shows us that the debtor delays in using the legal resources at his/her disposal, as is shown by the financial situation of the debtors at the time of requesting any protection or resolution mechanism and the existence of multiple concluded insolvencies that do not go through commercial courts. The data collected in the studies carried out shows us that close to 50% of the companies resort to judicial protection with negative own funds in the accounts of the previous year to request the contest. This leads us to think that at least they were insolvent a year before going to bankruptcy, which has taken more than a year to face the solution that the law provides. Regardless of sanctions or responsibilities that the law may foresee for this situation, we consider that the conduct may be reprehensible from an ethical perspective and we must approach its study also from this dimension. Together with this circumstance, we must highlight that the use of the judicial process is marginal in Spain compared to other countries in its environment. In 2018, in the United Kingdom there were a total of 17,439 insolvency resolution legal proceedings, 54,627 in France, in Spain only 4,131. Smaller countries than Spain present a greater number of judicial processes: Portugal 5,888 and Denmark 7,155. Analyzing the efficiency of our bankruptcy processes and how to improve the system is an urgent need.

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This situation worsens the competitive position of our country at an international level; the way in which each country solves insolvency problems is an important component of its level of competitiveness, as evidenced by the Doing Business report prepared annually by the World Bank. In the case of Spain, also as part of the European Union, the proper functioning of the internal market and freedom of movement of capital and establishment require an efficient insolvency resolution framework, as evidenced by the legal reasons of Directive 2019/1023 of June 20, 2019. The explanatory memorandum of the proposed Directive itself states that “the proper functioning of an insolvency framework is an essential element in creating a business-friendly framework, as it supports trade and investment, contributes to the creation and maintaining employment, and helping economies to cope more easily with economic crises, which generate a high level of non-productive loans and unemployment. These are the main priorities of the European Commission.” A national insolvency resolution framework can be a deterrent to international investment and the cross-border expansion of economies. The efficiency and continuous improvement of the problem-solving framework must constitute a strategic axis of the economic policy of any economy. The delay in the implementation of the mechanisms of resolution of the business crisis causes system inefficiencies, inefficiencies that take the form of reduced credit recovery rates by creditors, as well as the loss of innumerable jobs, and consequent loss of the productive fabric, as we will later quantify and analyze. It is also relevant to note that the procedure itself is slow. According to the report of the European Union that highlights the need to harmonize the insolvency settlement system in the different European countries in 50% of the member states, the insolvency settlement process requires two to four years. The duration of the process is an important factor in measuring the efficiency of the system and can also determine lower recovery rates. Recovery rates in the European Union vary between 30% in countries like Croatia and Romania and 90% in countries like Belgium or Finland, as the aforementioned report shows. Debtors must be aware of their obligation to resort to the legal mechanisms for resolving insolvency above the right of protection that they may entail, but regardless of the penalties or responsibilities that this delay may cause, and much more than that, they must approach it responsibly for the losses it may generate to the system whose quantification we will try to approximate in this chapter. Traditionally, legislation provides sanctions for those who breach their obligations. In the case of the insolvency of a company, it is mandatory to go to the legal solution. Failure to comply with this obligation may cause civil liabilities for those responsible, usually the company’s administrators. Spanish law establishes that failure to comply with this obligation may entail compensation for damages caused to the social administrator or even joint and several liability for the debts generated. Despite this, it seems that the existence of this coercive threat is not effective. Many insolvencies are solved outside the legal mechanisms provided. This imposes us to look for imaginative and innovative solutions. In our chapter we propose to approach the problem from an ethical perspective that tries to encourage the insolvent debtor to go to the legal mechanism in time.

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Main Text The Problem of Corporate Insolvency Insolvency arises when a debtor is unable to pay his debts with the flows that he generates in his daily activity, and it becomes necessary to reduce the debt, delay its maturity, or use some or all of its private assets to confront the debts. For some authors, the insolvency of the company and its eventual bankruptcy represent a paradigm of business failure (Pozuelo Campillo et al. 2009). The scientific community has strived to design models that can help predict business failure to avoid failure or try to detect insolvency in the early stages (Mora Enguídanos 1995; Pozuelo Campillo et al. 2009; James 2016). Business insolvency generates large economic losses, but not only to the debtor. It also causes losses to its creditors and to the entire national economy, which generates considerable social and economic costs. The commercial laws of all States provide formulas and procedures to resolve the debtor’s situation with a greater or lesser degree of judicial protection and intervention in the debtor’s powers and his/her ability to act. The explanatory memorandum of the Directive of the European Parliament and of the Council 2019/1023 states that the proper functioning of an insolvency framework is an essential element to create a favorable framework for companies, since it supports trade and investment, contributes to the creation and maintenance of employment, and helps economies to cope more easily with economic crises, which generate a high level of nonproductive loans and unemployment. In short, we can affirm that business restructuring frameworks constitute an essential element of the competitiveness of an economy and must be exhaustively analyzed to try to provide improvement proposals that strengthen the system. Another recurring aspect analyzed by the doctrine is the analysis of the conflict between the debtor and his/her creditors’ interests. A restructuring or insolvency framework that prioritizes the interests of debtors or creditors has a direct impact on the incentives of lenders to grant loans, access to financing and its costs, or the need for real guarantees to obtain financing (Horst and van Zwieten 2015). The indebtedness of companies constitutes a central theme of the financial economy (Cuñat 1999) and is directly related to business productivity. Hart (2000) shows us that reinforcing creditors’ rights increases the availability of credit and reduces its cost. In a study carried out by Rodano et al. (2016) on the reforms produced in the Italian legislation in the years 2005 and 2006, they concluded that the pro-debtor provisions aimed at increasing the agreements produced an increase in interest rates, the bank credit granted to companies, and a reduction in investment, while those aimed at increasing the rights of creditors in an eventual liquidation procedure had the opposite effect. In other words, different insolvency results are expected depending on the level of protection to creditors provided by the insolvency legislation. Davydenko and Franks (2008) carried out an analysis about the importance of insolvency legal codes for France, Germany, and the United Kingdom, countries

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with very different laws on the matter. The conclusion he draws is that there are important differences in the recovery rates of both, although paradoxically, no relevant differences in financing cost are detected. It also concludes that the control of financial institutions affects the number of insolvencies, and financial institutions with their loan and recovery policy also influence the number of insolvencies. The study carried out by Ponticelli (2012) on the Brazilian reform in 2005 showed that the system reform toward pro-creditor legislation benefited access to financing, improved investment in new technologies, and contributed significantly to business productivity. Vig’s (2013) study indicates that in India the strengthening of collateral creditors’ rights led to companies reducing their volume of collateralized debt, indebtedness, and investment. This study could indicate that credit privileges and their reinforcement affect insolvency. In Spain, the judicial procedures that resolve the insolvency of the debtor are contained in bankruptcy Law 22/2003, of July 9, that has just been reformed by Royal Legislative Decree 1/2020 of May 5 while a health crisis occurs that will surely lead to an unprecedented economic crisis. In this 17-year period between one text and the other, bankruptcy legislation has undergone up to 29 reforms, which have attempted to correct the deficiencies observed in the law (García and José 2018). The main lines of the reforms have been the creation of the figure of the bankruptcy administrator, the reduction of costs and deadlines in the bankruptcy process, as well as generating extrajudicial solutions for the resolution of insolvency (pre-bankruptcy, bankruptcy mediation, extrajudicial agreements). The truth is that none of these reforms follow an accurate and in-depth analysis of the efficiency of the processes or of the proposed solutions of bankruptcy’s reality. Scientific studies of the phenomenon are very scarce and the statistics available in Spain are limited to the description of the bankruptcy. Traditionally, legislation provides sanctions for those who breach their obligations. In the case of the insolvency of a company, it is mandatory to go to the legal solution. Failure to comply with this obligation may cause civil liabilities for those responsible, usually the company’s administrators. Spanish law establishes that failure to comply with this obligation may entail compensation for damages caused to the social administrator or even joint and several liabilities for the debts generated. Despite this, it seems that the existence of this coercive threat is not effective. Many insolvencies are solved outside the legal mechanisms provided. This imposes us to look for imaginative and innovative solutions. In our chapter we propose to approach the problem from an ethical perspective that tries to encourage the insolvent debtor to go to the legal mechanism in time.

The Problem of the Efficiency in Insolvency Resolution Methods The problem of bankruptcy efficiency is scarcely addressed in the economic literature despite its importance, as Hart (2008) has already shown. Insolvency resolution resources can fulfill multiple objectives:

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• That viable companies and entrepreneurs in difficulties can continue their activity. • That businessmen in good faith or over-indebted can enjoy the exoneration of their debts after a reasonable period of time. • Avoid unnecessary liquidation of viable companies. • Avoid loss of jobs. • Avoid loss of knowledge and skills. But there is a primary function that should be above all of them: a debtor is insolvent when he cannot regularly attend to his/her payments. And precisely this should constitute the essential function that informs the others: to maximize the return obtained by creditors. This was formulated by Hart (2008) through a formula that differentiates recovery by restructuring the company or by the liquidation process: E¼

V1  GC þ ðV2  cÞð1  GC Þ ð1 þ r Þt

V1 is equal to the degree of recovery by the creditors in the agreement. V2 is the amount obtained in the liquidation of the company’s assets in percentage terms. GC is a value of 1 if the company restructures and 0 if it is liquidated. C are the costs of the settlement process; t is the duration of the insolvency resolution process and r is the interest rate. Now, it is easy to mathematically formulate the problem of measuring the efficiency of the methods of insolvency resolution, but to obtain real data is not so easy. As we have already anticipated, the statistical data that exists in Spain regarding the efficiency of the process is very scarce. • The World Bank’s Doing Business report puts the recovery rate in Spain at 77.5 (cents per dollar) with an average duration of 1.5 years by 2020. Taking this data into consideration with the formula developed by Hart (2008), we conclude that the level of efficiency of the insolvency resolution process in Spain has an average of 74.13. An apparently high rate. But does it respond to the material reality in Spain? Or is it simply a comparative average with other economies? To respond to this, we seek and reveal other magnitudes that may corroborate these conclusions. • Another statistical study of the reality in Spain is the Bankruptcy Statistics Yearbook developed by the College of Real Estate, Personal and Commercial Property Registrars of Spain, according to its last report (Bankruptcy Yearbook, 2018). This report addresses the recovery of credit in Agreements, as well as the duration of the bankruptcy proceedings, among other issues.

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Regarding Credit Recovery and collection expectations, the report indicates that the recovery of creditors is 75.80% (considering the current value of expected payments as a percentage of their nominal value) when the approval mechanism is an advance agreement proposal and 47.20% when the approval mechanism is a meeting of creditors. In other words, we find real efficiency rates of 47.20 and 75.80, very far from the comparative reality revealed by the Doing Business report. Analyzing the efficiency of the liquidation processes is more complicated since there are no statistics that collect recovery data from creditors. The proposal from the Directive of the European Parliament and the Council on preventive restructuring frameworks, second chances, and measures to increase the effectiveness of remission, insolvency, and restructuring procedures aimed to establish the obligation of States to collect data such as: • The average costs of each of the procedures adjudicated by the court or administrative authority • The recovery percentages for secured and unsecured creditors, separately, as well as the number of procedures with zero or no more than two percent of the total recovery percentage for each of the types of preventive restructuring procedures, insolvency proceedings, and procedures aimed at the full discharge of the debts of natural persons This ambitious initiative was diluted in the text finally approved on March 28, 2019, which in its article 29.3 states that the Member States may collect and add, on an annual and national basis, data on: (a) the average costs of each of the procedures, (b) the average recovery percentages for secured and unsecured creditors and, if there is space for other categories of creditors separately. The Directive shows us that the European Union itself is aware of the difficulty of collecting this data, a difficulty that the signatories of this chapter suffered firsthand when we tried to prepare a survey to analyze the accounting and real values of the assets affected by a bankruptcy procedure as well as their net asset values to calculate the efficiency rates of the means of resolving insolvency in Spain. The study was a resounding failure since the survey was aimed at those who would have the required data, the bankruptcy administrators, and they barely answered despite its ample dissemination. Given the failure of the aforementioned study, we tried to approach the measurement of the efficiency of the bankruptcy process in Spain through the qualitative Delphi method. From the Research Group on Ethics in Finance (ECRI) of the Faculty of Business of the University of the Basque Country, we undertook a study that sought to determine the purpose of the judicial process of insolvency resolution and obtain an estimate of the degree of efficiency of the various methods of concluding insolvency resolution judicial processes. In this study, we estimated the average efficiency presented by the various methods of completing the judicial procedure for resolving insolvency according

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to the criteria of the experts consulted: bankruptcy administrators. The survey was sent to the 300 administrators with the most bankruptcies assigned during 2018, which was extracted from the Official State Gazette. The conclusions are summarized in Table 1. An initial analysis made us wonder about the causes of these low levels of efficiency perceived by those who managed the bankruptcy proceedings and know all the data and details: the bankruptcy administrators. There may be multiple factors that affect the efficiency of the judicial procedures for insolvency resolution, some of them are cited by Ramos and Amorrich (2012), who in their report indicate some reasons that could cause these circumstances: 1. The lack of agility of the liquidations, so that the value of the assets can be maximized, achieving greater creditor satisfaction, and promoting the sale of assets in the initial stages of the bankruptcy procedure, especially the sale of productive units. 2. When judicial bodies and insolvency administrators move quickly, the liquidation and adjudication processes, especially for operating businesses, can be accelerated with more optimal results. 3. The lack of specific training of some bankruptcy administrators. The lack of specific knowledge generates more waiting and unnecessary paperwork. 4. The lack of an Institute for the accreditation of certain legal professions, among which would be that of bankruptcy administrator and that of independent expert of article 71.6 of the bankruptcy law. All of these circumstances cause the debtor to use the insolvency resolution mechanisms late and this generates less efficiency of the process as we will analyze below, and is what the doctrine comes to call ex ante effectiveness (perception of process efficiency).

The Debtor’s Delay in Facing the Solution to Their Problem The low efficiency and poor protection of creditors in the Spanish insolvency system (see Gurrea Martínez 2016a) has led to a significant number of insolvencies being resolved outside the bankruptcy procedure, especially through the mortgage system. This circumstance caused company’s overinvestment in real estate (García Posada 2013). The question is, how can show that companies are late to use the resolution mechanism for their insolvency situation? Through two indicators, first: the number of insolvencies that do not go to bankruptcy proceedings, but that other procedures do reveal; and second: the deteriorated situation in which these companies go to bankruptcy proceedings or other means provided in bankruptcy legislation.

Source: Authors’ own

Solvency recovery Refinancing Agreement Agreement approval Liquidation with sale of production unit Debtor liquidation Resolution due to insufficient overall assets Simultaneous opening and resolution

Form of resolution

Efficiency Mean 70.33% 68.67% 57.00% 45.00% 27.33% 18.00% 17.33%

Table 1 Efficiency of the methods of bankruptcy resolution Mode 100.00% 100.00% 50.00% 40.00% 20.00% 10.00% 0.00%

Average 95.00% 70.00% 50.00% 40.00% 20.00% 10.00% 0.00%

Variance 1540.95 737.38 881.06 372.73 620.95 492.14 724.52

Standard deviation 39.25 27.15% 23.28% 19.31 24.92 22.18 26.92

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Table 2 FOGASA filing ratio/number of bankruptcy proceedings Years FOGASA companies affected by labor contracts FOGASA companies affected by bankruptcy FOGASA/bankruptcy filing ratio

2019 16,457

2018 17,714

Affected companies 2017 2016 2015 19,255 28,416 27,618

2014 39,050

2013 22,127

3011

3495

4311

7150

8128

10,233

6236

5.46

5.06

4.46

3.97

3.39

3.81

3.54

Source: Statistics from the Salary Guarantee Fund

Insolvencies That Do Not Go to the Judicial Process If we look at the number of insolvency cases processed by the Salary Guarantee Fund between the years 2013 and 2019 (see Table 2) we see that there are many more companies in insolvency than those that go to bankruptcy proceedings, but we also observe an even more troubling ratio and that is that this relationship is ascending, there are more and more insolvencies that do not use the legal mechanisms established for their resolution: The Salary Guarantee Fund (FOGASA) pays certain debts held by the debtor to its workers, subrogating it when the company becomes insolvent. In 2013, we observed that 21.98% of the payment of benefits made by FOGASA correspond to companies in bankruptcy proceedings, while the remaining 78.02% are benefits for companies declared insolvent outside commercial courts. This same magnitude referring to the 2019 financial year shows us that there are more and more FOGASA files that are not produced in the context of a bankruptcy. Specifically, 15.46% of bankruptcy filings, compared to 84.54% of other types of insolvencies. In other words, it is not just that there are a large number of insolvencies that are not resolved in the commercial courts, but that there are more and more, constantly increasing in ratio. This could lead us to think that despite all the reforms carried out in the insolvency resolution system and that we have previously mentioned, the truth is that it is still not considered as an efficient way of solving the problem since its use is marginal for insolvencies. Financial Position of Companies That File for Bankruptcy The aforementioned study by the College of Registrars (Van Hemmen 2019) analyzes the solvency of companies in bankruptcy from four ratios: the first one relates long-term financing to total assets, the second relates material and financial fixed assets to total assets, the third analyzes the ratio between the required liabilities and the total assets, and finally the ratio between reserves and total assets.

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The study’s conclusions are clear and alarming: • 41.60% of the bankrupt companies presented negative own funds in the year prior to the filing of the request for bankruptcy, that is, they go to the crisis resolution mechanism when asset destruction has been complete. • 50% of the analyzed sample accumulates a total liability close to the value of the asset, presenting a leverage ratio of 95%.

Spanish Debtor Companies Use the Legal Mechanisms Late This aforementioned situation shows that the Spanish debtor companies use the mechanism that the law provides to overcome insolvency late or simply do not go at all. This circumstance has a direct impact on its efficiency: the later the problem is solved, the lower the degree of efficiency of the mechanism (Hart 2008). Remember that efficiency is an indirect function of the time it takes to resolve insolvency and pay the creditor. For this reason, it is essential that companies, faced with their imminent or current default situation, resort to the appropriate means of resolving this, as it is an indisputable way of improving efficiency. Companies in the described situation, with negative own resources that consciously delay the decision to resort to legal mechanisms, reveal a case of moral hazard: they do not have the capital, and the funds with which they carry out their activity comes from third parties; shareholders are not taking additional risks on their decisions while their creditors are not aware of this situation; conscious creditors (e.g., financial creditors) require partners to provide additional personal or mortgage guarantees or guarantees outside the debtor’s assets, guarantees that harm the par conditio creditorum that should inform the insolvency resolution instead of giving priority to some more informed creditors than others. Leverage decisions in a current or imminent insolvency situation increase the risk of third parties without increasing or limiting the debtor’s. This situation cannot be addressed according to the paradigm of traditional Theory of the Firm (San Jose and Retolaza 2012) and remains hidden in most investigations, so there are no studies to address it. The problem is much more serious than indicated, since many debtors artificially hold their own funds with items such as intangible assets, inventories, or debtors that, if valued at their real market value, would lead the company to present negative own funds.

Losses Caused by This Circumstance We do not intend in this chapter to address all the variables covered by the current study, but it does allow us to advance some initial conclusions that we can later contrast with statistical robustness, conclusions that are already gaining relevance and robustness.

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It could be analyzed the bankruptcy proceedings to show and highlight the problem that carried out not only economical issue but also ethical ones. The selected data was based on bankruptcy proceedings concluded in January 2016. It is necessary to understand that the bankruptcy proceedings are not all the same. Then, a process under the current bankruptcy law can be concluded with a refinancing (a restructuring validated by the judicial body), an agreement (restructuring achieved within the judicial process), liquidation (sale of the company’s assets to pay the credits to creditors), and can conclude simultaneously with their declaration of insufficient assets when the application itself shows that the company does not have assets. Based on this classification, it has been analyzed the reality of the bankruptcy proceedings completed in the period of time outlined and that specifically applies to the subject of this chapter (Table 3). The truth is that the descriptive reality can rarely be so clear and allow us to extract reflections with less data: • The bankruptcy process solution seems to be directly related to the size of the company. The companies that resolve their insolvency through the refinancing mechanism are larger, while those that open and conclude the insolvency proceedings in the same act are the smallest. • The existence of negative own funds also seems to be directly related to the method of resolving the bankruptcy proceedings, which we recall is directly involved in the solution’s degree of efficiency. • The data obtained and the magnitudes of the companies in bankruptcy proceedings correspond to the Annual Accounts deposited in the Mercantile Registry prior to the judicial decree of insolvency, and in some cases it may be more than a year from the date of the application for the bankruptcy creditors, which makes us think that they could have requested the bankruptcy in an even more compromised patrimonial and financial situation. Presenting this data allows us a new exercise that, at least, can bring us closer to the losses that this situation can generate and reveal the magnitude of the problem at hand by applying the efficiency levels that we had estimated through the Delphi Method of each of the methods used for concluding the bankruptcy, which ultimately suppose what the creditors recover. Since we know the liabilities of the affected companies we can estimate the amount of credits that they lose, in addition to the assets impairments since in the liquidation the creditors recover their credits from the sale of the assets of the debtor company and not from the flows generated by its activity, unlike what happens in refinancing or in the agreement where the generated flows will be used to pay creditors while the company keeps the assets (Table 4).

Proposals from a Business Ethics Perspective The reality described seems to show that the companies do not resort to the legally established mechanism to resolve their insolvency, and when they do, they are in

165

22

Liquidation

Opening and resolution TOTAL

Source: Authors’ own

208

6

Method used Refinancing agreements Agreement

No. processes 15

Total assets € 331,167,138.00 € 29,160,057.00 € 493,544,662.00 € 12,412,652.00 € 866,284,509.00 € 315,351,675.00

€ 148,542,470.00 € 8,270,970.00

Liabilities € 148,542,470.00 € 9,995,765.00

3858

132

2597

94

No. of employees 1035

Table 3 Bankruptcy proceedings concluded in January 2016 accumulated data

72.73%

60.00%

16.67%

% Negative Companies Own Funds 26.67%

€ 4,164,829.37

Average asset € 22,077,809.20 € 4,860,009.50 € 2,991,179.77 € 564,211.45

€ 1,516,113.82

6

€ 375,953.18

18.54807692

15.66666667 15.73939394

Average employees 69

Average Liabilities € 9,902,831.33 € 1,665,960.83 € 900,257.39

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Table 4 Estimation of losses and impairment of assets Method used Refinancing agreements Agreement Liquidation Opening and resolution TOTAL

Process efficiency 68.67% 57.00% 27.33% 17.33%

Losses for creditors € 46,538,355.85 € 4,298,178.95 € 107,945,812.95 € 6,837,610.90

Impairment of assets €0.00

Impairment percentage 0.00 %

€0.00 € 385,598,849.05 € 5,575,041.10

0.00 % 78.13% 44.91%

€ 165,619,958.65

Source: Authors’ own

such a deteriorated situation that the legal mechanisms for solving the problem are absolutely ineffective, condemning the debtor to liquidation. The question we must ask ourselves is why this situation occurs? The authors indicate that the perception of ex ante efficacy causes the debtors to not resort to the protection of the bankruptcy law because they consider that it is not an effective solution to the problem. Now, let us remember that bankruptcy law is the only protection mechanism or way of solving the problem that the legislation provides. We must make the process efficient and also get the debtor to use it. A law sometimes is not enough, because unethical practices make it possible to obtain higher returns; those who do not start the bankruptcy on time maintain the reputation, activity, and many times the short-term returns. The bankruptcy process only is efficient if is start soon enough to be able to make decisions to fix the financial situation (Boatright 2013). Some authors begin to indicate (Gurrea Martínez 2016b) that there are mechanisms or processes within bankruptcy law that cause the debtor’s reluctance to resort to this mechanism: bankruptcy qualification or reintegration actions. Bankruptcy qualification exists in our commercial law since the Bilbao Ordinances of 1737, source, and inspiration of current Spanish commercial law. The qualification consists of the bankruptcy administrator analyzing the causes of the insolvency, proposing to the judge his/her consideration of unforeseeable or negligence, indicating, where appropriate, the person or persons responsible for the insolvency, as well as the possible economic consequences of that responsibility: full or partial coverage of the deficit generated or compensation for damages. The law foresees that this qualification phase occurs in the proceedings that are solved through the liquidation of the debtor or when the removal or waiting of the agreements exceeds certain thresholds. According to Gurrea Martínez (2016b), the qualification could encourage unviable debtors to undesirably avoid or postpone going to the process or the legal mechanisms for resolving insolvency. At the very least, we should study whether this is the reason why debtors do not resort to legal solutions, trying to avoid the uncertainty of possible responsibilities at the qualification office. The truth is that this new perspective can be interesting from an ethical perspective. The unethical behavior of debtors that delay the bankruptcy process even though they are aware of

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the situation, involve negative externalities that probably affect negatively third parties, and the whole economic system. Probably it benefits short-term results, but in the long term, all stakeholders suffer. Then, an efficient regulation should avoid this unethical behavior, at least in part, and being a priority. From an ethical perspective, result of regulation, all over the world, will support the debtor decision to short this process as much as possible for a common good. However, it is not only responsible the law, but also the culture and society. Then, they are important issues that must be properly dealt with, for instance, abuses of debtors that consciously they go bankrupt late, they try to avoid their responsibilities, actuations from each own benefits, and lack of transparency in the establishment of situation of organization related to the financial resources or economic activity, among others. Recurring to legal mechanisms for resolving insolvency is a debtor’s right; the legislation articulates mechanisms and procedures so that if the debtor’s business activity is viable, it can continue the activity and overcome the insolvency situation (bankruptcy mediation, judicial validation of a refinancing agreement, bankruptcy itself, etc.). But we must not forget that it also constitutes the debtor’s obligation, since the right of creditors to collect their credits under par conditio creditorum must also be protected in an orderly process of agreement or liquidation. The mandatory rules contain sanctions for the event of noncompliance, in this case, bankruptcy legislation provides that the debtor who does not correct his insolvency within the period provided by law may incur liabilities by declaring the bankruptcy negligent, which may carry the sanction of covering the bankruptcy deficit, that is, the part of the debt that remains uncollected, by whoever is responsible for the delay. Usually the social administrator, de facto or de jure. Then, the system is established, but the culture of acting under these conditions of the law that control delays in starting bankruptcy proceedings is not ingrained. It is accepted as unethical behavior, the regulation has developed the system to control it; however, the analyzed results and our expertise in this type of processes do not confirm that this is widely spread. It is a subsequent situation that carried the delays; it is that deborts racking up additional debts, at least, much more than those assumed by their responsibilities in their companies. It will be supported by the pool of creditors in general, or by the society that finally will forgive the debt, or even give grants or aid. This very specific insolvency qualification process that most bankruptcy processes go through could constitute a barrier or disincentive for the debtor to resolve insolvency through this legal channel. A superficial analysis could lead us to think that if we eliminate the sanction or the possibility of analyzing the cause of the insolvency, we could be leaving a misbehaving debtor without sanction, but this is not necessarily so. The legislation already establishes mechanisms that allow the negligent debtor to be held responsible, such as social responsibility for debts contained in the Capital Companies Act. It really should not be necessary for the law to establish a specific mechanism, if the creditors or the bankruptcy administrator see that they can resort to the ordinary mechanisms of claiming responsibility from the corporate management. Of course, the statistical reality should lead us to analyze all the causes that can lead the debtor to evade his solution in the manner provided by law to try to

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encourage him/her to use it as soon as possible. As we have analyzed before, it seems that reality indicates that insolvency solutions are more efficient the sooner it is properly treated; delaying access to legal protection only reduces the efficiency of the process, resulting in the dissatisfaction of all agents. However, most of the bankruptcy process start late, then the system fails, in part is not because of the law, at least no only, it is because of unethical actions of decision makers, as well. We have analyzed the problem from one perspective, the debtor, but let’s analyze the other side of the credit relationship: the creditor (Cowton and San-Jose 2017). Creditors must be aware that the debtor’s financial situation may influence the ability to fulfill their obligations and that the credit is effectively satisfied. It is one of the most important ethical issue that insolvents have promised to pay their debts but cannot keep their promise (Kilpi 1998). Durable business relationships should involve verification by the creditor of the debtor’s estate. Money laundering regulations are making us used to verifying the identity of the contracting parties and their activities. It is no longer strange for us to verify data from the other parts of the contractual relationship, and in the same way that we verify other extremes, we should naturally verify the annual accounts of our clients or suppliers. This is public data available to any company. Let’s imagine that we are going to enter a contract with a company that presents negative own funds (Urionabarrenetxea et al. 2018). The financial situation of this company, our future debtor, should show us that it is financing its past losses with the credit that we as suppliers grant it. The payment of our credit will take place with the future income that it generates, but there are already many previous creditors who cannot collect their credit and who will surely collect before us. Avoiding zombie companies has become a priority for regulation, all over the world. Unfortunately, many companies (around 10% across Europe) survive under this economic situation during years (at least 5). Then, it is another issue to show that the law is not enough to stop this unethical behavior. However, there is another point of view. The bankruptcy itself is unethical because by definition, it happens on the situation in which debtors have “guarantee” payments to creditors but they were not able to fulfill that payment. It means that they lied to third parties and probably those lies will generate negative externalities that will harm all of society, in short or long term. Relevant mention at this point deserves the asymmetry of information handled by the different stakeholders who join together in the bankruptcy. Those creditors with more up-to-date information not only on the debtor but on the general credit situation of the economy tend to seek that their credits be considered privileged in the bankruptcy process (public administrations, financial credit institutions, etc.). The most disadvantaged creditor, the ordinary, must seek to protect his/her credit by collecting information from the debtor, his financial situation and the composition of his assets and debt. The ordinary creditor is a provider of the debtor’s production chain, ordinarily, and is the transmitter on many occasions of the contagion effect that occurs in some sectors of the economy, mainly industry, as evidenced by various authors. If the debtor is aware that his/her situation is going to compromise any future contracts, s/he would be more careful with his patrimonial situation and try to use the tools that can solve his problem earlier.

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The zombie companies, we will name as such those that present negative own funds in their balance sheets, must be expelled from the commercial activity because they produce losses in the economic system, and are highlighting the inefficiency of the legal systems of resolution of insolvency. This should be an important study issue around business insolvency to provide you with solutions. We must be aware of the problem as it is the way to guarantee credit and economic legal traffic.

Conclusions The analysis of the efficiency of bankruptcy processes does not have the recurrence and importance in our scientific community that the problem requires. We analyze aspects such as early warnings, financial contagion derived from commercial failure or the conflict between the rights of creditors against debtors. When analyzing insolvency, we must define those processes that a priori will be inefficient because the debtor is late and is already doomed to liquidation, focusing on the analysis of the variables of the procedures in which the debtor arrives at the process on time. Another relevant aspect to analyze is the study of the reasons that lead the debtor to solve his problem outside the judicial process. If the debtor were to become insolvent earlier, the losses that would occur in the economic system would possibly be significantly less. This delay is evident because a large number of insolvent companies attend the process with negative own funds, they were insolvent long before resorting to legal resolution mechanisms. It would also be relevant to analyze how many companies come in a deteriorated situation that is not disclosed in their annual accounts. Some studies that we have in process indicate that there are elements such as inventories or debtors that have valuations well above their market value. These equity elements present realization rates significantly lower than other elements of the companies’ assets. If adequate impairments were provisioned, these companies could possibly demonstrate that they also had negative equity. This fact, if confirmed, would further enlarge the problem that we have revealed, condemning a priori the ineffectiveness of the legal system to resolve insolvency. These reflections should be taken with the caution that we have already shown that the investigation is in process. The data revealed in this chapter cannot be considered statistically significant since the sample is very small and lacks the precise randomness for it. Once the analysis of the competitions concluded in 2016 has been completed, this limitation can be corrected and the conclusions can be raised looking for their statistical significance. Despite this lack of significance, the reflections that we consider interesting in order to complete the study would be: • That companies attend the insolvency judicial resolution process late. They come when their patrimonial situation is so deteriorated that another solution other than liquidation is impossible. • That those companies that come in a better financial situation improve the efficiency indexes of insolvency proceedings.

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• That the largest companies are those that access the restructuring mechanisms, managing to save their insolvency situation more efficiently. • That smaller-sized companies have worse efficiency ratios, being forced to liquidate in most of the processes. These analyzes of the efficiency of the process are essential, but it is very difficult for the researcher to delve into it since the statistics that exist on bankruptcy are very scarce. There are no studies that show the inefficiency of the judicial process of insolvency resolution. The European Union itself has shown its inability to collect the necessary data for this when the obligation it intended to impose on the member states has been forced to reduce it to a mere recommendation. Showing and analyzing the consequences of the delay in the application for judicial resolution of insolvency should help to highlight the need for the existence of statistics that allow us to delve into the problem of efficiency. Insolvent debtors and all those affected by the process need the legislation to provide effective means of solving the problem. The consequences in terms of economic and job losses are relevant enough for us to become aware of the need to analyze the phenomenon seriously and in depth in order to solve it. For the insolvency resolution mechanism to be effective, companies must go to it in time, allowing their solvency situation to deteriorate further only increases the losses that occur in the economic system. The problem of the inefficiency of the process has been tried to solve imposing sanctions through bankruptcy qualification, sanctions such as compensation for damages or the obligation to cover the bankruptcy deficit. The data shows us that these measures have not managed to improve the efficiency of the process, quite the contrary, possibly have worsened them. We must approach the problem from a new ethical perspective seeking the co-responsibility of all stakeholders: • The financial situation of companies must be public and we must demand that their situation is known to all interested parties. There are many small companies that do not publish their annual accounts, which makes it difficult for creditors to know their situation. • Creditors should be aware of the equity situation of companies, avoiding contracting with zombie companies or whose insolvency is evident since the risk of default is high. • In this way we would ensure that companies with negative own funds were expelled from the market and could not generate more losses to the system.

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Davydenko S, Franks JR (2008) Do bankruptcy codes matter? a study of default in France, Germany and the UK. J Fin 53:565 García M, José H (2018) La ineficiencia del concurso de acreedores español: análisis de las causas y modelo explicativo. Universidad Politécnica de Cartagena, Cartagena García Posada M (2013) Insolvency institutions and efficiency: the case of Spain. Documentos de Trabajo n° 1302 del Banco de España, Madrid Gómez MGP, Sánchez RV (2018) Bankruptcy reforms in the midst of the Great Recession: the Spanish experience. Int Rev Law Econ 55:71–95 Gurrea Martínez A (2016a) El ineficiente diseño de la legislación concursal Española: una propuesta de reforma a partir de la experiencia comparada y del análisis económico del Derecho Concursal. Instituto Iberoamericano de Derecho y Finanzas, Working Paper Series 6/2016, Madrid Gurrea Martínez A (2016b) La incomprensible vigencia de la sección de calificación en el Derecho concursal español del siglo XXI. Instituto Iberoamericano de Derecho y Finanzas, Working Paper Series 1/2016, Madrid Hart O (2000) Different approaches to bankruptcy. National Bureau of Economic Research, NBER Working Paper N°7921, Cambridge, MA Hart O (2008) Debt enforcement around the world. J Polit Econ 116(06):1105–1149 Horst E, van Zwieten K (2015) Restructuring the European business enterprise: the EU Commission recommendation on a new approach to business failure and insolvency. European Corporate Governance Institute (ECGI) – Law Working Paper n° 301/2015, Brussels James SD (2016) Strategic bankruptcy: a stakeholder management perspective. J Bus Res 69(2):492–499 Kilpi J (1998) The ethics of bankruptcy. Psychology Press, Hove Mora Enguídanos A (1995) Utilidad de los modelos de predicción de la crisis empresarial. Rev española de Financiación Contabilidad 24(83):281–300 Paule-Vianez J, Gutiérrez-Fernández M, Coca-Pérez JL (2019) Prediction of financial distress in the Spanish banking system. Appl Econ Anal 28:69–87 Ponticelli J (2012) Court enforcement and firm productivity: evidence from a bankruptcy Reform in Brazil. Mimeo, New York Pozuelo Campillo J, Labatut Serer G, Veres Ferrer E (2009) Análisis descriptivo de los procesos de fracaso empresarial en Microempresas mediante técnicas multivariante. Rev Eur Dirección Econ de la Empresa 19(3):47–66 Ramos T, Amorrich A (cords) (2012) Temas candentes de los procesos concursales. Pricewaterhousecoopers Int, Madrid Rodano G, Serrano-Velarde N, Tarantino E (2016) Bankruptcy law and bank financing. J Fin Econ 120(2):363–382 San Jose L, Retolaza JL (2012) Participación de los stakeholders en la gobernanza corporativa: fundamentación ontológica y propuesta metodológica. Univ Psychol 11(2):619–628 Urionabarrenetxea S, Garcia-Merino JD, San-Jose L, Retolaza JL (2018) Living with zombie companies: do we know where the threat lies? Eur Manag J 36(3):408–420 Van Hemmen E (2019) Anuario de estadística Concursal 2018. Registradores Mercantiles y de la Propiedad, España Vig V (2013) Access to collateral and corporate debt structure: evidence from a natural experiment. J Fin 68(3):881–926

Social Banks A Case Study in Ethical Approaches to Banking Paul Gower

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethical Foundations in Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unethical Behavior and Its Possible Causes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Concept of Social Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Characteristics of Social Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Social Banks and Ethical Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions and Recommendations for Further Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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The causes of the 2008 financial crisis were numerous, but one aspect which has gained considerable attention has been the ethical behavior of bank employees across all levels. A number of studies have highlighted the unethical practices that were engaged in by some members of the banking profession and the incentives that may have been in place to encourage such behavior. In addition to recommendations to improve ethical behavior in mainstream banks, which have largely been accepted by the industry, there has also been renewed interest in alternative models of banking which may already exhibit the characteristics necessary for banking to be considered ethical. One such model is that of social banking. Social banks are those with an explicit objective, in their mission statements, of creating social benefit in addition to financial or economic benefit. Such banks are few in number, and the size of the sector is small, but increasing attention is being focused on them to try and determine whether they represent a viable model for new banks entering the sector. The renewed interest in sustainable finance and socially responsible investment means that, although academic research into P. Gower (*) Warwick Manufacturing Group, University of Warwick, Coventry, UK e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_20

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social banking is limited, at present, significant opportunities for new research are likely to emerge in the coming years. Keywords

Ethical culture · Unethical behavior · Ethical banking · Social banking

“. . .bankers are regular people who just happen to work in an environment that makes them behave less ethically than they otherwise would.” (Nouy 2018)

Introduction Since the financial crisis of 2018, attention has been focused on the culture operating in both investment and retail banks in the UK, USA, and elsewhere. There has been much discussion around the ethical behavior of those working in banks at all levels. The above remark comes from a speech given by Danièle Nouy, the former Chair of the Supervisory Board of the European Central Bank, in October 2018. It reflects a common perception, held by outsiders, of those who work in banks – namely, that it is the prevailing culture in banking organizations that somehow changes the behaviors of their employees into those which would normally be considered unethical. Nouy was referring to an experiment, conducted by researchers, into the values of professionals in the banking sector (Van Hoorn 2015). In this experiment bankers and other professionals took part in a coin tossing game which gave all participants the opportunity to cheat to gain higher rewards. In the early phases of the experiment, there was no significant difference in the levels of cheating between professionals. However, in later stages the participants were asked a series of questions which related to their jobs and which, in turn, required them to reflect on their professional identities. After these questions the game was repeated, and this time the bankers did appear to cheat more than other professionals. The conclusions of the study were that bankers did partake in unethical behavior only when they were encouraged to think of themselves as banking representatives, hence Nouy’s comment above. A number of authors have examined the potential causes of the lack of ethical behavior in banking, and a number of specific remedies have been proposed to create a more ethical culture in “conventional” or “mainstream” banks (e.g., Paulet et al. 2015; Bagus et al. 2016; Herzog 2019; Zaal et al. 2019). This research is part of a growing body of evidence on the role and importance of culture in banking (Group of Thirty 2018). This has reflected not just the issues emerging from the 2008 financial crisis but a series of high-profile and public conduct scandals that have emerged in the last 10 years. Examples would include the LIBOR scandal, foreign exchange market manipulation, mis-selling of financial products, money laundering, and insider trading (see Group of Thirty 2018 for an overview of these).

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In addition to the interest in reforming banking culture to improve ethical behavior, there is another body of literature which has begun to examine whether so-called “alternative” banks are likely to exhibit higher levels of ethical behavior and whether this implies that such banks should be promoted and their development encouraged further. One group of such organizations is the so-called social banks which, although only representing a small proportion of total banks assets, are slowly growing in number around the world and are receiving increasing attention in academic research (Benedikter 2011; Weber and Remer 2011; Weber 2014; Krause and Battenfeld 2019). This chapter will begin with a brief overview of the literature around ethical foundations in banking. It will then move on to examine some of the ethical issues that emerged during and after the crisis to try to establish a consensus as to what drove these issues. The concept of social banks will then be examined by focusing on some of the characteristics of such entities and how the specific culture, organization, and operational strategy pertaining to these banks might result in them being considered more ethical. Finally, the chapter will draw some conclusions from the research that has been undertaken so far and make some tentative suggestions for further investigation in this field.

Ethical Foundations in Banking Although there has been much discussion around ethical behavior and morality in banking, the issue is a complex one, and the complexity arises from the debate surrounding what might be identified as moral or ethical. Further complexity arises from a lack of agreement over whether ethics and morality are the same thing. In practice the two tend to be used interchangeably even though this may not strictly be correct. A paper by Aldhoni provides useful summary and discussion of these issues in the context of corporate governance (Aldohni 2014). Here the author distinguishes between the concept of moral realism, in which moral judgments are objective and independent, and moral relativism which suggests that moral judgments may be based on societal differences, traditions, or common practices. The latter gives rise to the conclusion that there will always be moral disagreements and disputes and that tolerance should be shown to those who hold differing moral values when the differences cannot be adequately resolved. This philosophical discussion is relevant as, it has been argued, the concept of moral relativism may provide those in the financial sector, who have been criticized for their lack of morals, with a self- justification for their behavior (Aldhoni 2018). Such behavior, it is argued, could be justified if it is approved of by the business and financial community in which they operate – “everyone does it so it must be OK” – and those who are considered outside of this business culture should be tolerant of such behaviors, even if they disagree with them on moral grounds, because such morals cannot be objective or independent.

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Although such a perspective may be difficult to justify, there is evidence that many of the participants in banking and financial markets, prior to the financial crisis, did adhere to this view. Interviews with employees in banks have highlighted a culture in which morality and ethics and the wider societal impact of their actions were subsumed beneath a desire to generate revenue for their employers and income for themselves (Tett 2009; Roose 2014). Many senior executives “had often been in the industry long enough to have built a self-reinforcing moral framework that allowed them to feel no compunction whatsoever about working in finance” (Roose 2014 p.81). In recent years, however, such views have become less commonplace, at least in public discourse, and there appears to be a growing recognition that corporate culture and the ethical framework of the financial sector needs to be changed. It has been suggested that such change may be distributed across three different dimensions – moral virtue, human dignity, and common good (Jackson 2010). Moral virtue can be viewed in terms of moderation and relates to the idea that banks should not take extreme positions. In other words neither a complete lack of lending nor excessive, reckless lending can be justified. A more prudent approach to lending behavior is therefore called for. Human dignity relates to the importance of ensuring that all stakeholders of a bank (borrowers, depositors, shareholders, and employees, for instance) should be treated with dignity and respect. In other words recent cases of mis-selling unsuitable products, to uninformed or vulnerable customers, cannot be justified. The concept of the common good is one of the most difficult to define as it is not straightforward. It implies that banks have an obligation to ensure that individual customers can achieve their personal goals while also appreciating that their actions also have a wider societal impact which must also be taken into account. Prior to the financial crisis, it has been argued that banks were too concerned with ensuring that the gains they were making from excessive risk taking were benefiting only a few individuals while, as the crisis unfolded, the impact of the losses emerging from this behavior were shared across society as a whole. Having established a framework for defining ethics in the context of banking and identifying ways in which improved ethical behavior may be conceptualized, the next section will assess the ways in which unethical behavior manifested itself and look at some of the reasons why such behavior may have occurred.

Unethical Behavior and Its Possible Causes The behavior of financial sector firms prior to the financial crisis of 2008 has been well documented (Parliamentary Commission on Banking Standards 2013 for an overview of the situation in the UK and Shiller 2013 for the USA). In addition, ongoing problems with culture and behavior have also been noted (Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry 2019 relating to Australia). In both the UK and the USA, the financial sector, immediately prior to 2008, had been characterized by both excessive leverage, often based on wholesale market

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funding, and excessive risk taking on the part of a number of banking institutions. At the same time, the creation of ever more complex financial securities had become commonplace. It appeared that many of the buyers of these products were unaware of the risks that they were taking on. After the crisis it became increasingly clear that sales practices in UK and US mortgage markets had often been designed to mislead uninformed or vulnerable borrowers (the so-called sub-prime market in the USA) and that many of these borrowers had been encouraged to take on excessive levels of mortgage debt at interest rates which implied future repayments would be impossible to meet. In addition it had also become common practice to engage in cross-selling of financial products to customers, particularly in the UK. Bank employees were encouraged to use the sale of financial products or services as an opportunity to offer customers other products – many of which may not have ben suitable for that specific customer. This, notably, manifested itself in the mis-selling of payment protection insurance (PPI) in the UK. Although the practice of cross-selling was not, in itself, illegal, there was evidence that customers were being subjected to undue pressure to purchase products such as PPI (Parliamentary Commission on Banking Standards 2013). It was often the case that such insurance was promoted to the consumer as being part of the credit agreement and, therefore, it had to be purchased. In fact it was a separate product which could have been purchased independently, but the consumer was not informed of this. Although PPI might have been appropriate for some consumers, they were not informed that they could have obtained it elsewhere – possibly at lower cost. This is an example of a selling practice that might be termed unethical as it does not necessarily take account of the individual’s need to be treated with respect. This type of attitude was not just confined to retail customers, however, as it became clear that business customers in the UK (particularly those in small- and medium-sized enterprises (SMEs)) had also been mis-sold products such as interest rate hedging products and many SMEs that had encountered financial difficulties had received inappropriate advice from their bank (Financial Conduct Authority 2019). A further scandal that affected the financial sector was that surrounding the setting of the London Interbank Offered Rate (LIBOR). This represented the rate at which banks might undertake unsecured borrowing from other banks. It was calculated by taking estimates of representative interest rates from a panel, comprising a number of large global banks, and then averaging these submissions, having excluded the highest and lowest rates. Banks were supposed to ensure that there were clear demarcation lines between those responsible for submitting the rates to the panel and, for instance, traders within the same bank. The LIBOR was crucial as it established a benchmark rate for setting interest rates across a wide range of financial products including loans and derivatives. It was, therefore, vital that the estimates of rates made by the panel banks were a fair and honest representation of rates that might be charged. In addition LIBOR was seen as proving a good indication of financial strength and perception of risk in the banking sector as it revealed how confident banks were about lending to each other.

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In fact, it became clear that there had been widespread manipulation of these rates for some considerable time. During the financial crisis, a number of banks submitted lower rates than they would have been prepared to lend at in order to give the false impression of financial security and low risk in the sector at the height of the crisis in 2008. In addition a number of banks also engaged in manipulation of submissions specifically to increase profits or reduce losses on LIBOR-based financial products. This required traders to collude with those in the bank who were responsible for submitting the reference rates. The manipulation of LIBOR was not confined to one or two banks on the panel, but appears to have been widespread among almost all banks required to submit rates (The Wheatley Review of LIBOR 2012). Having highlighted some of the behaviors by bank employees that exhibited unethical tendencies, it is worth considering some of the explanations that have been put forward for these behaviors becoming relatively commonplace. A recent paper has attempted a more rigorous assessment of potential factors in the context of the behavior toward customers of those working in wholesale banking (Zaal et al. 2019). The authors make the distinction between factors prevalent in formal and informal organizational contexts. The first group includes examples of the following: • • • • • •

Internal structures of banks Selection and recruitment procedures adopted by banks Staff training and induction programs Internal rules and policies Performance management systems including remuneration Formal decision-making processes

The informal organizational context relates to corporate culture and refers to the values, roles, and norms that influence behaviors within the organization. Often these are ill-defined and they may be linked to the more formal organizational context. For instance, recruitment and selection procedures may be used to ensure that new employees have values and beliefs that are compatible with those of the organization. These can be reinforced through induction programs and staff training, but, in a less formal setting, the everyday interactions between employees are also likely to reinforce certain expected behaviors. This is particularly the case when new recruits join an established team of more experienced employees. At this point it will become clear what types of behavior are considered both acceptable and essential within the organization (Roose 2014). Using this framework as the basis for their analysis, the authors develop a number of hypotheses to test the importance of formal factors such as the degree of delegated authority in a firm, the importance of financial performance targets, and the proportion of total remuneration in the form of bonuses. They also use a model of ethical culture from which they derive a set of additional hypotheses based on the effects of factors such as the perceived frequency of unethical behaviors toward customers and the moral acceptability judgment of such behaviors. Data was obtained from a

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web-based questionnaire sent to employees of a wholesale bank in the Netherlands. The reliance on data from just one bank may make generalized conclusions problematic, but the research does yield some interesting insights. First, and perhaps most surprisingly given the media coverage of such issues, the authors found that there was no significant relationship between organizational structures, in terms of delegated decision-making, and the perceived frequency of unethical behavior toward customers. Similarly, there was no significant relationship between such behaviors and the remuneration of employees, either in terms of total financial rewards or proportion of the remuneration taking the form of a bonus. However, it was found that a significant relationship did exist between informal structures within the organization relating to corporate culture and unethical behavior. The authors note that “Managerial and organisational initiatives should be focused to increase the extent to which employees experience trust and respect within their working environment and the extent to which employees identify and endorse the norms and rules of the organisation” (Zaal et al. 2019 p.842). In other words ensuring that an organization creates a supportive work environment in which individuals feel trusted and respected, particularly by those in more senior positions, could have a beneficial impact on ethical behavior. It is important to emphasize that this is only likely to be beneficial if senior managers, themselves, are seen as behaving in an ethical manner and adhering to the values and norms that they espouse. The importance of this will become more evident, still, when we examine the specific case of social banks. The authors acknowledge some of the limitations of such a study relating to the focus on a single bank within a specific part of the sector and the use of attitudinal questionnaires which may deliver biased responses depending on the characteristics of the individual respondent. However, it does provide a framework within which further research may be undertaken. Such avenues will be discussed later in this chapter.

The Concept of Social Banking Having examined the different dimensions along which ethical behavior may be assessed in banks and come to some tentative conclusions as to why such behavior may not be apparent in organizations and what may be done to improve it, it is now time to turn our attention to the social banks themselves and whether they are more likely to exhibit ethical behavior. First, however, it is important to try and establish precisely what we mean by a social bank, and this can be problematic. The Institute for Social Banking, an educational and research network comprising social banks, acknowledges this problem when it states that “We acknowledge that a generally accepted definition of ‘Social Banking’. . .does not exist, and – given the variety of its historic origins and underlying values – arguably cannot exist” (Institute for Social Banking 2020). However, it does propose one definition which defines social banks as providing “. . .banking and financial services whose main objective is to contribute to the

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development and prospering of people and planet, today and in the future” (Institute for Social Banking 2020). This definition aligns closely with that of academic authors in this field who have defined it as “. . .banking that aims to have a positive impact on people, the environment and culture” (Weber and Remer 2011 p.2). The phrase “social banking” is often used interchangeably with “alternative,” “ethical,” “green,” “sustainable,” or “values-based” banking. In addition, the realization by socalled “mainstream” banks, in recent years, that they too need to demonstrate the social benefits of their actions has led many of them to adopt the language of social banking and to claim that they, themselves, are committed to taking account of social and environmental concerns. One key feature of a social bank that distinguishes it from a mainstream bank, however, is the focus on the so-called “double” or “triple bottom line” approach to reporting. The former includes a focus on social impact as well as financial return, while the latter also includes environmental impact. The ambiguity of the definition of social banks means it is difficult to state, precisely, how many of them there are. However, the Global Alliance for Banking on Values (GABV), which represents such banks, has 55 members across the world as of May 2019 which gives us some idea of the relatively small size of this sector. Together these banks hold around $198 billion of assets and have around 67,000 employees (Global Alliance for Banking on Values 2020). To put this in context, total assets for all banks worldwide amounted to $86,401 billion at the end of the second quarter 2019 (Bank for International Settlements 2019) meaning that social banks represent just 0.2% of total global banking assets. However, the relatively small size of the sector should not mean that we underestimate its importance when discussing ethics in banking. As mentioned previously many mainstream banks are claiming that they have adopted elements of the strategies that social banks have been pursuing since their inception. The combination of ambiguity surrounding their definition and the relatively small size of the sector means, also, that there has been a general lack of academic research into social banking. However, an increasing number of studies are beginning to examine social banks in terms of risk taking, profitability, and efficiency (Weber 2011; Karl 2015; Cornée et al. 2016), and several others have looked at social banking from an ethical perspective (Relano 2008; Relano 2015; Climent 2018).

Characteristics of Social Banks In broad terms social banks have been defined as pursuing a “triple bottom line” approach to reporting which means that, in their strategic decision-making, they are focusing on the social and environmental impact of their activities as well as those of a financial nature. The following section will examine some of the specific characteristics of social banks in more detail which will then enable us to better assess them in terms of their

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ethical behavior. The common characteristics can be grouped within the following categories: • • • • • • •

Social objectives formalized in mission statements Lending decisions based on social as well as economic/financial impact Lack of reliance on wholesale markets for funding Absence of speculative trading in financial assets Transparency of operations Owners who are not focused on short-term profits Remuneration systems which rely less on bonuses and where differences between highest salary and average are less marked

First, when examining social banks’ mission statements, it becomes clear that all banks emphasize socially responsible or ethical principles rather than the pursuit of profits or shareholder value. For instance, the largest of the social banks, Triodos Bank (headquartered in the Netherlands), states that “. . . it is in business to help create a society that protects and promotes the quality of life of all its members, and that has human dignity at its core.” It goes on to emphasize that it “aims to maximise sustainability, embracing the need to be profitable but only as a means to a sustainable end” (Triodos Bank 2020). Alternative Bank Switzerland, in its mission statement, refers to “doing business in the interests of the public, mankind and nature,” and it aims for a “sustainable quality of life for present and future generations” (Alternative Bank Switzerland 2020). Merkur Bank, from Denmark, states that it “. . .operates its banking business based on the basic understanding that the world is a cohesive whole. Every human individual is intrinsically valuable and possesses the potential to develop its talents in freedom, and can use the opportunity to take responsibility for our society and our shared livelihood” (Merkur Bank 2020). Mission statements are, by definition, aspirational and do not always reflect the activities of organizations in practice. However, when we consider other aspects of social banks behaviors, it becomes clear that the aspirations are being supported by actions. In terms of lending policies, all banks claim that their credit allocation processes take account of social impacts as well as financial returns. This is best evident in the lending criteria adopted by Triodos and stated clearly on its website. As with other socially responsible investors (SRIs), there are certain sectors and types of business that it limits its exposure to alcohol, tobacco, weapons, and gambling. However, it is important to note that the bank does not completely exclude exposure to all of these sectors. It states that it accepts that people have the right to pursue their activities of choice, so, in the case of alcohol, for instance, it will not fund companies that do not have a policy on restricting sales to minors or do not have a program dealing with excessive alcohol use. Its policy on tobacco is more restrictive as it will not finance tobacco product producers or retailers when the revenue from such products exceeds 5% of the total (in the case of a producer) and 10% of the total (in the case of a retailer). As mentioned, this is common across all SRIs.

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However, Triodos, in line with other social banks, adopts a more positive approach to socially responsible investing, and rather than simply excluding certain companies or sectors from funding, it actively seeks out opportunities which can show positive social benefit. It prioritizes sustainable businesses in which to invest as well as educational and cultural projects, community activities, and other socially responsible activities. This implies that the selection criteria for projects must also include an element of judgment on social impact as well as financial return. Adding another element to the credit screening process could, in theory, increase the costs of screening and monitoring. There is limited evidence on this aspect of social screening, but one recent contribution to the research appears to indicate that such costs do not add significantly to total screening costs (Cornée et al. 2016). In terms of balance sheet structure, social banks are characterized by an absence of short-term wholesale market funding on the liabilities side of the balance sheet and an absence of speculative trading activity on the assets side. In the case of Triodos, deposits represent around 88% of total assets in 2018, and the leverage ratio, representing the proportion of total assets funded by equity, was 8.7% which compares favorably with a ratio of 3% as recommended by global minimum standards set by the Basel Committee. In fact the strict lending criteria adopted by the bank means that deposits are significantly higher than loans which contrasts strongly with what may be observed in mainstream banks. This pattern can also be observed in other social banks such as Alternative Bank Switzerland where deposits represent around 90% of total assets and Merkur, from Denmark, where the figure is around 85%. In addition to the particular funding characteristics of social banks, their balance sheets also reflect the fact that loans to the real economy represent a higher proportion of total assets than is the case in mainstream banks. This reflects the fact that social banks do not engage in speculative trading of financial assets. In the case of the three banks that have been mentioned previously, loans to the real economy amount to over 80% of total assets for Triodos and around 65% of total assets for Alternative Bank Switzerland and Merkur. Transparency is a key aspect of a social bank’s operations. This transparency can take the form of both quantitative and qualitative information for stakeholders. Triodos publishes details of all of its loans, and the annual report details the sectors in which the bank is operating. In addition narrative is used to inform stakeholders of specific projects that have been funded. A similar picture emerges of the information provided by Alternative Bank Switzerland where, again, details of loan are reported together with the use to which the loan has been put. There have been numerous attempts to develop a rigorous, consistent, and common methodology for the assessment of social impacts (Nigri and Michelin 2019), but there are still issues involved in the reporting of such information. One of the main problems is in ensuring that it is reported in such a way that is understandable to stakeholders and can thus be used to inform decision-making. Ownership models for social banks can vary considerably. Some operate as cooperatives, while others have more conventional shareholder structures. However, even in the case of the latter, there are often mechanisms in place to ensure that the bank’s social commitment is not affected by the demands of shareholders with a

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short-run profit motivation. This can result in complex systems of governance. For instance, shares in Triodos are held by a Foundation which then issues depositary receipts for these shares to the general public. The Foundation exercises the voting rights on these shares while taking account of the bank’s mission and the interests of the individual holders of the depositary receipts. These individuals can vote to appoint members of the Board of the Foundation with each member’s holding of the receipts being limited to 10% of the total number outstanding. Over 50% of the receipts are held by individual bank customers. The receipts can only be traded on an internal market with their price being based on net asset value. The Foundation acts as a monitor to ensure that the bank continues to follow the social and environmental principles and long-term strategies embodied in its mission statement. The role of incentives in mainstream banks has often been cited as one of the reasons for unethical behaviors on the part of mainstream bank employees although, as previously mentioned, their importance has been challenged (Zaal et al. 2019). Social banks tend to remunerate through a base salary and tend not to offer bonuses or other incentive payments based on revenue generation, for instance. The ratio between the salary of the highest paid employee and the lowest paid is significantly lower in social banks than for mainstream banks. For instance, the ratio for the three social banks that have been referred to in this chapter emerges at between 2.7 and 5.7x for the latest reported year. Although the figures are not directly comparable, it is interesting to note that the average ratio of the salaries of chief executives compared to median employee salaries in the USA stood at over 270x in 2018 (Mishel and Wolfe 2019). From the preceding analysis, it is clear that social banks exhibit characteristics that enable us to differentiate them from mainstream banks. The next section will assess how these differences might manifest themselves in terms of ethical behaviors.

Social Banks and Ethical Behavior In an earlier section, it was suggested that ethical behavior in banks could be viewed along three dimensions, namely, moral virtue, human dignity, and common good (Jackson 2010). These three aspects can now be considered in the context of social banking. Ethical behavior in banks can manifest itself in terms of: • • • •

The lending/investment strategy of the bank and the criteria used for assessment Attitudes of bank employees to borrowers (both actual and potential) Attitudes of bank employees to customers (depositors) Attitudes of senior management to other employees

In terms of lending/investment strategy, it would appear that social banks could be described as exhibiting moral virtue. Lending is not excessive, but projects that can meet the lending criteria, in terms of sustainability and social benefit, do appear

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to be able to access finance. The fact that social banks’ capital ratios are relatively high and leverage is relatively low is an indication of their “prudence” – a key feature assigned to moral virtue in banking. The attitude of the banks to customers, including borrowers and depositors, as well as the attitude of senior management to employees is crucial in determining the extent to which human dignity is actively pursued by social banking. Unfortunately no specific academic research has examined these issues in any great depth. It does appear that social banking customers tend to be in a younger age group and be higher educated when compared to those of conventional banks. They are also more likely to reveal a tendency toward sustainability in their everyday lives in terms of the nonfinancial products they buy (Krause and Battenfeld 2019). In addition the increasing numbers of customers switching to such banks, possibly as a result of their interest in sustainability, imply that social banks are perceived as being a viable ethical alternative to conventional banking. Much of the criticism of conventional banks, in terms of attitudes to borrowers, arises from the view that they do not offer sufficient support when borrowers experience financial difficulties and regard for human dignity is not apparent as a result. There is little tangible evidence, in academic studies, to support the view that social banks offer more support under such circumstances. However, the mission statements of these banks do appear to indicate that they are more willing to develop a longer-term relationship with borrowers to ensure that the projects that are financed are sustainable in the broadest sense of the word. Triodos highlights the role of its relationship managers in building these long-term relationships (Triodos 2020). Without in-depth studies of the internal organization of social banks, it is difficult to ascertain how, in practice, such banks ensure that their espoused concern for employee well-being reveals itself in practice. All banks have clearly defined principles in terms of employee well-being. Employees tend to be identified as “co-workers,” and many of them have moved into social banking having previously worked in non-profit organizations or other forms of social business. Alternatively recruits come from the conventional banking sector. These are more likely to be older individuals who have become disillusioned with the practices they have experienced in these banks and are seeking what they may perceive as a more ethical organization in which to work. As more of these individuals move into social banking, it would be interesting to examine the extent to which tensions and conflicts, if any, may emerge between them and colleagues who have come from social enterprises, for instance. The question revolves around the extent to which they can become immersed in the corporate culture of social banking having moved from organizations exhibiting very different corporate cultures. For instance, social banks tend to have less hierarchical structures, and employees are expected to undertake continual self-evaluation rather than be governed by performance targets that have been imposed on them. Finally, there is little doubt that social banks perform well when judged against the common good aspect of ethical behavior. As previously mentioned all social banks have an explicit commitment to meeting social objectives embedded in their mission statements. The assessment criteria that are used for evaluating projects

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include social as well as financial considerations. Ideas linked to sustainable economic development and social justice are embedded in their everyday activities. For such banks profit and shareholder value maximization are not objectives in themselves. Profit and shareholder return is seen as emerging from the main objective which is to ensure wider social benefit from banking activity.

Conclusions and Recommendations for Further Research This chapter has examined the growing focus on the need for all banks to be ethical in their operations. The financial crisis of 2018 highlighted a number of instances when unethical behavior came to the fore and this had an adverse impact both on individual bank performance and the wider economy. Apart from the short-term economic impact, however, there was a longer-term impact on how the sector was perceived in terms of its ethical behavior. Banks were no longer seen as trustworthy, and it became clear that reputational damage was having a significant impact on the industry. Against this background interest in ethical behaviors has intensified. However, when the concepts of ethics are examined more closely, it becomes clear that the subject is a complex one. This chapter has attempted to summarize some of the arguments surrounding definitions of ethical behavior and the ways in which such behavior can manifest itself in the context of banking. It was determined that ethical behavior can be considered across three different dimensions – moral virtue, human dignity, and common good. In addition to examining ways in which conventional banks could improve ethical behavior, the chapter has also considered an alternative banking model which has been claimed to represent a more ethical alternative to conventional banks – namely, social banks. In doing so it became clear that there are a number of difficulties in undertaking such an assessment – not least of which is the lack of clear definition of what constitutes a social bank. To resolve this problem, a general definition was formulated, and a set of common characteristics of social banks was identified. These characteristics were then related back to the different dimensions of ethical behavior that had been established in order to begin to formulate an answer to the question of whether social banks do represent an ethical alternative to conventional banks. The main problem encountered in formulating such an answer is that there is very little academic research related to ethical behavior in social banking. However, overall, the ethical aspects of social banking do appear positive. In order to develop a more rigorous evidence base that could be used to provide a more definitive link between ethics and social banking, a number of future research avenues could usefully be explored. First, although all social banks emphasize that they undertake some form of social and environmental impact assessment in their decision-making, it is still not clear that there is a consistent, rigorous methodology for conveying this in relatively simple terms which can easily be understood by less well-informed bank stakeholders.

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Secondly, all social banks emphasize the importance of transparency, and they certainly appear to be more transparent when compared to conventional banks. However, it would be interesting to study whether detailed information on funded projects or loans is actually used by depositors or shareholders in the banks and, if it is used, in what ways it influences depositor or shareholder activity. This raises the issue of the governance structures adopted by social banks – many of which are extremely complex. The impact of corporate governance on risk taking is a well-researched area, while the impact of corporate governance on ethical behavior is less so. It would be useful to assess the specific impact that corporate governance structures might have on social banks and their ability to meet their social and environmental objectives as well as on their ability to demonstrate ethical behavior. Finally, the chapter has highlighted one major area of research into social banking that is lacking – namely, the impact of the somewhat unique way in which employees are treated by the banks. The lack of incentives in the form of bonuses, the overall remuneration structures, and the amalgamation of employees from different corporate cultures (with its attendant potential problems), as the social banks grow in size, are all areas that warrant further investigation. In this context the framework established by Zaal et al. (2019) may be useful as the basis for further analysis of corporate cultures.

References Aldohmi AK (2014) Morality and religion: complementing or complicating corporate governance. J Religion Bus Ethics 3:1–15 Aldohmi AK (2018) Is ethical finance the answer to the ills of the UK Financial Market? A postcrisis analysis. J Bus Ethics 151:265–278 Alternative Bank Switzerland (2020). https://www.abs.ch/en/. Accessed 4 Jan 2020 Bagus P, Gabriel A, Howden D (2016) Reassessing the ethicality of some common financial practices. J Bus Ethics 136:471–480. https://doi.org/10.1007/s10551-014-2529-9 Bank for International Settlements (2019) Consolidated banking statistics. https://www.bis.org/ statistics/consstats.htm. Accessed 14 Dec 2019 Benedikter R (2011) Social banking and social finance: answers to the economic crisis. Springer, New York Climent F (2018) Ethical versus conventional banking: a case study. Sustainability 10:2152. https:// doi.org/10.3390/su10072152 Cornée S, Kalmi P, Szafarz A (2016) Selectivity and transparency in social banking: evidence from Europe. J Econ Issues 50(2):494–592. https://doi.org/10.1080/00213624.2016.1179056 Financial Conduct Authority (2019) Report on the financial conduct authority’s further investigative steps in relation to RBS GRG, June Global Alliance for Banking on Values (2020). http://www.gabv.org/. Accessed 3 Jan 2020 Group of Thirty (2018) Banking conduct and culture. Washington DC Herzog L (2019) Professional ethics in banking and the logic of “integrated situations”: aligning responsibilities, recognition, and incentives. J Bus Ethics 156:531–543. https://doi.org/10.1007/ s10551–017-3562-y Institute for Social Banking (2020). https://www.social-banking.org/. Accessed 4 Jan 2020 Jackson KT (2010) The Scandal beneath the financial crisis: getting a view from a moral-cultural mental model. Harv J Law Public Policy 2(33):735–776

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Karl M (2015) Are ethical and social banks less risky? Evidence from a new dataset; work package 602 MS219 “Best Paper Award II”; working paper 96. WIFO Studies, Vienna Krause K, Battenfeld D (2019) Coming out of the niche? Social banking in Germany: an empirical analysis of consumer characteristics and market size. J Bus Ethics 155:889–911. https://doi.org/ 10.1007/s10551-017-3491-9 Merkur Bank (2020). https://merkur.dk/artikler/english/. Accessed 4 Jan 2020 Mishel L, Wolfe J (2019) CEO compensation has grown 940% since 1978. Economic Policy Institute, August 14th Nigri G, Michelini L (2019) A systematic literature review on social impact assessment: outlining main dimensions and future research lines. In: Schmidpeter R, Capaldi N, Idowu S, Stürenberg Herrera A (eds) International dimensions of sustainable management. CSR, sustainability, ethics & governance. Springer, Cham Nouy D (2018) Ethics in banking – from Gordon Gecko to George Bailey. Speech given at the 7th Congress of the Solvay Schools and their Alumni, Brussels, October 15th Parliamentary Commission on Banking Standards (2013) Changing banking for good. Volume 1: summary, conclusion and recommendations, pp 1–68 Paulet E, Parnaudeau M, Relano F (2015) Banking with ethics: strategic moves and structural changes of the banking industry in the aftermath of the subprime mortgage crisis. J Bus Ethics 131:199–207. https://doi.org/10.1007/s10551-014-2274-9 Relano R (2008) From sustainable finance to ethical banking. Transform Bus Econ 7 No, 3(15), Supplement C:123–131 Relano R (2015) Disambiguating the concept of social banking. ACRN Oxford J Financ Risks Perspect 4(3):48–62 Roose R (2014) Young money. John Murray, London Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (2019) Final report volume 1:1–496 Shiller R (2013) Finance and the good society. Princeton University Press, Princeton Tett G (2009) Fools gold. Little Brown, London Triodos Bank (2020). https://www.triodos.co.uk/. Accessed 4 Jan 2020 Van Hoorn A (2015) Organizational culture in the financial sector: evidence from a cross-industry analysis of employee personal values and career success. J Bus Ethics 146(2):451–467. https:// doi.org/10.1007/s10551-015-2932-6 Weber O (2011) Mission and profitability of social banks. SSRN Electron J. https://doi.org/10.2139/ ssrn.1957637 Weber O (2014) Social banking: concept, definitions and practice. Glob Soc Policy 14(2):265–281 Weber O, Remer S (2011) Social banks and the future of sustainable finance. Routledge, London Wheatley M (2012) The Wheatley review of LIBOR. Final Report, September Zaal OS, Jeurissen RJM, Groenland EAG (2019) Organizational architecture, ethical culture, and perceived unethical behavior towards customers: evidence from wholesale banking. J Bus Ethics 158:825–848. https://doi.org/10.1007/s10551-017-3752-7s

Applying Ethics Developing a MoralScan for Middle-Sized Companies Aloy Soppe and Koos Wagensveld

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . New Developments in Management Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A MoralScan as Instrument in Applying Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Objective and Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic Aspects of the Construction of Survey Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Accounting Company X: The Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Theoretical Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Discussion on Practical Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix 1: Survey with Average Results Per Question . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Likert Scale: (1) Disagree Strongly, (2) Disagree, (3) Neutral, (4) Agree, (5) Strongly Agree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Results Test Questionnaires: Length of Scale, and Positive/Negative Formulation of Questions in 2018/2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix 3: Example Introduction Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Explanations scores . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Abstract

This chapter develops a so-called MoralScan for medium-sized companies as an instrument for arousing institutionalized discussions on company-ethics. Competition in the market economies easily encourages aggressive and sometimes even immoral company behavior in order to perform financially. However, the often forgotten Smithonian moral aspects of economics and finance are regaining A. Soppe (*) · K. Wagensveld Institute Financial Management, HAN University of Applied Sciences, Arnhem, The Netherlands e-mail: [email protected]; [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_22

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strength in modern Management Control. Soft controls are of increasing importance in measuring financial performance and risks. This chapter provides an example of how to measure morality in an accounting firm in the Netherlands. The model applies five criteria – justice, nature, legitimacy, stakeholder care, and sustainability and innovations – to develop right opinions that lead to the right actions in companies’ moral behavior. Based on surveys and structured interviews, the researcher calculates a MoralScanIndex (MSI) that can be used to compare the company, either longitudinally or cross-sectionally, depending on the chosen benchmark. The calculated MSI – as presented in this chapter – can be used as an estimator of moral standards of the company, but first of all as an instrument to encourage ethics in business. The chapter contributes to the discussion on how to measure morality and – more practically – how to create valid surveys and interviews on this topic. It is concluded that – despite theoretical correctness – practical pitfalls and complex psychological processes prevent robust statistical results in measuring morality. However, we do notice that by applying this instrument the quantitative results of the MSI are of minor importance in relation to the fact that ethics becomes a lively debated issue in organizations. Keywords

Management Control · Measuring Ethics · MoralScan · Soft Controls · Financial Ethics · Ethics

Introduction Morality is the backbone of modern market economies. Durkheim argues that morality – also called “social facts” (This distinction is based on the work of Emile Durkheid: Determination du fait moral, as translated by K. L. van der Leeuw, in Over Moraliteit, 1977, Boom: Meppel.) by him – contains three important elements. First is the imperative character of moral rules. He constantly stresses the constant quality of morality that permanently emanates from an ever-evolving society. A second aspect is the contents of moral actions that are always aimed at improvement of the social level of society. This could be the family, the association, the city, or the country, but morality always opposes evil and is beneficial for humanity. The third crucial aspect of morality is the autonomy of the willpower of individuals who voluntarily chose to do the right thing for society. Especially the latter virtue ethical aspect of morality is considered dominant in this chapter. Business ethics in general concerns the application of moral aspects to the company. There is a vast amount of literature on this subject with a wide range of specialized topics (e.g., Crane and Matten 2015; Fisher and Lovell 2009; Blowfield and Murray 2014; Boatright 1999). This research emphasizes the role of applying ethics primarily as an instrument to arouse moral discussion in management control. Modern financial risk and control models are no longer pure finance decisions. Administrative controls are called social controls (later called “soft” controls by

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Roth 1989, 2010). According to Roth (2010), “all the soft controls in an organization together constitute its corporate culture.” For administrative and social controls to be effective, these controls must operate as self-controls, which are controls people exert over their own behaviors (Hopwood 1976). Bellora-Bienengräber et al. (2019) demonstrate that an ethically focused MCS imposed on department managers decreases counterproductive work behaviors, which, in turn, limits the focus-onself in the work climate of their departments. Measuring morality is a daunting challenge. Using interview- and survey techniques to measure moral standard of people is admittedly vulnerable as a scientific instrument. On the other hand, it is a great impulse to enhance the role of ethics, by attempting to measure moral and cultural aspects of, and in, a company. Of course, the internal validity of questionnaires and surveys are at stake in communicating with people. Mild and severe satisficing (Krosnick 1991) effects of respondents occur frequently and must be interpreted by the researcher. However, the expected return of moral analysis is not an exact answer on moral and justice questions, but verifiable and transparent estimations of opinions of different participants in the company. The fact that morality is discussed openly within the company is more important than the results themselves. Transparency and thrust enhancing communication is at the heart of this approach of measuring and testing morality. The chapter is organized as follows. In section “New Developments in Management Control,” we start off with new developments in the role of management control as a system. The historical developments in management control are briefly mentioned and then a connection is made to insights of ethically focused management control and contents. Integrating soft controls, financial performance, and management control systems theoretically builds on the Levers of Control framework of Simons (1995). Then, in section “A MoralScan as Instrument in Applying Ethics,” we present an example product of soft controls: the so-called MoralScan. This model is theoretically presented and developed in Soppe (2017) and empirically designed, executed, and evaluated in the accounting sector in the Netherlands in 2018. The strengths and the weaknesses of the model are then discussed in section “Discussion,” at both the theoretical and the practitioners level. The chapter ends in section “Summary and Conclusions” with a summary and conclusions.

New Developments in Management Control The concept of management control as a system was first mentioned in Planning and Control Systems of Anthony (1965), who developed a conceptual framework that distinguished management control from strategic planning and tasks control. In this framework, the three types of control have a hierarchical relationship: strategic planning is at the apex and defines the strategic objectives and policies that management control implements by identifying a set of tasks that operational control executes effectively and efficiently. In this perspective, management control is designed to ensure that the day-to-day tasks performed come together in a coordinated set of actions which lead to overall goal specification and attainment, with a

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heavy emphasis on financial or accounting controls (Otley et al. 1995). This means that management control systems (MCSs) are associated with the reduction of variety and implementation of standards, which is referred to as the cybernetic model. Thereafter, in 1976, Hopwood proposed a framework of control in which traditional administrative control is complemented with social controls and self-controls. Administrative controls comprise formal rules and standard procedures and systems to influence the behavior of managers and employees. Later these were called “hard” controls by Roth (1989, 2010). When these controls are designed to influence individuals’ norms or values, such forms of administrative controls are called social controls (later called “soft” controls by Roth 1989, 2010). According to Roth (2010) “all the soft controls in an organization together constitute its corporate culture.” For administrative and social controls to be effective, these controls must operate as selfcontrols, which are controls people exert over their own behaviors (Hopwood 1976). In 1981 the first model for social accounting (the process of communicating the social and environmental effects of the organization’s economic actions to different stakeholders) and audit was designed (Spreckley 1981). In the early 1980s, management control literature started to adopt an open perspective with the emergence of the contingency theory of management accounting control systems (Otley 1980). This theory is based on the assumption that there is no universally appropriate MCS for all companies, but that it rather depends upon the specific circumstances in which an organization finds itself. The emergence of theory has led to the recognition of the impact of contingent variables such as technology, environment, organizational structure, and corporate strategy on MCSs. A noteworthy contribution within contingency-based research to the conceptualization of management control comes from Merchant (1985), who proposed a categorization of control based on the control object. He classified control into three categories: results, action, and personnel controls. These informal and social controls included in the framework presented by Merchant (1985) differ from the traditional dominant focus on financial controls in the management control literature so far. Later in 2012, the object of control framework is extended by Merchant and Van der Stede (2012) by adding the notion of cultural controls. Simons (1995) builds on the acknowledgment of incorporating social and cultural aspects of control and the contingent perspective on MCSs by designing a Levers of Control (LoC) framework. This framework concentrates on the use of MCSs and distinguishes between four control systems relevant in the analysis of the average firm: diagnostic systems, beliefs systems, boundary systems, and interactive systems (Simons 1995). Diagnostic control systems compare actual performance with planned performance and provide feedback on deviance. Beliefs systems are used by top management to communicate core values and inspire performance. Also, the alignment of external social and environmental sustainability values of stakeholders into organizational strategy is dependent on top management who make sense of external “beliefs” (Arjalies and Mundy 2013; Rodrique et al. 2013). While beliefs systems motivate the search for opportunities and create positive and inspirational forces, boundary systems constrain the search by limiting certain activities and

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ensure compliance with orders and rules (Martyn et al. 2016). Interactive control systems monitor and react to strategic uncertainties, involving top management in frequent informal interaction with employees. The four levers defined create opposing forces of effective strategy implementation, to which Simons refers to as “yin and yang” (Simons 1995). Two of these control levers, beliefs systems and interactive control systems, create positive and inspirational forces. The other two levers, boundary systems and diagnostic control systems, create constraints and ensure compliance with others. In recent years, an important part of the research agenda is to understand how controls can be combined to suit the particular circumstances of the organization. The growing interest in how management controls operate together as a package of interrelated mechanisms arose from the notion of “MCS as a package” of Malmi and Brown (2008). Since traditional contingency studies have neglected the nature of controls and how multiple controls combine, Cardinal et al. (2010) propose a configurational approach to control, building on configurational theory. While contingency theory adheres to the reductionist tenet by seeking linear correlations and an optimal organizational configuration, configuration theory considers control systems not as independent contingencies but rather as tightly interdependent elements of one internally consistent configuration (Brand 2013). The latter approach assumes that there are only a small number of high-performing control configurations. These configurations can either be developed conceptually (typology) or derived empirically (taxonomy). If we reflect on the research on MCSs in the past, it is surprising that the use of MCSs (e.g., interactive and/or diagnostic) has been intensively investigated (e.g., Bedford et al. 2019; Bisbe and Otley 2004; Henri 2006; Widener 2007). However, there is a lack of studies investigating the effect of specific MCS content. Notable exceptions are Journeault et al. (2016) for environmental information content and Bellora-Bienengräber (2019) for product development information content. Also the working paper of Bellora-Bienengräber et al. (2019) contributes to this stream of research by examining the ethical content of MCS and empirically demonstrating how and when related design choices (i.e., increasing or decreasing the emphasis on an ethically focused MCS) make a difference in influencing behaviors in organizations. Following Rosanas and Velilla (2005), BelloraBienengräber et al. (2019) suggest that Simons’ (1995) LoC framework can be used to communicate ethical values to employees and motivate them to behave accordingly. An ethically focused MCS is comprised of (Bellora-Bienengräber et al. 2019): 1. Ethically focused beliefs system: the explicit set of organizational definitions that senior managers communicate formally and reinforce systematically to provide basic ethical values, ethical purpose, and ethical direction for the organization. 2. Ethically focused boundary system: a set of rules delineating the ethically unacceptable domain of activity for organizational participants. 3. Ethical awareness in the diagnostic use of key performance measures: predictable goal achievement is ensured taking into account the ethical values of the firm.

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4. Ethical awareness in the interactive provision of strategic direction: dealing with strategic uncertainties as accompanied by an emphasis on ethical considerations. Bellora-Bienengräber et al. (2019) demonstrate that an ethically focused MCS imposed on department managers decreases their counterproductive work behaviors, which in turn limits the focus-on-self in the work climate of their departments. The present research at hand theoretically builds on the work of Bellora-Bienengräber et al. (2019), by presenting example contents of soft controls and discussing the MoralScan (see section “A MoralScan as Instrument in Applying Ethics”) as a possible instrument to decrease counterproductive work behavior.

A MoralScan as Instrument in Applying Ethics As explained above, management control distinguishes between hard and soft controls. The primary goal of the MoralScan is to apply soft controls to discuss corporate culture and thrust. Financial ethics therefore is used as an instrument to discuss morality. This section first describes the theoretical elements of the MoralScan shortly and then uses an example company to instruct its method. The MoralScan is theoretically developed by using relevant elements of the so-called: New Financial Ethics, of Soppe (2017). That model describes ethics in relative positions of good and bad behavior from a monistic perspective in order to create explicit moral opinions and discussions on specific criteria in financial ethics.

Theory Kaptein (2015) shows that unethical behavior occurs less frequently in organizations that have an ethics program than in organizations that do not have such a program. Based on a US database firm called National Family Opinions, which collected 5065 completed questionnaires in 2008, Kaptein showed that there is a direct relationship between the number of components of the ethics program adopted and the frequency of observed unethical behavior. It must be noted that he also observes that there is an optimal sequence of introducing ethics via an ethical code, providing dilemma training, delivering accountability, and monitoring, to a published ethics report line and incentive policies. The research very much encourages the high priority of ethics training in business. The MoralScan of this chapter does not pretend to reflect the entire range of the professional ethics policy above. In small and medium-sized companies, ethics is quite often an underestimated phenomenon. The profitability and the economic responsibility of such firms often have priority, where ethics sometimes intuitively pops up. The MoralScan only offers an introductory program in ethics, as starting point for a more professional program. The chosen application of ethics in business is based on the concept of “new financial ethics” which is defined as the “systemic development of right opinions leading to right moral actions regarding financial

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processes of individuals, companies, institutions and organisations – in relation to the (financial) markets in which they operate” (Soppe 2017, p. 27). The MoralScan aims to be an instrument to estimate the moral character of a company at a specific moment in time by implementing the results of either surveys or closed interviews, conducted by the researchers. Five criteria are selected to measure morality: (1) justice, (2) nature and environment, (3) stakeholder engagement, (4) legitimacy, and finally (5) innovation and sustainability. The criteria are briefly described below.

Justice Justice can be interpreted in many different ways because no clear definition can be presented. In this research, the Aristotelian distinction is made between distributive justice and corrective justice. The key words of justice in the MoralScan are relative (in) equality between people, as perceived by employees and perceived unreasonableness in relation to laws, norms, and codes. A fair organization shapes the division between the interests of different participants in a nuanced and correct manner. Justice is considered a cardinal virtue and therefore at the heart of all moral considerations. Nature and Environment Nature relates to the quality of the earth and the handling of people and the company with raw materials and scarce natural resources in production. Sustainability with regard to the environment is described as the respect of current business communities for future generations of stakeholders. Nature is often unpaid polluted by companies due to incorrect waste processing or excessive use of fossil fuels. In the MoralScan, it is important how companies deal with nature and the physical environment. The concern for society in the longer term and the influence of the natural environment on future generations are at stake in this estimator. Participant Engagement The participant approach is sometimes called stakeholder approach or even more active: “stakeholder engagement.” This research focuses on the input, cooperation, and importance of three stakeholder groups, namely: customers, employees, and the management of the company. Examples are questions about customer satisfaction, employee satisfaction, and the leadership of both the direct manager and the management. Variables such as the perception of the “tone at the top” and the employment conditions play an important role. For practical motives and lack of time, stakeholders such as suppliers, community, and (regional) governments are not considered. Legitimacy This criterion focuses on how regulations are dealt with by the companies’ employees and their compliance. These can be rules with regard to “hard law” such as in criminal law, civil law, and financial law – such as the Wft (Wet financieel toezicht) or Wta (Wet toezicht accountants) in The Netherlands. However, also rules from “soft law” such as governance codes or companies’ ethical codes are included

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in this criterion. Aspects of a more voluntary character such as social legitimacy of the type of “corporate social responsibility” (CSR) also play a role in this standard.

Innovation and Sustainability Innovation can be considered as an extension of the sustainability criterion. With the innovation criteria, we look at how much innovation is taking place in the company, including the question whether this is progress in the social sense for future generations and for all relevant stakeholders. Innovation is a necessary condition for sustainable growth and is therefore part of the moral quality of the company.

Objective and Methodology The MoralScan aims to measure the moral character of a company through a clear score – the MoralScanIndex (MSI) – at a certain point in time. The index is defined as the average of the Likert scores, divided by its standard deviation. The average represents the level of the variable and the standard deviation approaches the differences in opinion between the interviewees. This index is calculated for each of the relevant criteria: justice, nature and environment, participant approach, legitimacy, and innovation and sustainability. The MoralScan can be taken in two ways: (1) through surveys with individual questions to a sample of respondents and (2) by organizing structured interviews with representative members of the entire company. The individual questions are written as statements that were submitted to employees, stakeholders, and/or suppliers during the interviews or surveys. These statements concern judgments and opinions about elements of the relevant criteria, each with an answer on a five-point Likert scale. The questions are designed such, that a higher number as answer, represents a higher moral attitude in the question asked. Negatively formulated questions yield a reversed score, in order to maintain the principle of the higher the score, the better the MSI. Therefore, the higher the score, the better the moral attitude of the company.

Basic Aspects of the Construction of Survey Questions In order to be able to make relatively robust statements, as based on results obtained via standardized questionnaires, we first have to discuss the construction and characteristic of the applied questionnaire. The quality of a standardized questionnaire is often recognized under the term “internal validity,” defined in literature as: “the extent to which the methods and techniques of research ensure that the results and research conclusions actually concern the intended phenomenon” (see Van Zwieten and Willems 2004, p. 39). Therefore, the correct use of methods and techniques to guarantee internal validity lies essentially in the correct construction of a questionnaire. Redline and Dillman (1999) describe four types of language use in a questionnaire, namely: verbal, numerical, symbolic, and graphic language.

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These forms of language distinguish different elements that can influence the internal validity of a standardized questionnaire. Oppenheimer et al. (2009) then describe how internal validity can be influenced by other factors. For example, a respondent who is unmotivated, bored, or tired will give more thoughtless or random answers. Furthermore, fatigue and boredom can also cause respondents to drop out directly or halfway through the questionnaire. Krosnick (1991) describes the consequences of these effects when filling in a questionnaire with the term “satisficing.” The effect can occur in two forms, “mild satisficing” and “severe satisficing.” Mild satisficing includes the cases where the respondent encounters a problem at one of the steps in the response model and then skips an acceptable response. Severe satisficing is the effect whereby the respondent gives completely random answers, because imprecise formulations of questions incur complete lack of interest to give relevant answers. It is therefore important, if possible, to exclude most forms of “satisficing” effects and thus optimize the internal validity of the questionnaire. In order to minimize the “satisficing” effects, the first step in the response model is good understanding the basis research question (s). In the MoralScan questionnaire, therefore, we opened each interview session with random everyday moral choices, which are not related to the company at all. The motivation for these a priori questions is that general moral dilemmas will put interviewees at ease, because the cases introduced happen to everybody, have easy answers, and create a relaxed atmosphere for the interview. This policy successfully took away the formal setting at the opening of each interview session. See “Appendix 3” for some example questions. In the context of constructing a questionnaire, there is another step that precedes impeding factors for internal validity and forms of language use. The response model of Tourangeau et al. (2000) maps the respondents’ process by describing the four steps that make up a response process, namely, understanding the question, retrieving the required information, assessing the information, and formulating an answer. First, a respondent reads the question and must understand what exactly is being asked. In the next step, a respondent digs in his or her memory for all information that has to do with the question. All that information is assessed in the third step for relevance to the question in order to ultimately formulate an answer or to be able to display an answer on a scale. If complications arise during the first step of this process, the respondent interprets the question differently or does not understand the question at all; this has consequences for the subsequent steps (Tourangeau et al. 2000). For a better understanding of the concept of a MoralScan, in the next section we first present an example of a middle-sized accounting firm in the Netherlands in 2018. See “Appendix 1” for the applied questions and the example averages.

Example Accounting Company X: The Results The results are based on 13 structured interviews with employees, which is a selected and layered sample from the 87 employees of the company and 3 interviews with management, representing the entire board.

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Table 1 Results per criterion based on interviews with 13 employees Criteria Justice Nature and environment Legitimacy Participant approach Innovation and sustainability

Average 3.84 3.03

Standard deviation 0.87 1.16

Min. 1 1

Max. 5 5

N 110 65

MoralScanIndex (MSI) 4.41 2.61

3.25 3.96 3.63

1.17 0.95 0.82

1 1 2

5 5 5

156 324 78

2.80 4.17 4.43

Employees Perspective The results of the interviews with the selected employees are shown in Table 1. The average, standard deviation, highest and lowest score, number of observations, and the MoralScanIndex are displayed per criterion. In the table below, 3 is the neutral score. So, average values above 3 means that the interviewee scores positively on the questioned aspect, where 5 represents the maximum achievable result. Negatively formulated propositions are reversed in the Likert scores, so that the best moral position again yields a 5. Justice As shown in Table 1, it appears that on average employees score a 3.84 on questions that refer to propositions that measure perceived justice. That’s a score well above “neutral.” It appears that employees generally feel treated fairly. For example, they indicate that they themselves treat their colleagues fairly, while the opposite is also felt (see questions J-3 and J-4 in “Appendix 1.” It also emerges that employees believe that managers take integrity into account when making decisions (question J-9). The lowest score (3.36) is achieved on question J-7, on a fair valuation based on the number of directly attributable hours for the company, made by employees. Nature and Environment The nature criterion describes the extent to which employees are satisfied with the company’s environmental policy. The research shows that this variable scores the lowest of all – 3.03 on average. So neutral: neither negative, nor positive. The interviews show that the statement “company X encourages us to act/travel as environmentally friendly as possible” with an average of 2.12 is scored very low (question N-4). Moreover, it appears that all interviewees go to work by car, regardless of the distance they commute. Looking at the employment conditions, it appears that the car scheme is financially advantageous and that there is no incentive for, for example, hybrid or electric cars, or electric biking. Although environmentally friendly travelling is not encouraged, the research indicates that employees try to work digitally as much as possible and do not physically print reports unnecessarily. It is also clear that employees think that

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company X considers the long-term policy more important than the short-term policy (question N-5). This indicates that there is confidence that the companies’ management will prepare properly to prevent the company from lagging behind general market developments. Participant Engagement This criterion covers questions about employment conditions, leadership, and how customers are treated. This criterion, with an average of 3.96, scores highest in Table 1, but due to the somewhat larger standard deviation – which means that the differences between the opinions of the interviewees are greater – a somewhat lower MoralScanIndex results. The high average means that the answers generally show high employee satisfaction. The interviewees indicate that they can be themselves at work, feel sufficient freedom, and have ample opportunities in their work to develop further. On average, the interviewees feel heard by their managers and are proud of the developments taking place within X. It also emerges that everyone is aware of who the confidential advisers are and what their positions entail. It is also noticeable that the participant scores are still good, but are getting lower when it comes to questions that have to do with direct managers (P-16, P-17 and P-19). Despite the fact that management’s accessibility is very high, vision, inspiration, and innovation score above neutral but a little less (P-22 and P-23) than the other employee satisfaction elements. Finally, with regard to customer scores, it is striking that they are relatively low and close to neutral. In particular question P-26 about the relationship of trust with the client stands out with a low score of 3.0, so the question can be asked whether the importance of integrity of the accountant is sufficiently emphasized in the organization. Since 2010, audit firms have been under heavy pressure from the regulator and public opinion in the Netherlands, with regard to the independency of judgments. The combined tasks of audit- and advisory assignments to accountants mean that reputational risks are easily created. Chinese walls between the advice and audit departments can easily be avoided. Legitimacy Together with nature, the legitimacy standards is one of the worst scoring elements of the MoralScan in this example. With an MSI of 2.80 and 2.61, respectively, these indicators perform a lot worse than the other morality indicators. Both factors stand out because of the high standard deviation, which means that the answers vary strongly, implying that opinions within the company differ considerably. That the average level of the legitimacy factor with 3.25 hardly differs from the neutral position 3, with a high standard deviation, is nevertheless somewhat worrying. Questions L-2–L-4 and L-9–L-11 in particular contribute to this low score. It is suggested here that the code of conduct is sometimes being acted against and also that the integrity of colleagues is sometimes questioned. When it comes to keeping commercial performance at the required level (L-10), it also happens that the company standards and rules are violated. The transparent information provision within the organization and the possibility of consultation score positively. Company X offers sufficient scope to discuss moral

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dilemmas with each other (L-14) and with an average score of 4.25, few people fear that things will be done that cannot be publicly communicated (L-12). This means that there is enough confidence in the professional character of company X, as compared to other accounting firms.

Innovation and Sustainability In total, an average level of 3.63 is scored on the innovation and sustainability criteria. The interviews show that employees think that X is preparing well for the future. In addition, most interviewees believe that their own knowledge is up-to-date and that knowledge is also shared with clients at an early stage. When dealing with social media, the trend is carefully followed, but the role of the traditional newsletter remains important. Striking is that satisfaction with the internal automation system with an average level of 3.15 is poor (I-4) and that product development within the sector could be more progressive.

The Perspective of Management In addition to the employees, three people from management were also interviewed. Table 2 shows the results based on these interviews. Interviews with management showed slightly different questions than those of employees. This small adaptation of questions is necessary because of their different roles in the company. Because only three people have been interviewed, the standard deviations are automatically somewhat larger due to little data. This gives the MSI less informational insight than the average (Graph 1). The management gives a higher average score on the factors: Justice, Nature, and Legitimacy and a lower average score for Participants and Innovation in comparison with the opinions of the employees. Whereas the picture is comparable when it comes to the perception of justice, the perception of the management itself is higher when it comes to the contribution of the company to nature (on average 3.48 vs. 3.03). Nevertheless, both scores are low, so that there is a relative agreement that it is still possible to make a move on that criterion. In addition, it appears that employees recognize the accessibility and exemplary function of the partners more than the members of the partnership themselves.

Table 2 Results per criteria based on interviews with management Criteria Justice Nature and environment Legitimacy Participant approach Innovation and sustainability

Average 3.96 3.48

Standard deviation 0.81 1.16

Min. 3 1

Max. 5 5

N 24 15

MoralScanIndex (MSI) 4.89 3.00

3.65 3.21 3.28

1.16 1.24 0.96

1 1 2

5 5 5

30 48 18

3.15 2.59 3.42

Applying Ethics Graph 1 Difference between employees’ and management scores

489 DI FFER ENC E EMPL OY EES A ND MA NA G EMENT S C OR ES

5 4

Employees Board

3 2 1 INNOVATIE

LEGITIMITEIT

PARTICIPANTENBENADERING

NATUUR EN DUURZAAMHEID

RECHTVAARDIGHEID

Recommendations for Company X Based on the interviews with employees and with management, the following recommendations were made by researchers: 1. Keep company policies up! Employees are satisfied and feel at home in the organization where labor relations are experienced as just, the atmosphere is good and people are proud to work for company X. 2. In the field of nature and sustainability, consideration should be given to how the current social trend regarding the strengthening of climate policy can also be implemented to company X. To date, no clear policy line is visible here. 3. An open discussion about the role of an honest customer relationship and the danger of customer dependence in relation to one’s own professional independence seems desirable (see P-26). 4. A stronger focus on – and possibly investment in – innovations in the field of accountancy products and services. Reinforcing its own automation also seems to be a wish of many employees.

Discussion The above example of accountancy firm X shows that useful and practical recommendations can be presented from implementing the MoralScan to a specific company. The results of Tables 1 and 2, representing the different opinions of management and employees, are a fruitful basis for transparent consultation within the company. The MoralScanIndex enables a practical platform for discussing morality as contents of soft controls. In this section, however, we first need to address the complex theoretical question on the measurability of ethics in practice

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and secondly the theoretical and practical problems occurring in developing survey questions in general and the application to a company specifically. Then we give attention to a core question in this research, and relevant for all research based on surveys: how to develop a right questionnaire? Another important question is: do we use surveys, structured interviews, or both? Clear answers are not available, but we need to address these issues explicitly.

Theoretical Issues Two important issues are distinguished: the measurement of morality and ethics in general and in business ethics more specifically, and secondly the issue of developing right survey questions.

On Measuring Morality How to make the impossible possible? The easiest answer is statistically: to realize that in measuring morality we produce estimators of concepts that approach reality the closest. We try to find unbiased estimators, not for the results alone, but primarily for the sake of discussing a moral topic. The duty ethics of Kant and the virtue ethic of Aristotle are probably impossible to quantify. These approaches are too diverse, too personal, and too context- and time dependent. Bentham, however, the father of utilitarianism, claims that whether an act is morally right or wrong depends on the amount of “pleasures and pains” that are inflicted by a specific act, suggests implicitly that measuring morality is possible. Although immediately denied by Mill, and many others, this consequential approach is still dominant in most business ethical analysis. This approach therefore can be seen as an encouragement for measuring morality. There is rich literature on measuring corporate social responsibility and on corporate reputation. In Soppe et al. (2011), for example, an empirical model was estimated on corporate social responsibility reputation (CSRR), based on 176 survey questions on corporate responsibility, to develop both a qualitative and a quantitative interpretation to measure CSRR. The new aspect of that research was the explicit modeling of the confrontation of CSR expectations and CSR performance. Where quantifying CSR is generally accepted in literature, in the past only few studies have been performed on measuring morality more directly. For example, Martin and Austin (2010) investigated the extent to which the Moral Competency Inventory (MCI) measures (un)ethical behavior. The purpose of that research was to introduce practitioners to the appropriate use of measures of unethical behavior, for use in personnel selection, and determine the validity of the moral competency index (MCI) instrument by using standard validation procedures. The results of the MCI purport to align with one’s moral values and behavior; however, no single factor structure on moral behavior could be discovered. Mänttäri-van der Kuip (2016) tried to measure the experience of moral distress in a case study among professional social workers. The study is based on an empirical article aimed at shedding light on the experiences of moral distress among social

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workers with specific focus on the role of perceived resource insufficiencies. The empirical article utilized survey data collected as a part of a dissertation project on the capabilities and well-being of professional social workers. Here, moral distress is defined as work-related distress experienced by different professionals in the field of social and health care. Nearly 11% of the respondents reported experiencing moral distress and perceived resource insufficiencies strongly explained this experience. Moreover, social workers with moral distress reported that they were less willing to continue in their post, were more frequently on sick leave, and had positive workrelated experiences less often than their colleagues who did not experience moral distress.

On the Construction of Survey Questions In “A MoralScan as Instrument in Applying Ethics,” MoralScan as instrument in applying ethics, some basic theory of the construction of research questions was already reported. A well-known and severe problem in answering survey questions by participants is losing interest and motivation after some time, creating false answers. An example of wrong interpretations of questions is that respondents become tired or bored by the length of a question, which in turn can lead to “satisficing effects” (Oppenheimer et al. 2009). The appropriate length of a question is tested in this study as a language construct of numerical language use, by presenting long and short-formulated questions to test respondents, and by asking which ones are better and why. Converse and Presser (1986) claim that the length of the question influences the answer given by a respondent. A classical study by Payne (1951) says that a question should contain no more than 20 words. A study of the optimal demand length in the context of healthcare, conducted by Henson (1979) and Laurent (1972), showed that respondents mentioned more symptoms with a long question than with a short question. According to Sudman and Bradburn (1982), this can be explained by the fact that a longer question evokes a longer answer from the respondent. On the other hand, respondents have more time to think about a longer demand, according to Cannell et al. (1979). Despite a nonconformity, it remains difficult to say which question length impedes or actually promotes internal validity. Then there is the language construct “positive/negative question formulation.” A practical implication of the “verbal language” language form that triggers “satisficing” effects concerns the tone of a question. A question can be formulated both positively and negatively, but still questions the same thing. This can be done by adding a “not” or by using an antonym “just” or “unjust” (Converse and Presser 1986). According to Converse and Presser (1986), it is better to opt for a positive formulation. According to them, a negative formulation can cause confusion. Whether this is always the case is not mentioned in the study. In any case, it seems sensible to consider only positive formulations when designing a questionnaire. Also the “length of the Likert scale” is a permanently returning discussion. The length of Likert scales to be used is a characteristic form of numerical language in a standardized questionnaire Redline and Dillman (1999). Likert scales are mostly used for answering options of a questionnaire with closed questions or statements. Although there may be a difference in the number of intermediate choices, the scale

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is always symmetrical with approval on one side and rejection on the other. A possible middle option with, for example, “no opinion” is optional (Trochim et al. 2015). It is important that the answering options present the actual opinion of the respondent. On the other hand, the number of answer options should not provoke thoughtless or random answers, as this would result in “severe satisficing.” A study by Matell and Jacoby (1971) investigated which length of the Likert scale is the optimum. In this study, a two-point Likert scale was started and, as a last option, the 19-point Likert scale was tested. This research has shown that a longer Likert scale does not necessarily mean that reliability and validity are higher. Lehmann and Hulbert (1972) have also conducted research into the optimum length of the Likert scale. This study has shown that the length of the Likert scale depends on the purpose of the study. In every situation it is important to assess the benefits and costs of each length of the Likert scale and to make a choice based on this. A longer Likert scale has the advantage that the results are more precise. On the other hand, a longer Likert scale entails more processing costs. For the MoralScan questionnaire at hand, two language constructs were tested in a sample of 31 respondents, who attended presentations on the MoralScan at our University of Applied Sciences in Arnhem, in spring 2019. This concerned: (a) the language constructs: positive/negative formulation of a question and (b) the length of the Likert scale (five- or seven points scale). “Appendix 2” presents the results. There we see that, apart from question 6 in the second block of questions that the deviation of the score, compared to the alternatively formulated question, does not statistically deviates from zero. A T-test found that the average Likert number resulting from the questionnaire is not statistically different with both types of questions or lengths of Likert scales. The research question asked was: “which way of question formulation and which length of the Likert scale ensures that the respondents of the MoralScan interpret the questionnaire in the same way?” In the test samples, two identical questions were posed either positively or negatively in one block of questions and on a five-point Likert scale or a seven-point Likert scale in another block of questions in both samples. We concluded that no relevant difference is found in our sample.

Discussion on Practical Issues The main contribution of this research is to present content in soft control management systems by using the MoralScanIndex. By implementing the 72 theses as shown in “Appendix 1,” in either a survey or in structured interviews, a concrete result can be derived. However, the calculated MoralScanIndex (MSI) of company X is first of all an instrument to arouse the discussion on the role of ethics in the company specifically and in the market economy in general. The index is just a number indicating a specific level of moral opinions in relation to other classifications. The crucial contribution of the calculation of the MSI is the process of interviewing the employees and board to retrieve relevant opinions. This triggers people to recognize morality in their profession and realize the importance of this on

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the daily working conditions. This process primarily emphasizes the role of ethics and cooperation within the company. Of course, the 72 questions, as presented in the “Appendix 1,” are not a scientific law of nature, nor even an unbiased indication of correctly measuring morality. It is used to force people to think on morality and to express opinions at a specific moment of time that can be used for the companies’ sake. In this case we focused on the accountancy sector. The method, however, can also be applied to any other sector or company. The questions and thesis need slight reformulations then, but the structure can be identical. Justice, Nature, Legitimacy, Stakeholder engagement, and Sustainable innovation represents a robust framework to measure morality. Of course, more topics can and maybe should be added, but that heavily depends on the character of the business and/or production process at hand. A longer term goal of this type of research is the development of a database, either longitudinal in one company, or cross-sectional between companies and/or sectors. The calculation of numbers also enables comparison between morality criteria themselves. This immediately encourages discussion on the explanation of these differences. If a company is able to repeat the process every 2 years, updating and slightly reformulating the questions, historical data may strengthen the quality of the current process. Cooperation between researchers of different universities and countries could also bring interesting results. Finally it is advised that for optimal research results, a combination is needed of one external researcher and one internal – for example, human resource – officer. In this situation, the status of the project is obvious and dedication of employees might be better. Relevant inside information can be weighed by the HR officer when people show evasive behavior. On the other hand, a crucial aspect of (structured) interviews is the safety and secrecy of answers of the respondents. The primary role of the independent researcher is guaranteeing the latter aspect and creating the safe and scientific atmosphere.

Summary and Conclusions This research contributes to literature that present contents to soft control instruments in modern management control systems (MCS). The applied model develops a so-called MoralScan for medium-sized companies as an instrument for arousing institutionalized discussions on company-ethics. Five criteria are applied – justice, nature, legitimacy, stakeholder care, and sustainability and innovations – to develop right opinions that lead to the right actions in companies’ moral behavior. Based on surveys and/or structured interviews, the researcher calculates a MoralScanIndex, that can be used to compare the company, either longitudinally or cross-sectionally, depending on the chosen benchmark. The calculated MSI – as presented in this chapter – could be used as an estimator of the moral standards of the company, but is most of all functional as a starting point for further company discussion on soft controls within its management control system. In other words: ethics as an instrument in modern management control.

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Conclusions Soft controls contribute to better performing company structures and work motivation. The concept MoralScan first of all contributes to the contents of interactive and boundary Levers of Control framework of Simons (1995). Calculating a MoralScanIndex as such is not a sufficient measure to compare different companies. However, executing the research either by surveys or through structured interviews intensifies moral communication and encourages compliance to companies’ ethical codes. This process is helpful to institutionalize ethical behavior in business. Secondly, despite all kinds of theoretical limitations, the attempt to quantify ethics contributes to nuanced moral discussion and curtails self-focused work climates. The process of developing a specific MoralScan and applying it to a company improves the transparency of the company and enhances cooperation, moral consciousness, and multiple value creation.

Appendix 1: Survey with Average Results Per Question Likert Scale: (1) Disagree Strongly, (2) Disagree, (3) Neutral, (4) Agree, (5) Strongly Agree Average per question Justice 1 At company X everyone is treated equally regardless of their position 2 I am seen in my power by my managers 3 I generally feel treated fairly 4 I treat my colleagues the way I want to be treated myself 5 My colleagues treat me the way I want to be treated 6 I am being judged fairly on compliance with respect to result agreements 7 Based on the direct hours I make, I am judged fairly 8 My supervisor regularly addresses my colleagues about undesirable behavior 9 My manager considers integrity to be of paramount importance when making decisions 10 To protect a nice colleague against possible dismissal, you are willing to do a white lie that does not really harm anyone but is good for his (her) interest 11 I always try to treat rude colleagues and clients as mildly as possible 12 Acting prudently and consciously is unjust with perceived fraudulent behavior Nature and environment 1 How do you go to work every day? 2 What is the distance of your commuting traffic? (single travel distance) 3 We try to print digitally as much as possible and we do not print documents unnecessarily

3.62 4.08 4.31 4.31 3.77 3.42 3.36 3.55 4.00

Car 24 km 4.08 (continued)

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X encourages us to act as environmentally friendly as possible The short-term return within X is more important than the long-term return The decoration of the office and the physical environment inside are attractive 7 The environmental factors, such as temperature and light, are set correctly 8 For me personally, environmentally conscious action is very important 9 Current CO2 emissions and the associated global warming will not go that fast 10 I love taking long walks or bike rides in nature 11 If I can choose between a 3-h train journey and a 45-min flight for a business trip to Paris, I will opt for the flight due to time savings for the company and myself Participant approach 1 My employer gives me enough opportunities to develop myself further as a person and as a professional 2 I can be myself at work 3 I would like to make use of the company savings plan or share plan, if there is any 4 The terms of employment at X are competitive with comparable organizations 5 I am aware that confidants (internal/external) have been appointed within X 6 I feel no threshold to go to the confidants within X 7 X is a good employer for me, because suitable facilities are offered 8 At X I am constantly monitored and I do not get the freedom to make decisions independently 9 The training options offered to me meet my expectations 10 At X I get the opportunity to consciously take up space, show creativity and grow personally 11 I find my workplace and environment pleasant to work in 12 X offers sufficient possibilities for flexible working hours 13 I have faith in the organization 14 I am proud of the developments taking place within X 15 I receive sufficient feedback about the development of my managers 16 My immediate supervisor is an example for me 17 I feel heard by my immediate supervisor 18 I receive feedback (both positive and negative) from my supervisor 19 The partnership (partners) are accessible to me 20 The partners have an exemplary function and are culture-bearers in my eyes 21 The partners ensure continuous innovation within its mission and vision 22 The partners act as an inspirator and figurehead for me 23 At X, customers always come first 24 Large and small customers are treated equally 25 The relationship of trust with the customer is more important than the independence of the accountant

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Average per question 2.15 4.00 3.23 3.69

4.69 4.46 3.85 2.91 4.77 4.08 4.23 4.46 4.08 4.00 3.62 3.85 4.31 4.23 3.60 3.56 4.00 3.73 4.46 3.92 3.46 3.77 3.69 3.38 3.00 (continued)

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Average per question Legitimacy 1 I am aware of the rules of conduct and professional rules of the company 2 I am sometimes alerted/pointed out to the professional code of conduct by my supervisor (s) or by internal supervision 3 I have once acted against the code of conduct 4 I sometimes doubt the actions and behavior of my colleagues when it comes to integrity 5 I sometimes doubt the actions and behavior of customers when it comes to integrity 6 Acting in accordance with laws and regulations is always paramount within our organization 7 I am aware of our house rules and try to comply with them 8 If I have doubts about the integrity of the customer, I take action 9 I address my colleague if (s)he does not follow the house rules 10 In our organization, employees are willing to violate laws, rules and standards to achieve the required performance 11 Within our organization, the professional code (the integrity statute) is seen as guiding all actions 12 There are issues within X that cannot be published because external stakeholders might disapprove 13 I am the same person at work as at home 14 X offers sufficient scope to discuss moral dilemmas with each other Innovation and sustainability 1 I think X is preparing well for the future (self-organization, new products, etc.) 2 X believes that an innovative image is important in contact with the customer 3 Social media is used appropriately in contact with the customer 4 I am satisfied with the internal computer department as it is implemented within X 5 As a knowledge organization, our own knowledge is up-to-date and we share that knowledge with our customers at an early stage 6 We are leading when it comes to product development and services that are indicative for colleagues and external parties 7 When introducing technological innovations, we must explicitly take into account the interests of future generations 8 Our children and grandchildren are equally entitled to a safe future than we are 9 Current social innovations (Facebook, Instagram, Twitter, etc.) lead to biased information sets and therefore unsustainable society 10 Robotization of our production process is a necessary condition for the continuity of the company

4.00 2.25 2.25 2.54 3.55 3.92 4.00 3.55 2.83 2.42 2.82 4.25 3.70 4.25 4.00 4.08 3.77 3.15 3.62 3.15

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Appendix 2 Results Test Questionnaires: Length of Scale, and Positive/Negative Formulation of Questions in 2018/2019 “Onderzoek om van te leren” (22/10/18) Scale difference from 5 to 7

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19

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1

(continued)

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Question Participant 1 Average deviation

1.0

Q2 1.0

Q5

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3.0 1.0

Q9

Q3

3.0 0.013

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Average deviation

0.05

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Total 0.05

20.0

0.12

0.12

0.17

Appendix 3: Example Introduction Cases 1

Suppose you are an employee at an accounting firm and work long days. The work is sometimes boring, so your thoughts easily drift into your big hobby and passion: playing the piano. For a musical performance in which you were asked to play solo, you must copy a piece of music with a size of 43 pages. You do the following: You brighten up your day by copying the piece at work at a quiet moment of the working day at the nearest companies’ copy device, allowing your anticipated joy to enable you to continue working refreshed afterwards

3

You wait until a moment after 6 o’clock, so the chance that someone finds you at the copier becomes extremely small

4

You simply copy the piece where others are with you and say with a smile that a good and loyal employee like you deserves to get some extra service from your employer

2

You will copy the piece in the evening at a print shop near your house 2

1

You are a mortgage advisor and have a credit interview with a young couple who have been drawn to a well-known new-build project in the area and are about to buy a house when the mortgage comes around. From your boss you accidentally heard that there are serious problems with the environmental standards of the land under the new construction project. However, the young couple is so enthusiastic that they can finally live in a new house that the mortgage advisor does not name this information. That is not his job, he thinks. He must sell mortgages and the customers must meet all the conditions for a mortgage. What would you do? You verbally support your clients in their decision to buy the house and you sell a customized mortgage

4

You do not say anything about environmental pollution, because you did not check the information about the pollution yourself, but took it from your boss. You advise taking more own money and less mortgage with your bank

3

You tell the rumor of your boss and advise the customer to first gather further information about the new-build project

1

You say nothing but invent a rule that prevents the customer from qualifying for a mortgage

2

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Explanations scores 1. Naive idealist: A well-meaning person who forgets that evil exists everywhere and shows himself better than he or she really is. 2. Idealistic realist: A realistic person who understands that morality is very important in business and acts accordingly. 3. Realistic commercial: A realistic person who usually takes business interests ahead of the collective goals of business and society. Is especially fair if he or she thinks the chance of being caught is high. 4. Aggressive Utilist: Someone who only and always chooses for his own (financial) interest.

References Anthony RN (1965) Planning and control systems: a framework for analysis. Harvard University, Boston/New York Arjalies DC, Mundy J (2013) The use of management control systems to manage CSR strategy: a levers of control perspective. Manag Account Res 24(4):284–300 Bedford DS, Bisbe J, Sweeney B (2019) Performance measurement systems as generators of cognitive conflict in ambidextrous firms. Acc Organ Soc 44:21–37 Bellora-Bienengräber L (2019) Configurations of control in product development. J Account Organ Chang 15(1):127–146 Bellora-Bienengräber L, Radtke RR, Widener SK (2019) An ethically focused management control system and the importance of peer managers being less egoistic. Working paper, University of Hamburg, Germany Bisbe J, Otley D (2004) The effects of the interactive use of management control systems on product innovation. Acc Organ Soc 29(8):709–737 Blowfield M, Murray A (2014) Corporate responsibility. Oxford University Press, Oxford, p 2014 Boatright JR (1999) Ethics in finance. Blackwell Publishers, Oxford Brand B (2013) Management control systems: subcomponents, optimal design and the role of time as a contingency. Retrieved from: https://publications.ub.uni-mainz.de/theses/volltexte/2014/ 3593/pdf/3593.pdf Cannell CF, Oksenberg L, Converse JM (1979) Experiments in interviewing techniques. Institute for Social Research, Ann Arbor Cardinal LB, Sitkin SB, Long CP (2010) A configurational theory of control. In: Sitkin SB, Cardinal LB, Bijlsma-Frankema KM (eds) Organizational control. Cambridge University Press, Cambridge, pp 51–79 Converse JM, Presser S (1986) Survey questions: handcrafting the standardized questionnaire. SAGE Publications, Thousand Oaks Crane A, Matten D (2015) Business ethics: managing corporate citizenship and sustainability in the age of globalization, 4th edn. Oxford University Press, Oxford Fisher C, Lovell A (2009) Business ethics and values: individual, corporate and international perspectives, 3rd edn. Pearson Education Limited, Harlow Henri J-F (2006) Management control systems and strategy: a resource-based perspective. Acc Organ Soc 31(6):529–558 Henson T (1979) Questioning as a mode of instruction. Taylor & Francis, Abingdon

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Hopwood AG (1976) Accounting and human behaviour. Prentice-Hall, Englewood-Cliffs Journeault M, De Ronge Y, Henri J-F (2016) Levers of eco-control and competitive environmental strategy. Br Account Rev 48(3):316–340 Kaptein M (2015) The effectiveness of ethics programs: the role of scope, composition, and sequence. J Bus Ethics 132(2):415–431 Krosnick JA (1991) Response strategies for coping with the cognitive demands of attitude measures in surveys. Appl Cogn Psychol 5:213–236 Laurent A (1972) Effects of question length on reporting behaviour in the survey interview. American Statistical Association, Alexandria Lehmann DR, Hulbert J (1972) Are three-point scales always good enough? SAGE Publications, Thousand Oaks Malmi T, Brown DA (2008) Management control systems as a package – opportunities, challenges and research directions. Manag Account Res 19:287–300 Mänttäri-van der Kuip M (2016) Moral distress among social workers: the role of insufficient resources. Int J Soc Welf 25(1):86–97 Martin DE, Austin B (2010) Moral competency inventory validation: content, construct, convergent and discriminant approaches. California State University East Bay, Hayward Martyn P, Sweeney B, Curtis E (2016) Strategy and control: 25 years of empirical use of Simons’ levers of control framework. J Account Organ Chang 12(3):281–324 Matell MS, Jacoby J (1971) Is there an optimal number of alternatives for Likert scale items? Study I: reliability and validity. Educ Psychol Meas 31(3):657–674. https://doi.org/10.1177/ 001316447103100307 Merchant KA (1985) Control in business organizations. Pitman, Boston Merchant KA, Van der Stede WA (2012) Management control systems: performance measurement, evaluation and incentives, 3rd edn. Pearson Education, Harlow Oppenheimer DM, Meyvis T, Davidenko N (2009) Instructional manipulation checks: detecting satisficing to increase statistical power. J Exp Soc Psychol 45:867–872. https://doi.org/10.1016/ j.jesp.2009.03.009 Otley DT (1980) The contingency theory of management accounting: achievement and prognosis. Acc Organ Soc 4:413–428 Otley DT, Broadbent J, Berry A (1995) Research in management control: an overview of its development. Br J Manag 6:31–44 Payne SL (1951) The art of asking questions. Princeton University Press, Oxford Redline CD, Dillman DA (1999) The influence of auxiliary, symbolic, numeric, and verbal languages on navigational compliance in self-administered questionnaires. Geraadpleegd op 5 januari 2019, van https://www.sesrc.wsu.edu/dillman/papers/1999/theinfluenceofauxiliary.pdf Rodrique M, Magnan M, Boulianne E (2013) Stakeholders’ influence on environmental strategy and performance indicators: a managerial perspective. Manag Account Res 24(4):301–316 Rosanas JM, Velilla M (2005) The ethics of management control systems: developing technical and moral values. J Bus Ethics 57(1):83–96 Roth J (1989) Soft, dangerous, essential. An interview with Jim Roth. Internal Auditor. http://www. thelia.org Roth J (2010) Best practices: evaluating the corporate culture. Institute of Internal Auditors Research Foundation, Altamonte Springs Simons R (1995) Levers of control: how managers use innovative control systems to drive strategic renewal. Harvard Business School Press, Boston Soppe A (2017) New financial ethics: a normative approach. Routledge Frontiers of Political Economy, Abingdon/New York Soppe A, Schauten M, Soppe J, Kaymak U (2011) Corporate Social Responsibility Reputation (CSRR): do companies comply with their raised CSR expectations? Corp Reput Rev 14 (4):300–323 Spreckley F (1981) Social audit – a management tool for co-operative working. Beechwood College, Leeds

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Sudman S, Bradburn M (1982) Asking questions. Jossey-Bass, San Francisco Tourangeau R, Rips LJ, Rasinski K (2000) The psychology of survey response, 2nd edn. Cambridge University Press, Cambridge Trochim WM, Donnelly JP, Arora K (2015) Research methods: the essential knowledge base, 2nd edn. Cengage Learning, Boston Van Zwieten M, Willems D (2004) Waardering van kwalitatief onderzoek. Huisarts en Wetenschap 47(13):38–43 Widener SK (2007) An empirical analysis of the levers of control framework. Acc Organ Soc 32 (7):757–788

Ethical Responsibility of Financiers Project Management Perspective Yolanda Angelina Altamirano Sánchez and Fernando Macedo Chagolla

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Strategic Planning in the Establishment of Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Elements that Integrate the Strategic Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The State and Its Roles in Project Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Evaluation of Public Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Vectorial Hierarchy Model for the Evaluation of Social Projects with a Sustainable Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Role of Auditing in Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Project Management Challenges in Multinational Environments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adoption of the Standard for Project Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Standard of Project Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Competences Required of a Certified Project Manager . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics in Project Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Strategy Model for the Encouragement of Ethical Commitment in Project Management Within the Governmental Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shaping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Implementation of the Strategy for the Encouragement of Ethical Commitment in Project Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Description of the Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Scope of Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Suggested Sources of Consultation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Implementation Path of Model Strategy for the Encouragement of Ethical Commitment in Project Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

504 505 506 507 508 510 515 516 517 518 519 519 519 519 520 521 529 530 530 531 531

Y. A. Altamirano Sánchez (*) · F. Macedo Chagolla Facultad de Estudios Superiores Aragón, Universidad Nacional Autónoma de México, Mexico, USA e-mail: [email protected]; [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_12

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Validation by Stakeholders: Practitioners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

533 533 533 535

Abstract

This chapter will address the ethical responsibility aspects of funders, from the perspective of project management, with the government context as the focus. From this perspective, the managers face significant challenges and dilemmas, since they are required to conduct themselves professionally and make decisions regarding ethical performance on a day-to-day basis, which is not easy to manage, even less so when. On the one hand, there is no common ethical action guide for the institutions – public and private – with which projects are linked and articulated; and on the other hand, in the existing documents or ethical frameworks to which they must be subjected, they are not considered situations or circumstances in which they must exercise their judgment. It is understood that it is through public projects with the social value that the future is outlined for the benefit of citizens, where governmental organizations, companies, economic, material, human, and intellectual resources are also articulated. In the current context in which projects are developed, the resulting social value does not coincide with the expected value; the initial requirements diverge from the results regarding compliance with the technical and management standards required; also, the motivations and conduct of the people involved in the projects could be incompatible about social conscience, the common good, and the adoption of codes of ethics. Most of the projects and their management have not yet managed to offer the expected value or satisfy the expectations. The results of these projects kind, often, carry on tremendous economic, financial, political, and social impact. Therefore, the field of project management has faced for years, and since its creation, questions related to the contrast between theory and rigor of practice, technical relevance, organizational philosophy, behavior, and social consciousness of practitioners. Due to the above, this chapter devotes attention to the standard in project management, the ethics code, and action guides linked to the public sector. Keywords

Ethics code

Introduction Project managers and senior managers of major multinational companies are increasingly being singled out for unethical or unlawful conduct, which notoriously resulted in bankruptcies, financial losses, and job losses. However, this situation is not exclusive to the private sector, as there are many pages in the newspapers devoted

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to observations or complaints by high-ranking public officials in many countries, this type of incident being even more severe, due to the national property damage and the high social cost involved. At the end of the Second World War, due to the devastation it caused, economic resources began to be applied to numerous social projects at the international level, with emphasis on projects for the reconstruction of war-affected cities through public and private financing. Other types of projects were also evaluated, such as those aimed at providing education, urban development, and housing, as well as preventive actions in health, nutrition, and job training. All of this led to the execution of huge budgets, generating evaluation processes that sought to reduce investment risk and make the results of these projects more effective. It is through public projects with a social value that the future is outlined for the benefit of citizens, where governmental agencies, companies, economic resources, materials, human, and intellectual resources are also articulated. In the current context in which projects are developed, the resulting social value does not coincide with the expected value, the initial requirements diverge from the results regarding compliance with the technical and management standards required, and the motivations and conduct of the people involved in the projects could be incompatible about social conscience, the common good, and the adoption of codes of ethics. The field of project management in the governmental context has faced, for years and since its creation, questions related to the contrast between theory and rigor of practice, technical relevance, organizational philosophy, conduct, and social consciousness of practitioners. Several of the approaches in this work are derive from the compilation and review of own research study, for the development of a strategy model for the engagement of ethical commitment in the project management within the governmental context (Altamirano 2018) and a vectorial hierarchical model for the evaluation of social projects with a sustainable approach (Macedo 2019).

Strategic Planning in the Establishment of Projects One of the crucial aspects for the incorporation of ethical principles in project management is strategic planning because it establishes how an organization will survive or prosper and links a starting point of the organization with the long-term vision (Hernández 2002), and for this, it is necessary to know the organizational conditions and situation, with an internal and external focus. From the process of strategic planning derive the definition of initiatives and the establishment of intermediate objectives; a suitable strategic plan is oriented in the viability of execution, turning it into an operative reality, centered in the achievement of goals and the obtaining of results. Indicators and indices are established to measure this result or progress toward the goals.

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Elements that Integrate the Strategic Planning From the analysis and reflection of the proposals of diverse authors, a scheme is presented in Fig. 1, which frames the common elements that integrate the strategic planning (Hernández 2002; Münch 2005; Herrera and Didriksson 2006; Hellriegel et al. 2009). This scheme has the purpose of giving visibility to the impact and influence of the strategic plans in the inclusion of the organizational ethical sense in the ways of raising the strategic objectives, measuring the results, and establishing the work methods. Besides, four types of elements stand out, according to their purpose: (1) elements oriented to reason for being; (2) elements oriented to the governability and fulfillment of the regulation; (3) elements oriented to the result and to the measurement to reach said result; and (4) elements oriented to the work method, to produce products or services, and that are organized by functions, processes, or projects (Altamirano 2018). Under this consideration, organizations could more assertively present their strategic plans without confusing the strategic objectives with the compliance objectives of the normative framework or with the purposes to implement components oriented toward the work method. When the objectives pursued by organizations are congruent with the values of society, they are being legitimized to access scarce resources.

Elements Oriented to the Reason for Being Thus, the organizational philosophy in which the vision, mission, values, and policies are presented aims to be for organizations that constitute their personality and character as an organism.

Fig. 1 Elements that integrate the strategic planning

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Governance and Compliance-Oriented Elements Elements that, by the way, give legitimacy to organizations, which, from an institutional theory perspective, need to be recognized by other organizations, institutions, or groups with which they could establish exchanges of resources, such as customers, suppliers, distributors, authorities, and employees, as well as for their activities to be perceived as appropriate and desirable (Díez et al. 2010). Therefore, elements such as the corporate name of the organization, policies, and guidelines spilled into the constitutive act, as well as all those ordinances that grant it legality and therefore legitimacy, are included in policies that form part of strategic planning, since this brings with its greater possibilities of achieving success. Result-Oriented Elements Once the vision of the future scenario has been defined, strategic planning focuses on the definition of objectives and goals to measure the results of the organization’s work. For this, it will be necessary to determine the structure of the organization, which in turn is related to the hierarchy of objectives that can be strategic, tactical, or operational. Working Method-Oriented Elements The operation of the organization will depend on the form of production or the methods to organize the work, which a generic way could be by functions, by processes, by projects, or even combinations of these; this will depend on the type of product or service that the organization offers to society. In short, the fundamentals of any organization will be described by its philosophy, which will give rise to the development of the organizational culture. This philosophy starts from the vision, mission, values, policies, guidelines, and rules, which in turn form the strategic planning. This philosophy will determine the path, direction, or route to follow to achieve the vision, besides it will also contribute character and personality to the organization, thus conforming the organizational culture; this culture, in turn, will permeate both the results-oriented elements and those oriented to the work method and its products, which are generated by processes and projects. This chapter focuses on the elements oriented to the reason for being and those oriented to the working method, specifically by projects.

The State and Its Roles in Project Design It is necessary to understand the purpose and the reason for being of the state and contrast it with that of private enterprise. The functions of the state are to administer, regulate, and organize war and peace, as well as the justice, wealth, culture, customs, religion, health, education, and industry – among others – of its citizens. Likewise, in this sense, the author explains that it is the state that empowers other citizens, granting them legal freedom within the framework of private law. However, its most important role is the adequate organization of men and resources to achieve the

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well-being and happiness of citizens in the society it governs, the latter being what it grants to the State, scientific legitimacy, because happiness is related to the survival, life, and well-being of community and constitutes its motive and function as a social science (Guerrero 2000). Those in charge of this function are called civil servants, administrators, or public servants, who commit themselves to make smart and intelligent use of federal funds for the benefit of the republic. These civil servants are the foundation of the economy and the treasury, and they are the ones who determine the administrative matter corresponding to the diverse collective or social needs, and beyond what is indicated by the law without contravening, it is the essence of the public administration, conceived in the form of power that corrects and improves society, and its object of study is medicine, engineering, finance, law, and service, in short, professions directed to the benefit of community (Ibidem). For such immeasurable importance of the role of the state and its transcendence, it is that this chapter has dedicated its focus to ethical responsibility of financiers since project management perspective for the direction of the projects linked to the public sector, on which depend the development and welfare of the society in the broadest sense, preferring it over aspects and private interests, as in the case of the private company.

Evaluation of Public Projects During the decade of the 1950s, social researchers participated in evaluations of projects funded by governments in the world, to address problems of different social nuclei; some of the issues that were sought to address are crime prevention, public housing programs, economic development of community organizations, educational activities, among others. Project evaluation mechanisms at that time took qualitative variables generated by experts into account; these were highly biased according to experience. It is, therefore, appropriate to address some considerations concerning project evaluation, which is a tool or set of techniques that facilitate decision-making to allocate public resources efficient means of carrying out those programs and projects that maximize the well-being of the country, so it is essential to determine which are the most convenient since it allows selecting the most profitable projects, as well as prioritizing to carry out two of the main objectives of good governance: economic growth and combating poverty (Meixueiro and Pérez 2008). The evaluation of projects could be considered as applied research, of interdisciplinary tendency, carried out through the application of a systematic method, whose objective is to know how to explain and value a reality (Cardozo 2006). Evaluation, as opposed to management control, audit or audit, as Cardozo explains, involves a set of activities, the sequence of which varies according to the type of evaluation to be carried out:

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(a) Identify the effects of the action, program, policy, or assessment to be evaluated and the costs incurred. (b) Apply a measurement scale to the identified impacts (nominal, ordinal, interval, or ratio). (c) Compare the measure achieved with another action that serves as a parameter for the evaluation (e.g., the measure of effects obtained in previous periods by the same organization, policy, or program; in the current period by similar organizations, policies, or programs; the one determined in organizational plans as an expected goal, etc.), primarily, in the case of social programs, to determine whether there was an improvement in the population’s welfare conditions. (d) Explain the comparative results found, depending on the design and conditions of application of the program. (e) Issue a value judgment that qualifies the activities carried out, the services provided, their effects, and their overall impact. (f) To make the necessary recommendations to address the problems identified and to build on the strengths of the program to contribute to the higher achievement of its objectives. Evaluated actions could be linked to various evaluation objects: people, organizations, policies, plans, programs, projects, or evaluations. And they can be of diverse types such as evaluation of objectives, relevance, coherence, context, inputs or means, process, achievements, results or outputs, effectiveness, goals, efficiency, effects, impact, and satisfaction (Ibidem). At this point, note the forcefulness of García Sánchez (2009), in the Diccionario Crítico de Ciencias Sociales, in the technical sheet Metaevaluación, published electronically and quoting various authors, which he tells us: The importance that evaluation has been acquiring in both academic and institutional circles does not reside only in its character as scientific research -as one might think in principle- but very especially in its notable political implications. Many of the most recent theoretical elaborations in the field of evaluation revolve around the political dimension of evaluation: (i) Evaluations are about elements – public policies – that are proposed, elaborated, debated, financed, and approved in the political process (Weiss 1991; Palumbo 1987). (ii) Evaluation reproduces the dynamics, the features of the political context in which it arises, and the procedures, structures, and actors that make it up to have a significant impact on its implementation. (iii) The impulse towards its consolidation comes, fundamentally, from the public powers, in the form of institutionalization and financing. Governments see it as an element of legitimacy, as well as an opportunity for control. Thus, the government legitimizes evaluation, and evaluation legitimizes government action (House 1993). (iv) Evaluation is also an intrinsically political activity, since it involves politically relevant, opposing interests that struggle to obtain a more significant share of power and influence in the negotiation. (v) The criteria according to which the policy is judged, the design of the evaluation itself, do not cease to be political, since they imply adopting one position or another for such controversial issues as the access of certain groups to the evaluation, the ownership of the information produced, etc. (Weiss 1991).

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(vi) Evaluations are carried out with the purpose – implicit or explicit – of informing and influencing, in one way or another, the political decision-making process. They are often used as a means of making the political effort profitable or even become a weapon between options of different sign. Evaluation produces information, and information provides power. They are, therefore, especially prone to be instrumentalized, used for political or partisan ends (García 2009).

Some methods of evaluating social projects were no longer of interest to social researchers, due to the lack of maturity and stability in their implementation in the government sector. However, private sector organizations took up these methods again and integrated them into their feasibility analyses to establish indicators and criteria for socio-economic impact. In this sense, the application of hierarchical evaluation methods should be considered an integral part of social policy actions and public and private administration.

A Vectorial Hierarchy Model for the Evaluation of Social Projects with a Sustainable Approach The sustainable social approach arises from the World Commission on Environment and Development of the United Nations who in the report entitled the Brundtland report: “Our common future” carried out in 1987 establish different policies for global economic development that allow a balanced growth and that assure the existence of human society. It mentions that governments and companies in their quest to satisfy human needs have devastated the environment around them, making it indispensable to consider at least three dimensions of the impact of their actions or projects; these are: • Social dimension: Social equity, health, poverty, gender equity, housing, and educational level population • Environmental dimension: Atmosphere, agriculture, desertification, urbanization, oceans, seas and coasts, coastal zone, drinking water, and biodiversity • Economical dimension: Economic structure, financial level, profitability, consumption, and production patterns waste management and generation The dimensions of sustainability seek that governments or companies establish policies that allow them to satisfy the needs of current and future society, carrying out actions that are economically viable, environmentally friendly, and per the cosmovision of the community receiving the good. In a sustainability approach, economic development obtains a balance in function with respect for society and its environment, in such a way as to ensure the existence of humanity in the long term. That implies a significant challenge that requires the collective drive of society. Therefore, governments and private companies should consider in the evaluation of projects the three dimensions of sustainability.

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Each dimension considers several elements; therefore, it is possible to define several indicators per theme so that carrying out an evaluation process under a conventional approach could be a complicated task.

Mathematical Model Conception It is in this sense that the vectorial hierarchy model for the evaluation of social projects with a sustainable approach has its strength in offering an orderly mechanism to attend an evaluation process of this nature, for the case the reference criteria can be given by three unique dimensions which in turn can be integrated by vectorial subspaces (Macedo 2019). The former can be structured as follows: • The vectorial evaluation space will be determined by the dimensions for sustainable development, which will be considered as a vectorial subspace, i.e., the vectorial space for project evaluation will be constituted by the three subspaces (social, economic, and environmental). • To ensure the orthogonality of each dimension or subspace is necessary to weight the projection of the vector. Therefore the evaluation of the criterion must be multiplied by the scalar of the corresponding projection before generating the evaluation vector. This weighting should be made according to the expected impact of each of the dimensions in the evaluation process. • Each subspace should be constructed according to the characteristic indicators of the respective dimension. • The respective weighting criteria will be established for each vector subsystem for ensuring adequate weighting. • The definition of the above criteria of the system of equations representing the projects to be evaluated will be as follows: A ¼ ðC3xn U 3x3 ÞP where A is the matrix of polynomials C is the criteria evaluation matrix U is the matrix of unit vectors of the evaluation criteria P is the weighting matrix From the above the following structure is developed: 2

A1

3

02

C11

6 A 7 B6 C 6 2 7 B6 21 6 7 ¼ B6 4 ⋮ 5 @4 ⋮ An

Cn1

C12

C13

C22 ⋱

C23 ⋮

Cn2

Cn3

3 2 i 0 7 b 76 74 0 b j 5 0 0

1 3 2 3 0 C P1 7 C6 7 0 5 C 4 P2 5 A P3 kb

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The preceding generates vectors that characterize the hierarchy and then: !   Cn1 P1 i Cn2 P2 j Cn3 P3 kb      A n ¼  An   An  þ An  þ An  sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m X    An  ¼ ðCni Pi Þ2 i¼1

where An ¼ Characteristic vector of evaluation of the alternative n-th P1 ¼ Weight of the social variable P2 ¼ Weight of the economic variable P3 ¼ Weight of the environmental variable Cn1 ¼ Evaluation of the n-th alternative for the social dimension Cn2 ¼ Evaluation of the n-th alternative for the economic dimension Cn3 ¼ Evaluation of the n-th alternative for the environmental dimension  An  ¼ Vector module An-th i ¼ It’s the unit vector of the social variable j ¼ It’s the unit vector of the economic variable k ¼ It’s the unit vector of the environmental variable Likewise, the construction of the criterion evaluation will be represented by vectors that characterize the hierarchy for social subspace and then:   Csn2 Ps1bi Csn2 Ps2bj b Cs Ps m  þ   þ    þ nm m Asn ¼ Asn   Asn  Asn  Asn  sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m X   Asn  ¼ Cn1 ¼ ðCsn1 Psi Þ2

!

i¼1

where Asn ¼ Characteristic vector of evaluation of the alternative n-th in the social subspace Psm ¼ Variable weighting m-th of social subspace. Cnm ¼   Evaluation of the n-th alternative to m-th criteria of social subspace. Asn  ¼ Vector module Asn-th. bb ¼ It is the unit vector of the criterion m-th of social subspace. m That is applied to the other two vector subspaces, so that represents the system for the evaluation using Table 1.

Social subspace Weight Projects or alternatives

Dimensions Weight Projects or alternatives

Cs21

⋮ Csn1

As2

⋮ Asn

⋮ An

As1

⋮ Cn1

A2

⋮ Csn2

Cs22

Social criterion 2 Ps2 Cs12

C21

A1

Social criterion 1 Ps1 Cs11

Social P1 C11

Table 1 System of hierarchical vectorial evaluation for social projects

⋮ Csnm

 ⋮ 

Cs2m

 

⋮ Cn3

C23

Environmental P3 C13

Social criterion m Psm Cs1m

⋮ Cn2

C22

Economic P2 C12

i¼1

i¼1

i¼1

⋮ sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCsn1 Psi Þ2 ¼ Cn1

i¼1

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCs2i Psi Þ2 ¼ C21

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCs1i Psi Þ2 ¼ C11

(continued)

Hierarchy of the social subspace

⋮ sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCni Pi Þ2

i¼1

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðC2i Pi Þ2

i¼1

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðC1i Pi Þ2

Hierarchy

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Weight Projects or alternatives

Ca21

⋮ Can1

⋮ Aan

⋮ Aen

Aa2

⋮ Cen1

Ae2

Aa1

Ce21

Ae1

Environmental criteria 1 Pa1 Ca11

Economic criterion 1 Pe1 Ce11

Environmental subspace

Economic subspace Weight Projects or alternatives

Table 1 (continued)

⋮ Can2

Ca22

Environmental criteria 2 Pa2 Ca12

⋮ Cen2

Ce22

Economic criterion 2 Pe2 Ce12



⋮ Canm

Ca2m

 

⋮ 

Environmental criteria m Pam Ca1m

⋮ Cenm

Ce2m

 ⋮ 

Economic criterion m Pem Ce1m

  i¼1

i¼1

i¼1

⋮ sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCan1 Pai Þ2 ¼ Cn3

i¼1

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCa2i Pai Þ2 ¼ C23

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCa1i Pai Þ2 ¼ C13

Hierarchy of the environmental subspace

i¼1

⋮ sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCen1 Pei Þ2 ¼ Cn2

i¼1

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCe2i Pei Þ2 ¼ C22

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi m P ðCe1i Pei Þ2 ¼ C12

Hierarchy of economic subspace

514 Y. A. Altamirano Sánchez and F. Macedo Chagolla

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However, to be able to carry out the selection process according to hierarchies,  the   c decision-maker must select the projects according to the vector module  An . In such a way that projects with a module of greater absolute magnitude will have a higher preference, that is to say, projects that are better evaluated in the three dimensions of sustainability and therefore have more top hierarchy will be preferred. The main limitation of the hierarchical vector evaluation system is the need for computer systems for its implementation. In short, the work of financial evaluation of projects plays an essential role as a phase before the establishment of government programs and projects, which lays the foundations, purposes, objectives, and character of such projects.

The Role of Auditing in Projects The purpose of audits is to ensure compliance with provisions established by the organization for the development of work and, thus, the involvement of a group of trained professionals to review the management, its results, and production requirements, products, services, or delivery and verify that they have complied with the guidelines, standards, policies, processes, procedures, and so on. This auditing function may be performed internally within the organization or be entrusted to other companies, through external auditors, who will have the task of certifying or attesting to compliance with established provisions, which does not exempt the organization from having its group of internal auditors (Hernandez 2002). In other words, the audit is a measurement or evaluation to measure the productivity of a system to determine whether the purposes and objectives have been achieved (Garza 2000). The scope of internal auditing within an organization is broad and may include issues such as governance; risk management of an organization and management controls over efficiency; the effectiveness of operations – including safeguarding assets; reliability of financial and management information; and compliance with laws and regulations. Internal auditing may also involve conducting proactive audits to identify potentially fraudulent acts and conducting subsequent reviews to identify control failures or establish financial losses (Al Hosban 2015). The audit function has extended beyond the revision of accounting and financial standards (SOX USA 2002) to other productive areas, among them the audit of marketing, which includes the evaluation of a company’s commercial strategies; the quality audit, for ISO standards; the reviews of computer systems (Information Systems Audit and Control Association 2010); the environmental audit; the administrative audit, focused on verifying the adequacy of legal and administrative procedures (Cardozo 2006), which is common in cases of public organizations, financial compliance audits, and performance audits; both institutional and public officials are carried out through internal control organs. From the above, it is concluded that regardless of the rigor with which these types of audits are carried out, it is observed that the application is left out of opportunity,

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to correct deviations, since most of the time it has the purpose of inspection and sanction, when the projects have concluded, and these presented irregularities. Therefore, it is considered that a rigorous practice of early quality auditing of project management, from all perspectives, would mitigate deviations or risks that could impact results; but audits with preventive purposes and with mechanisms to implement preventive and corrective actions require the political will of the responsible institutions and those involved in project management.

Project Management Challenges in Multinational Environments To reinforce social policies is common for international organizations to provide funding to growing countries for health, education, infrastructure, energy, and agriculture projects, exerting enormous pressure on public administration today. Because of this situation, the public sector has been forced to adopt criteria, procedures and standards for project management, as well as elements of the philosophies and organizational culture coming from private multinational corporations, given by Ríos, the public and private are so intertwined that it is almost impossible to analyze the consequences of the actions of supranational or multinational companies with the so-called political decisions of governments and that the major political decisions contain a high percentage of consideration toward the interests of these supranational organizations (Ríos and Paniagua 2007). At the same time, essential deontological elements are omitted or made invisible in the current context in which the most significant pressure on ethical aspects is related to the phenomenon of globalization (Velásquez 2006). Thus, the future of social policy and the moral commitment immersed in it require the confluence and compatibility between state and private initiative (Alemán and Garcés 1998). To provide higher elements of understanding is pertinent to describe previous events. After the Second World War, the United States and the allied countries set themselves the objective of reproducing in the countries of the south the processes of industrialization and modernization, as well as establishing new markets since the industrial revolution would allow the West to dominate the world because of its wealth and technological level. As the leading strategy, relevant technical and financial resources were made available, in the form of credits, for the newly independent nations and developing countries (Brunel and Guerre 2005); international organizations such as the Organization for Economic Cooperation and Development (OECD); the World Trade Organization (WTO), and the so-called Bretton Woods Institutions, such as the World Bank (WB); the International Monetary Fund (IMF); among others. More than 60 years after their establishment, they are still controlled by a small group of industrialized countries that keep developing countries as less representative partners in decision-making, even though they contribute in real terms with more than half the world’s production, a large part of consumption, and the majority of the population (Buira and North 2007).

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Thus, the member countries of the mentioned institutions, which consider themselves creditors, have attributes to decide on the policy, norms, and rules of operation of these institutions, while the developing countries, in course or potential debtors, are subject to the policies, standards, regulations, and plans of structural adjustment formulated by the other previous ones, in spite of being the main contributors of the international reserves. Under these conditions, the international environment shows a rapid increase in both the size and importance of the economies of developing countries in the world economy, particularly those with emerging markets. This trend has made the governance structure of these institutions, which reflects the political agreement reached at the end of the Second World War, increasingly obsolete; thus, they begin to suffer from a crisis of legitimacy (Ibidem). That and the various economic events have forced an adaptation of the functions of these institutions to respond to the new configuration of international financial markets and the needs of their member countries and, above all, to the World Bank’s strategies for financing projects in health, education, infrastructure, energy, and agriculture (Dávila 2005). With this purpose and strategies, these institutions have been the promoters and responsible for the international flow of capital and the propagation of multinational corporations, which are companies that support manufacturing, marketing, services, or administrative operations in many countries (Velásquez 2006). It is pertinent to point out that this derives the great difficulty in handling different moral, cultural, political, social, and legal standards that influences the adoption of ethical relativism (Ibidem). For this reason, the WB’s efforts have focused on establishing and placing policies in an institutional context of “governance” without which welfare contributions seem to lose a large part of their meaning, value, and effectiveness, which poses very complex challenges for the following decades (Dávila 2005).

Adoption of the Standard for Project Management Due to the pressure of compliance with international treaties for “governance,” in countries that are debtors of international financing, for example, in Mexico, the conditions for the professionalization of officials have been met public sector, providing as a study the Guide to the Project Management Body of Knowledge. (Governance: The Governance Global Practice supports client countries to build capable, efficient, open, inclusive, and accountable institutions. This is critical for sustainable growth and is at the heart of the World Bank’s twin goals of ending extreme poverty and boosting shared prosperity. Countries with strong institutions prosper by creating an environment that facilitates private sector growth, reduces poverty, delivers valuable services, and earns the confidence of its citizens – a relationship of trust that is created when people can participate in government decision-making processes and know that their voices are heard (https://www.worldbank.org/en/topic/governance/overview. World Bank Last Updated: Sep 27, 2018).

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In addition, it has also been required that companies providing services for bidding projects linked to the state should assign as responsible for such projects project management professionals certified in the practices of the standard of the Project Management Institute. Since then, some organizations intending to provide services, works, and projects have adopted, among others, the practices of the standard in project management. This requirement contributed to the methodological and procedural incorporation of the chosen standard, with the expectation that by establishing clear goals, concrete objectives, standardized planning, and execution of their projects, a high performance, efficacy, and efficiency in the short term in the result of the projects would be glimpsed. On the other hand, in academia, higher education institutions began to incorporate the study of project management standards into their graduate and master’s degree plans in administration and business. Currently, the courses of instruction and training of the standard of project management chosen by the public sector are part of the academic offerings of multiple educational institutions in the world.

The Standard of Project Management The set of disciplines, techniques, and practices of the project management arises from the contributions of the administration, in the context of the private sector; but there are initial adoptions by the state for norms and protocols of the military agencies of the United States and, later, by the aerospace industry – National Aeronautics and Space Administration (NASA), in its Apollo project. More afterward, these sets of disciplines were adopted for the coordination of construction projects, and so the Project Management Institute was founded in 1969, of private character, to share experiences and solve similar problems (Project Management Institute 2015). In general terms, the composition of the standard to which reference is made includes a compilation of techniques and tools that, for its application, is organized in ten areas of knowledge, scope management, costs, time, risks, resources, quality, acquisitions, communications, integration, and stakeholders, and establishes a group of processes related to the stages of project management: initiation, planning, execution, follow-up and control, and closure. It also incorporates, among others, a code of ethics and professional conduct, a frame of reference for ethical decision-making, a frame of reference for the competencies to be developed by a project manager, a requirements guide for maintaining project manager certification, and an organizational implementation guide that suggests the incorporation of unified processes, methods, and principles about organizational structure, technology, cultural aspects, and human and material resources, for the follow-up of projects in organizations and to support strategic objectives.

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Competences Required of a Certified Project Manager The framework of competencies that the project manager must continually develop to maintain certification as a project manager is established in the standard as the talent triangle of the project management, describing competencies that are classified and grouped into three types: skills in technical knowledge, which are referred to the understanding and application of the disciplines of the standard; performance-oriented competencies in the achievement of objectives and alignment to organizational strategy, which establish performance criteria and evidence that a project manager must show; and leadership skills, which include the description of behaviors and skills such as communication, leadership, cognitive skills, achievement orientation, managerial skills, and professionalism (Project Management Institute 2017).

Ethics in Project Management When it is talking about professional ethics, could diverse positions focused on technical elements, related to the administrative process; those based on normative forces; those focused on economy as efficiency, performance, and competition; concerned about rationality as cost-benefit; and those of alignment to law that establishes norms and prohibitions, interacting with technoscience under the conception of “good practices” (Canto-Sperber 2001). Once the standard was adopted and accepted in the practicing community, in 1981, a set of principles was incorporated into project management practices, establishing a code of ethics and professional responsibility of the project manager.

Social Responsibility It should be clarified that social responsibility is a set of organizational practices adopted voluntarily; these practices respond to the impetus given by the United Nations (UN), since 1999, for the adhesion and commitment of companies, mainly private, to the global pact, which establishes ten universally accepted principles to promote sustainable development in the areas of human rights and business, labor standards, environment, and anti-corruption in the activities and business strategy of companies, for corporate sustainability.

Considerations Numerous organizations that are concerned about their effectiveness; efficiency and effectiveness, both public and private, have defined codes of conduct, philosophies, policies, and organizational guidelines, tending to influence civic behavior, ethical, humanistic, and respect for human rights; however there is still a significant distance

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to travel, in terms of ethical commitment in the practices of project management linked to public bodies, despite the adoption of standardized rules for project management – the Project Management Institute – which includes a code of ethics; but they do not always obtain the expected benefits and, even also it is observed in some cases, the omission of their policies and guidelines established in their organizational philosophies and the lack or null adoption of codes of ethics, in the development of projects (Project Management Institute 2014). For this reason, it is necessary to know the aspects that encourage ethical commitment in projects related to the governmental sector, and it is required to promote or emphasize this standard. In cases of this type, reflections arise on why the principles of the United Nations Global Compact have not been observed, in the guidelines of transparency, government regulations imposed by internal control bodies, where a significant gap is identified in the adoption of the code of ethics in the project management.

A Strategy Model for the Encouragement of Ethical Commitment in Project Management Within the Governmental Context Despite attempts to achieve high performance in the implementation of large projects, it has been evident that even adopting standardized practices of project management and conducting quality audits in project management, some organizations, both public and private, see their efforts to adopt such methodologies minimized and even diminished and sometimes discarded, with a learning curve and change too long to evaluate the benefits of procedural implementation. In this context, it is considered an indispensable condition that elements of the organization’s philosophy are present such as mission, vision, values, policies, and objectives, both in public organizations that generate projects and in the organizations that are linked to such projects. Likewise, it is assumed that these elements are necessary to influence civic, ethical, humanist behavior, respect for human rights, and collective welfare when proposing, developing, and executing projects. However, codes of professional or organizational ethics are not always adopted, even when there is an explicit commitment to the organizational philosophy. The challenges inherent to projects linked to the governmental sector are profiled toward covering deviations and omissions on the management of stakeholders concerning ethical conduct, collective welfare, evaluating sustainability and foresight that give rise to projects, developing complements to the code of ethics, and conforming models of its application. Project management, as part of administration, has had to incorporate elements, tools, and strategies of the various contributions to administration into its work, so that today’s project management is oriented toward efficiency, organization by processes, quality, learning, labor relations, control in decision-making, organizational behavior, leadership, and ethics, which suggests that the latter, the element of most significant challenge and challenge, insofar as project management – as project managers say – is confronted with its results and evidence, that is, the successful

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completion of projects in scope, cost, in the established time, with the expected quality, the obtaining of benefits, the satisfaction of its beneficiaries, and minimizing risks and assuming the expectations of those involved, all immersed in the environment and organizational culture of the instances that give rise to the projects. In some cases, although there are enough elements in the organizational philosophy that could guide the ethical conduct of the project manager, there are no mechanisms established in the standard to encourage ethical commitment in the work team or others involved. In the standard mentioned above, these aspects are considered only as external and internal cultural, environmental factors within the organization, in which the project is immersed, which do not fall within the scope of control of the project manager, and which, without any justification, is attributed to the project manager the responsibility for any deviation from the purposes of the project, which invariably impacts on the financial aspects. Regarding the nature of government projects, it has been observed that more often than not, the benefits offered by the projects lack the real impact on the common welfare of citizens, despite the implicit monetary costs; this is explained by the lack of visibility of social benefits on the part of those involved in the development of the projects and the lack of understanding of the ethical commitment to the common welfare. There is still a gap to be bridged between the existing methods for project management and the formalization and adoption of ethical commitment, where project managers face multiple challenges to align organizational philosophies to daily performance, where it is observed in a general manner the adoption of codes of conduct oriented mostly to the fulfillment of “labor duty,” having as a guideline the use of strategies and methods developed in the contributions to scientific management before the 1990s, leaving aside ethical behavior as professionals, as citizens, and as human beings, belonging to a social group.

Shaping Then in order to reduce the mentioned gap, it is presented a shaping scheme in Fig. 2. for the development of a model strategy for the encouragement of ethical

Fig. 2 Stages in the shaping

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commitment associated with the practice of the project management standard in the governmental context (Procedure -see Altamirano 2018), which consists of the following six stages: • • • • • •

Construction of the interaction scheme Determination and construction of the convergence of interests’ scheme Defining model elements Outline of a model strategy for the encouragement of ethical commitment Validation by stakeholders Implementation

Construction of the Interaction Scheme In general, it is observed that the project manager, certified in the standardized standard, may be required to intervene in a project from three different roles, functions, or perspectives: • Project manager, for the overall direction of the project, management from the initial stages, until its closure. • Dictaminator or expert for quality assurance, when entrusted with the surveillance and supervision of the monitoring of processes, whether technical or administrative, in the project. • Public officials attached to the government institution, which, most of the time, acts as the person in charge of the project within the organization. Even if he or she does not lead the project, he or she is involved in the strategic decisionmaking of the project. The project manager linked to government sector projects, regardless of their designated intervention role, faces enormous challenges related to ethical aspects in which they are exposed to various dilemmas, grouped into five main categories: CDM_1 Quality of specifications and minimum technical requirements CDM_2 Organizational environment and culture, concerning the control of its environment, immersed in organizational culture. CDM_3 Management of interests (personal, political, and private), those situations in which political or private benefit precedes or contradicts the stated objectives of the project and its beneficiaries or is detrimental to the benefits that the project will offer. CDM_4 Accountability, related to its designation of responsibilities for accountability and transparency CDM_5 Intervention of senior managers, when people from the highest institutional hierarchy give them indications, which contravene ethical principles (Ibidem) The interaction of the project manager scheme – presented in Fig. 3 – facilitates understanding of the project manager’s interaction for his role, responsibilities, aspirations, the challenges he faces, his points of support, and the pressures he

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Fig. 3 Interaction of the project manager in the governmental context

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receives within the governmental context; in the central part of that, there is the project manager, who is invested with attributes, which he sustains with the technical knowledge, skills, and competencies in which the project manager has been trained; he assumes the enormous task of managing and giving way to projects, promoted by government agencies, for the benefit of and for the future well-being of citizens and the society to which he belongs (Ibidem). These projects can be, among others, education, technology, health, infrastructure, telecommunications, or energy; in their daily work, they face multiple challenges related to the type of quality of specifications and minimum technical requirements, environment and organizational culture, management of interests (personal, political, and private), accountability, and intervention of senior management. To face them, it has a standard and points of support that helps it to make decisions, its ethical principles, the code of ethics, its strategy for the encouragement of commitment, and ethical criteria. To develop the strategy for encouragement, ethical commitment is necessary for the project manager to know the context and environment of the organizations involved; to do so, he needs to observe and analyze the form, type, and structure of the organization, economic and social conditions and organizational culture, market conditions, and technological advances and trends related to the project. In the area of structure, social object, and productive sector, it will be necessary to understand the differences and characteristics of the type of organization where the model is implemented, since it will require a different treatment of governmental organizations, nongovernmental organizations (NGO’s), or private industrial sector than those of services or even small- and medium-sized enterprises, to infer the conditions in the dynamism or obstacles faced by the organization and understand its culture, access to capital, material, and technological resources at its disposal, computer processes and systems, intangible assets, and knowledge management. Likewise, it will be necessary to know the openness and normative flexibility of the organization, to adopt intervention schemes, as well as internal mechanisms – formal – to resolve conflicts on ethical aspects, such as accusation, complaint, mediation, arbitration, conciliation, and remediation that institute justice policies for the whole group concerning rights, obligations, and sanctions, which foresee and prevent typified conflict situations.

Convergence of Interests When the private organization intervenes in providing services to the government sector and from the perspective of the private sector, the search for higher rates of profitability, higher profit margins, increasing competitive advantage in the face of globalization, and satisfying requirements in bidding are some of the motivations to implement strategies and standards of project management or hire project managers certified in the standard. That is because the project manager assigned to such a function is the only one responsible for the success or failure of such a project. At this stage, it is necessary to identify the appropriate approaches for private sector organizations to adopt a strategy model for the encouragement of ethical commitment in project management, whether, in such methods, appeal, among

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others, to the interest of the benefit of sustainable investment, compliance with legal provisions, avoid fines or sanctions, competitive advantage, achieve reliability and corporate stability, and be a candidate to obtain higher demand for projects by the government, trend, and prospective, expansion, social responsibility, or increase in social value. However, the most significant impetus could be found in compliance with the “Anti-corruption Law that will also oversee the private initiative.” Therefore, when formulating a strategy for the encouragement of ethical commitment, it will be indispensable to have full knowledge of these motivations to be assertive in proposing a proposal that opens the way, guides the change in the conduct of those involved in such projects, and becomes a reality. It should be noted that many organizations adhere to policies and standards and that also respond to the sense of humanistic, social responsibility, and philanthropic as part of their philosophy or subscribe to the Global Compact of the United Nations (UN), by pressure and condition of the international market. That also imposes the implementation of codes of ethics for OECD multinational companies; this presupposes the abundant availability of legal and procedural references that support the operative reality in a framework of ethical action. Joint, coordinated, convinced, and agreed participation will determine the success of the organization itself for the project, provided that the organization is identified as a plural organization, in which the agents assume and accept not only a legal contract but also adopt and commit themselves to an ethical, moral contract, together with a social contract, for the future shared welfare, having in it, the opportunity of transcendence, where the project is a convergence of interests between the private sector, the public sector, the political sector, and the citizens – see Fig. 4 – that require to be harmonized assertively for the real success of the project, always

Fig. 4 Convergence of project interests in the government context

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maintaining the superior purpose, for the maximum benefit of the citizens, while they are the ones who pay, through taxes, the cost of public projects (Altamirano 2018).

Defining Model Elements For the definition of a model strategy to encourage ethical commitment, items such as knowledge, parties, fundamentals, challenges, and shaping, which derive from the previous approaches and reflections, are considered – see Fig. 5. Knowledge For the required knowledge and disciplines involved, it is essential to remember that the work of project management requires the support of various disciplines and specialists. Thus, for implementing the model, it will be necessary to be assisted by professionals in multiple areas of knowledge such as project management, administration, industrial engineering, organizational psychology, information technology, pedagogy and law, and maybe other discipline in accord of project type.

Fig. 5 Main elements in a model strategy

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Parties The appropriate strategy for encouraging ethical commitment will depend to a large extent on the visibility of most of the actors involved, achieving proper communication and collaboration with them on aspects of ethics, legality, and civility, to make visible opportunities and restrictions based on risks. In general, they will be involved: project management team, area principals, shareholders, suppliers, advisory groups, social groups, governors, and politicians. Fundamentals Once the appropriate frame of reference has been identified, it will be necessary for all those involved to formally know and understand it, including the study of the standard updated materials. Such support would be in existing documents such as laws and regulations, organizational strategic planning, the social value of projects, research reports and trends in ethics, prospection, and projection of the state of results and risk plan. Additionally, depending on the nature of the project, it will be necessary to consider some other livelihoods, such as estimation of the social value of projects, risk plan (plan validation), and project integration plan. Challenges Based on the above, it should be clarified that the formulation of a strategy model for the encouragement of ethical commitment is involved in its conception and development. To do that is necessary to observe the challenges faced by the project manager in carrying out his work. Some examples of these challenges could be the follows: • Understand organizational motivations and purposes. • Anticipate all environmental and contextual factors that affect or could affect the project. • Orient axiological dimensions to business strategies. • To have assistive technologies at their disposal. • Contribute to the value of the organization. • Betting on social responsibility. • Generate trust and give legitimacy to motivations in the organization. • Adhere to organizational governance mechanisms. • Generate facilitating mechanisms for innovation in the encouragement of ethical commitment. • Optimize investments. • Increase efficiency and productivity of the organization. • To have substitution tables, either by contingency or separation. • To reduce the distance concerning civic, ethical knowledge, among others. Based on former definition, a synthetic scheme was generated, shown in Fig. 6, to keep visualized the main elements involved in the design of the model for the encouragement of ethical commitment (Ibidem).

528 Fig. 6 Main elements in the model strategy for the encouragement of ethical commitment

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Once these challenges are taken up and there is the will to face them, a viable strategy model can be outlined; the following section describes the model shaping in further detail.

Implementation of the Strategy for the Encouragement of Ethical Commitment in Project Management It is true that although it has been observed that the standard documentation of project management practices is insufficient to guide ethical performance, it is also important to mention that this model is intended to be a complement to such literature, to strengthen the project manager and his team working in the government context by providing additional tools and guidelines for the encouragement of ethical commitment. At this stage, the main challenge has been to offer parameters and criteria that strengthen the ethical positions of the project manager, in his performance, in the various moments associated with the application of the practices of the standard, with the full knowledge that, on the one hand, projects linked to the public sector respond to strategies in the economic, political, social, cultural, intellectual, and technological management of various areas of society and, on the other, involve the participation of stakeholders immersed in a specific organizational context. The model implies the active involvement of people who participate in the project of government institutions and supplier organizations, making them co-responsible for facilitating the means and establishing the mechanisms to achieve the ends of such projects. It is pertinent to point out that, for the design of this model, the findings and results of the research from which this work derives (Altamirano 2018) have been considered, but, also, additional elements were included in the design of the model for facilitating the understanding of the model. The aspects included are the following: 1. Description of the model 2. Scope of application 3. Suggested sources of reference: • About the standard • On ethical issues • On legal and regulatory aspects • About the organizations involved • On change management

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4. Model strategy for the encouragement of ethical commitment in project management: • Diagnosis • Strategy • Strategy support 5. Validation by stakeholders: practitioners 6. Implementation of the strategy

Description of the Model Project management, as a specialized branch of administration, arises from the integration of the contributions of scholars, of the physical-mathematical sciences and engineering, and the social disciplines and humanities. Since then, the practice of this specialization has promoted the generation of technical standards, such as that of the Project Management Institute, PMI. Therefore, the strategy model for the encouragement of ethical commitment in project management within the governmental context offers a set of elements that contributes to encouraging an ethical performance of the project manager and those involved to achieve the successful execution of public projects. The purpose of this model is to encourage the majority of those involved and interested in the projects to understand, appropriate and exercise full ethical responsibility for the actions they carry out in dictating, directing, and supervising projects in the governmental context, in addition to providing mechanisms that contribute to the achievement of the objectives and in the enormous task of managing public sector projects for the welfare of the social future. The model considers the confluence and harmonization of interests, both private sector organizations, interested in their survival and prosperity, and of the public sector and the political sector, interested in giving visibility to government actions. The premises for its use suggest the training of the project manager for the incorporation from early stages to the beginning of projects to maintaining rigorous control in the stages of planning, execution, and closure of projects. The model also suggests steps for the management of change, for the assurance of ethical, civic, legal, social coexistence, and even human rights knowledge and organizational intervention actions, through the establishment of mechanisms for compliance with statutory provisions, with emphasis on the encouragement of commitment rather than sanction. The objective of the strategy model is to strengthen the management practices of standardized projects, providing a set of guidelines, tools, and methodological support points that contribute to the success of the projects and the achievement of social benefits.

Scope of Application The main scope of application of the model is in public sector projects, to facilitate the development of mechanisms for transparency and accountability, interest

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management, quality control and compliance with technical requirements. It promotes the ethical commitments adoption by the organizations that participate in such projects, and the awareness of the managers in the institutional hierarchy. Similarly in projects with social purposes, in order to promote their sustainability. Also in productive sector projects, the evaluation of the organization ethical conditions, leads to the establishment of policies and guidelines that guarantee the stability and prosperity of the companies. Even in innovation and development projects, the suitable policies and guidelines that foresee the ethical conduct in all the cycle of life of the products derived from these projects could be determined early.

Suggested Sources of Consultation To have documentary sources to accompany the implementation of the strategy model and with the premise that the standardized practices of project management have been adopted, additional references will be required: • • • • • •

About the updated standard, documentation On ethical aspects On legal and regulatory aspects About the organizations environmental On change management On good practices fostered by global agencies

Implementation Path of Model Strategy for the Encouragement of Ethical Commitment in Project Management The elements that comprise the implementation path of strategy model for the encouragement of ethical commitment in project management, with a practical framework, located in how. It will be defined as a life cycle of three main phases of the model and which in turn include the following stages: • Diagnosis – Organizational diagnosis – The conception of the possible optimal scenario – Analysis of deviations and omissions • Strategy – Design – Action lines definition – Socialization and commitment • Strategy support – Change management plan – Plan for monitoring the strategy – Continuous improvement

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Fig. 7 Implementation path of model strategy for the encouragement of ethical commitment in project management within the governmental context

The generic schema for visualizing the strategy implementation path is shown in Fig. 7, which includes three main phases that group together nine key stages (Ibidem). The diagnostic stage includes various aspects of the context, both internal and external to the organization focused on issues of ethics, for the next step, under a prospective approach which will continue with the stage of conception of the optimal scenario possible, returning to the theoretical references, best practices, and trend in insertion of ethical commitment. This scenario should be presented under a systemic approach that helps to visualize the subjects, objects, procedures, tools, and resources available, the environmental conditions, as well as the theoretical-ideological elements, which will facilitate the immersion in the next stage, for the analysis of the deviations and omissions in an integral way between the real scenario and the optimal possible scenario. As a result of this diagnostic phase, a range of potentially viable strategies to be implemented as part of the developed strategy model is derived. The strategy phase involves two stages: first, a design stage, to develop a plan for the promotion of the ethical commitment, ad hoc to the organizations of the context of the project and its diverse actors, second, an execution stage under the perspective of action research, which includes the iterative execution of adjustment and

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improvement, between the stages for the definition of lines of action for the promotion of the ethical commitment and that of socialization with the project team and the main stakeholders; to achieve the consensus of the project manager and the adoption of the ethical commitment of the main stakeholders, on a set of policies and procedures; to generate then, a plan for the encouragement of ethical commitment, which contributes to ethical performance throughout all phases of development of the project and with various actors and stakeholders. Finally, the strategy support phase will accompany the execution of the plan for the encouragement of ethical commitment, establishing stages generating control points, evidence and indicators in the change management plan, and the strategy follow-up plan and a continuous improvement stage. In general, the purposes of these stages are, among others, to put into practice the incorporation of ethical criteria, from the early stages to the beginning of the project; the development of competencies oriented toward the ethical sense, in all the members of the project team; the encouragement of commitment and ethical action, the practice of values; the establishment of mechanisms for the adoption of codes of ethics; and sensitization of those involved, which emphasize and give visibility to the achievement of benefits for the common welfare, through the project that is managed.

Validation by Stakeholders: Practitioners In the modeling and design phase, a graphic representation emerged, which exposes the interaction of the project manager linked to the public sector; a scheme to give visibility to the convergence of interests in public projects, which proves of interest groups to be involved in the encouragement of ethical commitment; a set of elements to be integrated in a strategy model of the encouragement of ethical commitment; and elements that establish the theoretical bases and clarify the necessary premises for the design of the model.

Implementation Concerning the implementation phase, the main product is the detailed description of inputs, outputs, technical, and methodological elements of each one of the components of the strategy model, which contributes to consider methodological and documentary elements, proper to the practice of the standard; but above all, it provides adequate details to strengthen and complement the methods oriented to encouragement of ethical commitment in project management within the governmental context.

Conclusions It should be noted that, from a teaching and research perspective, this chapter contributes to the field of knowledge of administration and finance by providing various products that are additional to the model of encouragement of ethical

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commitment within the governmental context and the system of hierarchical vectorial evaluation for social projects. Initially, the scheme of the elements, which integrate the strategic planning according to its purposes, facilitates the understanding of the location and relation that keeps the organizational philosophy relative to principles and ethical values, which by the way is what distinguishes the role of the private company contrasting with the one that keeps the state in its function to watch over the interests of the citizen for the common welfare. That facilitates the visualization of those organizational strategies, oriented to the promotion of the ethical commitment, which also drives the generation and understanding of codes of ethics by those involved in the projects and processes. At the same time, it generates a spirit of synergy and collaborative work toward the objectives of the projects and encourages work with high professional values. Theoretical elements of criticism and analysis were provided for the understanding of the state kept by the standardized practices of project management in the governmental context and the challenges in multinational environments. That reiterates that the rigorous exercise of standardized practices can be used whenever they help to encourage ethical commitment to decision-making in the face of ethical dilemmas. Nevertheless, and with greater relevance, these products helped to identify those elements that were absent despite their needs, to foster ethical commitment in those involved and interested, as well as to guide the conduct of project managers in the face of possible ethical dilemmas; this mitigates the need for sanctioning, coercing, or punishing measures. From there, the common challenges faced by a project manager when managing projects linked to the public sector were described, which help to establish mechanisms for prevention and early correction of behaviors that may lead to misconduct, sensitize the involvement and linkage with citizenship, facilitate the work of new professionals committed to ethical action, who are integrated into government contexts, and foster the development of an ethical sense in diverse environments and groups. It should be emphasized that the strategy model provides a pathway map for the encouragement of ethical commitment in project management within the governmental context and beyond for manage change, adaptation, and improvement; establishes viable strategies implementation iterations in diverse environments and groups; and socializes the planning of different types of projects. Since another perspective, the main limitations could be the model depends on the ethical approach of the stakeholders involved, including the project manager; the limit model scope to the stakeholders identified by the project management team. The model implementation requires the project manager expertise, also project cost could increased due to the raise in the hours of effort of specialists dedicated to the project. This work responds to the deficiencies in the adoption of ethical principles, which have been the main barrier to economic development and productivity in countries like Mexico, comparable in importance to national challenges in four other areas:

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institutional strength, social development, equal opportunities, and international projection. Although the government is the main actor responsable and promoter of social progress, and involves co-responsibilities of institutions at the three levels, federal, state, and municipal. However such responsabilities involves authorities of both public and private educational institutions too, like directors, teachers, researchers. In the legislative sphere, it means deputies and senators; in the social field, it includes foundations and civil society organizations; and in the economic area, it includes business chambers. Therefore, this work has oriented its purpose to propose a set of instruments and a strategy model for mitigating etical deficiencies around the project management in governmental contexts, in which diverse actors of society intervene. From the organizational perspective, both public and private, it can be inferred that the implementation of model requires the vision of high-level shareholders and directors; the work of coordinating middle management, aimed at achieving objectives and goals; the enthusiastic participation of the rest of the people in the organization who work on the projects; and, in short, the consensus of union parties. It is indisputable that the joint, coordinated, convinced, and agreed participation will determine the success of the project in its social mandate. For the project manager in the governmental context, the main challenge is to maintain the course of the project’s purposes, toward the vision of the optimal possible scenario, to transcend toward a shared future well-being, to be willing to confront and anticipate threats, to observe the context and the environment, knowing that in the adoption of the model for the encouragement of ethical commitment, it will require persistence and visibility of the obstacles, and to adjust the path toward the primary goal of public projects, which is to provide the maximum benefit for society. For this reason, it considered project management as a bridge between a vision for the future and the shaping of a shared reality.

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Part IV The Influence of (Social and Ethical) Accounting in Ethics in Finance

The Many Merits and Some Limits of Social Accounting Why Disclosure Is Not Enough Adrian Zicari

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Social Accounting and Its Promise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Short Story of Social Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Disclosure on Social and Environmental Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regulation of Social Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Social Accounting Inside of the Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From Social Accounting to Financial Results (or the Other Way Round?) . . . . . . . . . . . . . . . . . . . . The Promise of Social Accounting to Achieve Organizational Change . . . . . . . . . . . . . . . . . . . . . . . Conclusion – Social Accounting and Ethics in Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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This chapter explores the potential and limitations of Social Accounting, a much relevant discussion in the context of a book about Ethics in Finance. This chapter intends to introduce some of the ongoing discussions around Social Accounting to scholars from other disciplines. There is no intention of presenting an exhaustive picture of Social Accounting, and the choice of literature has been narrowed to those issues more relevant for Ethics in Finance. The chapter presents a short introduction to Social Accounting and its recent history. Then, there is an exploration of five issues that may interest a general academic audience: first, the reasons and purpose of corporate disclosure of social and environmental information, being that this kind of disclosure is usually not mandatory; second, the current discussion about regulation in this field, whether regulation of Social Accounting contributes to Sustainability or not; third, an introduction to the use of Social Accounting for internal purposes, that is, information not disclosed to external parties but used instead by management A. Zicari (*) Accounting and Management Control Department, ESSEC Business School, Paris, France e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_14

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for decision-making; fourth, the link between Social Accounting and financial performance; and finally, the promise of Social Accounting to contribute to Sustainability. Some of the main ideas are as follows. There is a tension between companies, which possibly do not share all social and environmental information, and stakeholders, who would expect higher transparency. Thus, we should not assume that companies naively disclose social and environmental information. Then, regulation for social reports could help to increase the quality of reports, but some studies show that regulation by itself will not automatically improve disclosure. Additionally, studies in managerial accounting emphasize the complexity of working with social and environmental indicators. Thus, it is possible that managers struggle to collect and make sense of information about all the social and environmental impacts of their firm. Furthermore, the link between sustainability and financial performance remains elusive. Finally, we should be aware of what Social Accounting can deliver (and what it cannot do) in terms of organizational change. Consequently, practitioners should not refrain from using complementary tools from other disciplines. Overall, Social Accounting can contribute in a consistent way to the improvement of corporate sustainability. In that sense, Social Accounting is an increasingly important tool for both managers and stakeholders. Keywords

Sustainability · Ethics · Finance · Social Accounting · Stakeholders

Introduction In their exploration of different questions in Ethics in Finance, San-José and Retolaza (2018) point to Sustainability as one of the most pressing issues today. This is not surprising, as we are collectively becoming more aware about environmental degradation, climate change, and inequality. While those problems correspond to different causes, companies’ activities are certainly one of those factors at work. Following San-José and Retolaza (2018) definition of Sustainability, namely, “. . .a social and environmental balance with the aim of diminishing future negative returns or the generation of negative externalities,” it is clear that those externalities, returns, and balance have to be measured with some kind of Accounting. More precisely, with Social Accounting tools. Consequently, a discussion about Social Accounting, its promise, and its limitations is much relevant in the context of a book about Ethics in Finance. Thus, this chapter intends to introduce some of the ongoing discussions around Social Accounting to scholars from other disciplines. There is no intention of presenting an exhaustive picture of Social Accounting, and the choice of literature has been narrowed to those issues more relevant for Ethics in Finance. Besides, this chapter uses the expression “Social Accounting” as a broad term that also includes environmental contents. Some other equivalent expressions may exist,

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for instance, sustainability accounting, social and environmental accounting, and nonfinancial accounting. Similarly, for this chapter we use the expression “social report,” which can be replaced by sustainability report, Corporate Social Responsibility report, among others.

Social Accounting and Its Promise Social Accounting attempts to measure a complex, broad, and not always clearly defined object. It is curious to see that corporate social responsibility (CSR) has at least 37 different definitions (Dahlsrud 2006), not all of them equivalent. Consequently, it is difficult to say that any company is more or less socially responsible, or that it has a better CSR performance than that of any other firm. For instance, when Margolis and Walsh (2003) analyzed 127 studies that attempted to measure the Corporate Social Performance of firms, they found that in those studies, Social Performance is measured in many different ways: disclosure of pollution elements, reputation rating in a business magazine, evaluations from social investing rating agencies, and so on. Thus, the scope of Social Accounting can be subject to debate. Besides, this scope is clearly broad, as it includes an ample specter of indicators that attempt to capture the complexity of social and environmental impacts. Testimony to this breadth of Social Accounting is social reports, which in many cases have been increasing in length in the last years. Because of this mentioned breadth of scope, social accounting reports bring a wealth of information that can potentially interest many different stakeholders. However, there is a tension between comprehensiveness and comprehension – the longer, the more complex and complete social reports are, the more difficult they become to read. Thus, when reporting about many different social and environmental features, possibly each of one of them much interesting in itself, we may end up producing a report that is difficult to read. Stakeholders can struggle to appreciate “the big picture” of a company’s social performance when the firm prepares a lengthy, complex-to-understand report. Legibility of social reports is a relevant issue for stakeholders, particularly as most of them are not necessarily experts in social accounting. Additionally, those indicators are in many cases nonfinancial (i.e., not measurable in money), which implies that the source of data goes beyond the conventional accounting system of the company. As a comparison, the source of financial accounting reports is the company’s accounting system, a coherent and usually well-prepared system, which already exists and has a single unit of measure (i.e., money). Practitioners of Social Accounting need instead to collect, record, and analyze different types of information. This information corresponds to diverse units of measure (i.e., hours, tons, number of people) not found in the accounting system of the firm. Consequently, setting up and maintaining a reporting system for Social Accounting can require a consistent effort, which not all companies can afford to do. It is not surprising that social reports are much more common in large companies than in small ones.

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Furthermore, and following the comparison with conventional financial accounting, Social Accounting is a far more recent practice. While the conceptual basis of conventional accounting was set during the Italian Renaissance (Fra Luca Pacioli published his treatise of Geometry and Accounting in the late fifteenth century in Venice), Social Accounting is a creation of the twentieth century. Thus, there are five centuries of continuous practice and academic study of conventional accounting, compared to only few decades for Social Accounting. It is no surprising that both academics and practitioners in Social Accounting still struggle to agree on conceptual frameworks and standards.

A Short Story of Social Accounting Some of the early discussions in Social Accounting come from the 1970s. Curiously, many of the early papers raise issues that remain valid today. Mobley (1970) argued for the need of Accounting to go beyond the measurement of economic impact only. Estes (1972) pointed to the urgency of measuring external diseconomies, at a time when some environmental regulation was beginning to appear, while Ramanathan (1976) proposed the broad lines of a model for stakeholder reporting. With the benefit of hindsight, we can see that those papers were still isolated and that there was not yet a developed discussion around Social Accounting. The situation changed in the 1990s, mainly in the UK and Continental Europe, with the appearance of a vibrant community of scholars. Bebbington, Gray, and Owen (1999) distinguish between studies that call for a complete revision of the economic system, while others are more oriented to developing tools that could improve corporate practices. At that time, the emphasis has been more on the first type of papers, more conceptual pieces, sometimes inspired in critical theory. There also has been a discussion around the creation and use of Social Accounting information, that is who prepares that information and who should read it. Social Accounting information can interest investors (Gray et al. 1996) and other stakeholders (Gray et al. 1997). One of the most important rationales for increased disclosure and transparency has been to empower stakeholders so that they can look for improvements in companies’ behavior, for instance, by means of negotiations in the case of NGOs, and investments in the case of socially responsible investors. While many studies have emphasized on the information that companies disclose to external participants, recent papers also study internal information (i.e., managerial accounting). Besides, Gray et al. (1997) point to reports prepared and published by external parties to the company, sometimes called “shadow accounts” or “social audits” (Medawar 1976). For instance, an NGO can prepare information about a company, based on publicly available data from other sources (i.e., not coming from the company itself). As a recent example of this idea, Perkiss, Dean, and Gibbons (2019) present the notion of “Spotlight account”: a crowdsourcing process of data collection about a company, led by independent stakeholders, with the aim of preparing a social report on that firm.

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Nowadays most of the largest companies in the world regularly produce some kind of social responsibility report. The field is today more mature, with many active practitioners, including specialized consultants, analysts, and investors. Several reporting standards and models coexist today, and we may expect a gradual convergence in the next few years. In the academic world, Social Accounting is no longer a niche discipline, and today it is quite common to see social accounting papers presented in the main accounting conferences in the world. In the remaining of this chapter, we will explore five of the issues that may interest a general academic audience: first, the reasons and purpose of corporate disclosure of social and environmental information, being that this kind of disclosure is usually not mandatory; second, the current discussion about regulation in this field, whether regulation of Social Accounting contributes to Sustainability or not; third, an introduction to the use of Social Accounting for internal purposes, that is, information not disclosed to external parties, but used instead by management for decision-making; fourth, the link between Social Accounting and financial performance; and finally, perhaps the most relevant issue on the long run, the promise of Social Accounting to achieve long-term change in companies, and by that doing, to contribute to Sustainability.

Disclosure on Social and Environmental Information While some countries, particularly in Europe, have been recently regulating on the issue, most of Social Accounting disclosures remain to this day voluntary. Thus, companies can decide on what to disclose, how frequently, and to what extent. There are several social reporting frameworks, and they are quite useful as they make intercompany comparisons easier. For instance, the Global Reporting Initiative proposes an extensive collection of different indicators of economic, environmental, and social impact. There are other international standards, for instance, the Sustainability Accounting Standards Boards (SASB) and the Integrated Reporting. However, the adoption of those standards remains always voluntary for companies. Thus, a company can choose to prepare a social report that does not follow any reporting framework. Today’s situation poses questions of comparability across companies that use different reporting standards or no standard at all. Compared to conventional financial reports, where disclosure is much regulated and independent external audit is de rigueur, social reporting remains much flexible. Consequently, a company has a relatively ample leeway about what to disclose in its social reports, and it can decide to leave those social reports without an external audit. Many studies have been exploring the reasons for reporting, and what companies eventually decide to report. Regarding the reasons for reporting (the “why” question), one of the answers is legitimacy (Deegan 2002). In line with the classical institutional explanation that companies have to answer to social expectations, companies would choose their disclosures about social and environmental impacts in order to gain legitimacy. For instance, Pérez et al. (2015), in their study of finance

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companies in Spain, show that CSR reporting has a positive impact on those firms’ reputation. Shabana, Buchholtz, and Carroll (2016) propose a more elaborated theoretical model, also in line with institutional theory. Social reporting would begin as a defensive strategy, particularly from companies facing environmental problems. In a second step, companies would proactively engage with CSR as it becomes a more mainstream practice, and in a third step, when a critical mass of reporting companies already exists, non-reporting companies would feel pressured to imitate reporting firms. Regarding the content of social reporting (the “what” question), many empirical studies have explored corporate decisions on disclosure. For instance, Cho and Patten (2007) explain that companies with lower environmental performance tend to report more, for instance about expenditures in pollution remediation and environmental related projects. This would also be the case for companies operating in environmentally sensitive industrial sectors. That is, the decision to disclose would not be a “technical” one, but it relates instead to the situation of the company, its competitive environment, and its willingness to convey a positive impression. In a similar tone, Cho, Roberts, and Patten (2010), when analyzing the language used in corporate reports in the USA, conclude that companies with worse environmental performance tend to use a more optimistic language tone. The two aforementioned studies, using either quantitative or qualitative methods, arrive to similar conclusions. Disclosures would be strategical, in order to influence social perceptions about the firm. Whenever deciding whether to disclose or not a particular piece of information, the company would evaluate pros and cons (or costs versus benefits) of disclosure. From an Ethics in Finance perspective, these studies do not necessarily imply that companies disclose wrong or misleading information. We can reasonably imagine that such an action would be exceptional and extremely risky for companies. However, we cannot expect companies to naively disclose all their social and environmental information. Similarly, external stakeholders would be empowered in their relation with the firm by having more information about the company. Thus, there would be a tension between companies, which refrain from disclosing all data, and stakeholders, who push for increased disclosure.

Regulation of Social Reporting As a general principle, CSR actions are voluntary initiatives that go beyond legal obligations. Consequently, we may expect social and environmental accounting to be voluntary as well. While the majority of scholars have shared this notion, a few colleagues have raised their objections. For instance, Unerman and O’Dwyer (2007) argue for a regulation of both CSR and Social Accounting. The authors claim that this regulation could prove to be beneficial for both shareholders and other stakeholders. In any case, there is an increasing consensus in that some regulation on social reports could improve comparability among reporting companies and diminish the

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aforementioned problems with disclosure. Furthermore, we may imagine that mandatory social reporting would increase the volume of social and environmental information and that, consequently, a better-informed population would more empower vis-à-vis companies. As the Accounting Standards Steering Committee famously put in 1975, several audiences (not only shareholders) “have a reasonable right to be informed. . .by corporate reports.” Thus, there would be some grounds for regulation of social reporting, tending to increase the number of reporting companies, extend the scope of issues reported, and standardize reporting rules. The point is which kind of regulation would be the most appropriate to achieve those objectives. The first kind of possible regulation for social responsibility corresponds to softlaw initiatives. These initiatives include existing social reporting frameworks such as GRI, SASB, and Integrated Reporting. Voluntary as they are, these frameworks provide some structure to social reports. That is, if a company claims compliance with some particular framework, it has to abide to its norms. The company would no longer be able to present an inarticulate collection of data as a social report. It will have instead to prepare a presentation of its social and environmental information according to the disclosure rules of the chosen standard. In this sense, compliance to these soft-law frameworks gives at least some comparability among companies that report with the same standard. However, comparability among companies using the same reporting standard can still be difficult. After having explored the reports of several mining firms that follow the GRI guidelines, Boiral and Henri (2017) conclude that comparability can remain an elusive objective. Beyond these difficulties with comparisons, voluntary disclosures can still be much helpful for improving stakeholder engagement. For instance, Zicari and Perera-Aldama (2017) explain how a mining firm in Mexico has been using a voluntary social reporting model as an important reference for its discussions with stakeholders. The second kind of regulation is hard-law. Some countries, particularly in Europe, have been mandating social and environmental disclosures. This responds to the impulse of the Directive 2014/95/EU of the European Union, which asks companies with more than 500 employees to disclose nonfinancial information. While most of these initiatives are quite recent, some studies suggest that this kind of regulation for social reporting has a limited effect on information quality. For instance, Acosta and Agostini (2016) analyze social reports for a sample of large companies in Italy, both before and after the enforcement of a new regulation for social reporting disclosure. While disclosure increased after the new law, companies tend to report good news more easily than bad news. Besides, disclosure remained selective, as companies end up informing more about the environment than about employees. The authors suggest that lack of involvement from stakeholders and a top-down approach on the side of regulators may have contributed to the situation. For their part, LuqueVílchez and Larrinaga (2016) did a comparable study for Spain, also before and after the enforcement of a new law on social reporting disclosure. Curiously, the number of social reports did not increase while their quality improved marginally. The two aforementioned studies focus on the link between regulation and better social reporting. We could also go a step forward and pose a question about

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improvements in sustainability performance. After all, social reporting is not an end in itself. It is (or it should be) instead a means to improve the sustainability performance of the firm. This is the question that Leong and Hazelton (2019) explore in two cases of social reporting regulations adopted in different contexts. They conclude that regulation can improve social reports, but that this improvement in itself will not necessarily lead to more sustainable operations. While stakeholders will have more information, this does not imply that those shareholders would be able to influence companies for change. We may end up having simply more information and scarce change. For substantive change to happen, Leong and Hazelton (2019) give some propositions. For instance, they suggest rules that facilitate the involvement of “information intermediaries,” that is, civil society organizations that have time and resources to understand the information released and act on it. They also propose to make access to sustainability data easier, by presenting that data at different levels of aggregation and in a comparable way among different companies. In terms of Ethics in Finance, these studies show that regulation of social reporting is not a silver bullet. There is no easy recipe for solving the shortcomings of social reporting. Granted, regulation can help, but the law by itself cannot replace the efforts of an involved, active citizenry. Stakeholders cannot abdicate their responsibility for advocating sustainability. They have instead to actively use Social Accounting information as a tool for its negotiations with the company.

Social Accounting Inside of the Company Up to this line, our discussion was mostly oriented to corporate reporting, that is, information that the company discloses to external parties. This focus makes sense, as social reports are a tangible, concrete materialization of an accounting process. These social reports being publicly available information, we can easily analyze them, compare them, and reach to conclusions. However, our understanding of Social Accounting would be incomplete if we fail to explore what happens inside of the company. In a case study, Durden (2008) studies a small industrial company in New Zealand. Its owner and CEO is a firm believer in CSR. He consequently strives for different initiatives that clearly differentiate the company from comparable firms. Among other initiatives: donations, a socially oriented hiring policy, and several contributions to local community. Besides, the firm owner wants to measure and manage the sustainability impact of his firm. However, the author found that despite all these sincere good intentions, the company failed to provide a set of internal indicators that could support managers in making decisions. At the end of the day, managers still used conventional financial indicators, in the same way as managers in any other company would do. Curiously, many concurring factors would have facilitated the full deployment of CSR internal indicators in this firm, namely, a very committed owner, who is involved in day-to-day operations, a small, one-site firm. Besides, there cannot be internal resistance to CSR, as this policy comes from

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the owner himself and is implemented under his control. Of course, there is no greenwashing here. This case is a reminder that despite all these favorable conditions, a company may still have difficulty in implementing internal social accounting indicators. Gond et al. (2012) attempt to address the possible disconnection between a company’s set of internal indicators, usually called “management control system” (MCS) and the firm’s CSR indicators. Based on a series of case studies, the authors propose a typology of different relations between MCS and CSR indicators. At one extreme, both systems (MCS and CSR indicators) are completely decoupled and there is no sustainability strategy. In the other extreme, both systems are fully integrated, as the company pursues a coherent sustainability strategy that considers CSR indicators within the global MCS. Between both extremes, several possibilities exist. For instance, the company can be in a compliance mood, “tick-the-box” mentality for its CSR indicators, while it can have a very sophisticated use of its MCS. In this case, the strategy for Sustainability is just to comply with requirements, without integrating CSR performance in the global corporate performance. Gond et al. (2012) also propose different pathways for companies, so that they can progress from an initial situation of decoupling to the ideal situation of fully coupled systems (i.e., MCS and CSR indicators working in an integrated way). They also affirm that companies may not achieve this ideal situation, and that they could remain somewhere in the way, for instance in the compliance situation. Much in line with the previous study, Arjaliès and Mundy (2013) explore how managers use in practice CSR indicators and link them to the company’s MCS. Their article is an empirical, qualitative study, based on the notion of the levers of control theory (Simons 1995), a tenet of contemporary management control. That theory distinguishes between the diagnostic and interactive use of indicators. On one side, diagnostic use corresponds to a more classical approach to control, including target setting, upward reporting, and identification of gaps. On the other side, interactive use corresponds to a collective learning process in which top management uses indicators as an occasion to discuss and interact with the operational team. Also following Simons (1995), the authors explore the companies’ boundaries systems (i.e., set of restrictions in order to control risks), beliefs systems (set of core corporate values in order to inspire action), and their interrelation with CSR indicators. Thus, this study puts CSR indicators into the broad context of an integrated MCS, with the support of a classical theory in management control. Burritt and Schaltegger (2010) present an integration of two complementary perspectives for Social Accounting. A first perspective, which they call “insideout,” emphasizes the role of social accounting as a supplier of reliable, actionable information that contributes to better decision making. This is particularly the case with internal social accounting information, as it provides tools that help managers to improve sustainability. This perspective needs to be complemented with the “outside-in” approach, where external stakeholders advocate for the improvement of corporate practices with the help of information that was disclosed in social reports. The authors consider that both perspectives (inside-out and outside-in) are complementary and that both of them are necessary for improving corporate sustainability.

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In terms of Ethics in Finance, these studies cast a new light on our understanding of corporate decisions related to sustainability. First, we realize that the path to corporate sustainability is not as simple as it seems to be. As the case written by Durden (2008) shows, even a manager with uncontested power and complete conviction can find it difficult to implement a CSR policy in a consistent way. Thus, a company may fail to improve its sustainability performance despite the best intentions of its managers and owners. Second (and because of the latter point), the discussion about corporate disclosure has to be nuanced. The latter studies show how complex is the collection, process, and sense making of social and environmental indicators. It is possible that corporate managers struggle to have a complete picture of those indicators for their companies. Thus, limited or incomplete disclosure may not necessarily mean that managers refrain from sharing social and environmental information. Perhaps managers do not have all the internal CSR information in the first place. This can be particularly the case for large, multisite companies. Instead of assuming omniscient managers who consciously hide information, we could instead consider the possibility that managers ignore in good faith some of the social and environmental impacts of their firm. Third, these studies, with different and complementary approaches, call for an integration of social and environmental perspectives in business. This integrated approach calls for a seamlessly articulation between CSR and corporate performance, far away from the usual situation of CSR being the province of a specialized department or unit.

From Social Accounting to Financial Results (or the Other Way Round?) A common discussion about Social Accounting is how it relates to conventional accounting. One may imagine that they are two different practices, with different scopes and objectives. Indeed, we may also imagine that Social Accounting only matters to some stakeholders, while conventional accounting matters only to investors. In reality, Social Accounting is increasingly closer, and sometimes even articulated, with conventional accounting. While their respective scopes are different, we may consider that interactions exist and audiences overlap between the two types of accounting. For instance, a company that makes an expenditure in order to make its operations greener. Thus, the same action has an impact on the Profit and Loss statement (i.e., the expenditure) while there is also an impact on the social report (i.e., less pollution). As an example of audience overlap, an investor may read both the financial statements and the social report of the company. Financial statements would help to evaluate the company prospects, while social reports would help to understand environmental risks. This articulation between social and conventional accounting is far more than putting two reports together. This is not an issue of sharing the same format, but instead of exploring possible cause-to-consequence relations between both dimensions. In this sense, there is an unavoidable comparison with the Balanced Scorecard (Kaplan and Norton 1992). In that tool, there is an attempt to identify, describe, and

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measure cause-to-consequence relation. Thus, the Balance Scorecard distinguishes between actionable indicators and result indicators. Managers directly act on actionable indicators while they expect that their actions will bring results (usually, financial results). For instance, if job satisfaction increases, possibly employee turnover will decrease as well, which a consequent diminution in costs. Thus, managers could attempt to increase job satisfaction, with the hope that expected consequences (i.e., less employee turnover and less costs) happen. In the similar way that the Balanced Scorecard attempts to capture the business model of a firm, the articulation (or integration) of social and conventional accounting expects to achieve a comparable tool. With the noble ambition of improving corporate sustainability, echoing the famous claim from Kaplan and Norton: “What you measure is what you get” (1992, p. 71). However, the comparison with the Balanced Scorecard remains limited. The cause-to-consequence relation between Social Accounting and financial performance is possibly not as straightforward as it seems to be for the Balanced Scorecard. To begin with, it is not always clear how sustainability performance influences financial results. While a complete discussion of this relationship is out of the scope of this chapter, a classical reference is Porter and van der Linde (1995), who famously claimed that companies could be at the same time be “green and competitive.” They argued that improvements in operations could simultaneously diminish costs, increase productivity while decreasing pollution. Indeed, many empirical studies tried to assess the relationship between sustainability and financial performance (Margolis and Walsh 2003). Those empirical studies are frequently correlations between some sustainability indicator and financial performance. However, the problem usually lies in that correlation is not necessarily causation. Simply said, it may be that the company is more profitable because its sustainability performance increases (in line with Porter and van der Linde 1995), or it may be that a more profitable company can afford to spend resources in social and environmental actions. Furthermore, each situation is different, and it may well be that what works in one industry does not work the same way in another industry. Alternatively, a particular strategy achieves to align sustainability and financial results while other strategies do not. Thus, the question about the relation between sustainability performance and financial results remains to this day open. Each standard for social reports has in some way tried to address this issue. The GRI presents a broad set of indicators encompassing wide areas of economic, environmental, and social performance. The GRI has been created and updated by a large group of stakeholders, who bring their complementary perspectives. This collective processes ends up in an aggregation of indicators, with the purpose of accountability to different stakeholders. Thus, the focus is on disclosure and not necessarily in making links between different indicators. For its part, the Integrated Reporting attempts to bridge the gap between the two perspectives (sustainability and finance). As the Integrated Reporting is a relatively recent experience that has less implementations than the GRI, it is too early to conclude about its potential. On its part, SASB is a more recent framework, which presents sets of indicators that are adapted to different industries. The idea behind is that sustainability issues can differ

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among industries and that, consequently, there is a need for different sets of indicators. Besides, SASB has an emphasis on those sustainability issues that can be material (i.e., financially relevant) for investors. There are other initiatives that attempt to address both economic and social value, such as the methodology recently developed by Retolaza, San-José, and Ruíz-Roqueñi (2016). The authors present an integrated approach that takes into consideration the viewpoints of a large spectrum of stakeholders. In terms of Ethics in Finance, there are two reflections to make. First, as the causal link between sustainability and financial performance is not completely clear, it is possible that managers will not be completely sure whether sustainable policies pay off or not. Being “green and competitive” (Porter and van der Linde 1995) may not happen all the time. Otherwise said, in many cases, managers may implement a sustainability policy because they consider that it is the appropriate thing to do, even if the business rationale is not clear for the moment. Second, when choosing a framework for social reports, managers need to be aware of the purpose of the framework they choose. Even if all the mentioned frameworks are complementary, each one of them has specificities that make it more appropriate for some cases than for others.

The Promise of Social Accounting to Achieve Organizational Change This is possibly the most relevant issue for the years to come. Social Accounting, important as it is, is not an objective in itself. It has to be instead a means to achieve sustainability. Now the question is if Social Accounting can be conducive, or at least favorable, to improvements in sustainability. In this sense, there are very different viewpoints. Some scholars are confident in the potential of Social Accounting tools in bringing organizational change. For instance, Burke and Clark (2016) in their analysis of a particular framework (Integrated Reporting) claim that this kind of tool will provide better information for decision-making, more teamwork inside of the company, and the promise of improvements in sustainability. Other scholars are less convinced about the promise of Social Accounting in achieving organizational change. This is the case for instance of Rodrigue, Magnan, and Cho (2013), who study a sample of environmental-sensitive companies and conclude that in many cases, environmental governance is “symbolic,” that is, without achieving real changes. In a similar vein, Larrinaga-González et al. (2001) perform a qualitative study, based on interviews, for a sample of Spanish companies, and they come to similar conclusions. The authors argue that environmental accounting may not lead to significant organizational change. Larrinaga-González and Bebbington (2001) present the case of an electricity utility in Spain that implemented an environmental accounting system. The authors contrasted two opposing tendencies, which they called “organizational change” and “institutional appropriation.”

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While in the first tendency a real improvement in corporate practices appears, this is not the case for “institutional appropriation,” where environmental accounting fails to achieve significant improvements. After studying in depth the case of this electricity utility, the authors come to a nuanced conclusion: despite some organizational change, the company failed to achieve a complete environmental transformation. In another case study, Mitchell, Curtis, and Davidson (2012) explore the use of Triple Bottom Line (a classical Social Accounting tool) in a large organization in Australia. They conclude that despite some marginal improvements, there was no iterative learning (double-loop learning) in the organization. These previously mentioned studies share a rather grim view of social accounting as a tool for organizational change. They underline the difficulties companies may find in achieving concrete improvements. After reading those papers, one realizes that the mere implementation of a social accounting system will not automatically lead to substantial improvements in sustainability performance. We could ask ourselves whether Social Accounting is able to deliver on its promise, and if that were not the case, what to do about it. Taking a step back, we can see that Social Accounting has been an uncontested success in many realms. For instance, the KPMG Survey of Corporate Responsibility Reporting (2017) studies reporting practices in almost 50 countries all over the world. According to that report, social reporting is a mainstream practice for large firms in many countries, and not only in developed ones. Furthermore, there is a vibrant community of practitioners, consultants, NGOs, and standard setters constantly looking for the improvement of reporting practices. Besides, in the academic world, Social Accounting is no longer an isolated niche, as most of the international journals regularly include papers of this discipline. However, in some other senses, the Social Accounting project has not yet achieved its objectives. Granted, we know more about companies’ motivations for disclosure, about how to improve disclosure, and what to expect from social reports. We understand better the possibilities (and limits) of regulation of disclosure in Social Accounting. Besides, we have more insight about the role of management accounting (i.e., indicators, incentives, budgets) in supporting Social Accounting and in providing managers with concrete tools for making companies more sustainable. But we may still see that the expected results are not there. Improvements in some large companies, praiseworthy as they are, do not compensate for a business-as-usual behavior in many small and medium companies, that remain below the radar and that collectively constitute most of the production and employment. Furthermore, we may argue that Social Accounting with its increased disclosure may induce incremental, marginal improvement, without challenging the subjacent business model. Take the case of transportation. Social Accounting’s disclosures may indicate improvements in efficiency, perhaps as measured by tons of carbon per kilometer, fuel efficiency, and asset rotation. But we could still fail to pose more fundamental questions about transportation. For instance, do we need really to travel

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that much? Recently, the recent COVID-19 crisis made us realize that much (if not most) of our business meetings could be done online. Even if the technology for online meetings has been there for a while, and we have been more or less familiar with it, we have strangely remained too much attached to travelling. Otherwise said, looking for incremental (and much welcome!) improvements in Social Accounting could hide the pressing need for revising our conventional business models. On the long run, it is probably not a matter of improving incumbent business models, but perhaps in many cases, of changing those business models. Take the example of mining. There is nothing such as “green mining.” Mining, by definition, will always be a polluting activity. Moreover, it is frequently socially controversial as well, as explorations frequently happen in remote areas, sometimes where fragile populations live. Despite all those problems, we still need mining, as minerals are basic inputs for most industrial production nowadays. We may not like the impacts of mining, but mining is still necessary in order to maintain our way of life. In this context, Social Accounting would give managers and stakeholders in mining companies most valuable information that may help to achieve improvements in many areas. This kind of effort is worthwhile and certainly merits to be done. However, on the long run we would ask ourselves about how to diminish the need for industrial inputs that come from mining, perhaps by new technologies that ask for less minerals, or by some kind of circular economy solution. Social Accounting is necessary, welcome, and helpful for improving incumbent business models. More disclosure will help managers to focus on opportunities for improvement, to reorient companies’ efforts and resources toward increasing social expectations. More transparency will also empower stakeholders in their relation with the company. In that sense, Social Accounting has a bright future, both in practice and in academia. But there is a limit to the kind of improvements that Social Accounting can bring. After all, Accounting as a discipline tends to look at the past, certainly with the aim of taking stock, learning, and improving things. This is the same for both conventional and social accounting: the status quo remains the starting point for any accounting practice. In many industries, in many business models, merely improving the current situation is not enough. Radical change may be necessary in those cases, and Social Accounting will not be of much help. Most probably, we would have to redesign business models, and sometimes to create business models from scratch. For example, the report of Ludeke-Freund et al. (2015) brings interesting propositions for developing more sustainable business models. Otherwise said, complementary approaches from other disciplines, like Design Thinking, could complement efforts toward changing current business models. In terms of Ethics in Finance, this last point makes us to be cautious about the potential of Social Accounting. Useful as it is, Social Accounting remains a mean to an end. Its test of success will be its ability to create tangible change in corporate practices. This is most possibly the case for the improvement of existing business models. However, in those cases where business models have to be completely changed, Social Accounting most probably needs to be accompanied and supported with other complementary approaches and tools.

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Conclusion – Social Accounting and Ethics in Finance This chapter brings a succinct analysis and discussion of the main contemporary issues in Social Accounting, from the viewpoint of Ethics in Finance. This chapter has its place in a book on Ethics in Finance because Sustainability is nowadays a most relevant issue in Ethics in Finance (San-José and Retolaza 2018). The discussion has been organized around five major issues. First, in terms of corporate disclosure, there is a tension between companies, which possibly do not share all social and environmental information, and stakeholders, who would expect higher transparency. Thus, we should not assume that companies naively disclose social and environmental information. Second, regulation for social reports could help to increase the quality of reports, but studies show that regulation by itself will not automatically improve disclosure. Most probably, an active involvement of citizenry is necessary in order to reap the full potential of regulation on disclosure. Third, studies in managerial accounting emphasize the complexity of working with social and environmental indicators. Thus, it is possible that managers struggle to collect and make sense of information about all the social and environmental impacts of their firm. Consequently, these studies tend to nuance the first point about corporate disclosure. It could well be that managers are not hiding some information for the simple reason that they do not have it themselves. Fourth, the link between sustainability and financial performance remains elusive, and this is despite Porter and van der Linde’s (1995) promise of becoming “green and competitive.” Additionally, when managers choose a framework for social reports, they need to be aware of their specificities. Finally, we should be aware of what Social Accounting can deliver (and what it cannot do) in terms of organizational change. Besides, and in a more fundamental sense, Social Accounting can help to improve existing business models, but by itself, it does not lead to the creation of new business models. Consequently, we should not refrain from using complementary tools from other disciplines. Overall, Social Accounting can contribute in a consistent way to the improvement of corporate sustainability. In that sense, Social Accounting is an increasingly important tool for both managers and stakeholders.

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Ethics in the Independent Audits of Financial Statements Greg Shailer

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethics Issues for Auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Self-Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Audit Firm Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Self Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advocacy Threats . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Familiarity Threats . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intimidation Threats . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Research into Ethical Threats . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Addressing Threats to Auditor Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Government Regulatory Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . International Standard Setters’ Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . APES 110 PART 4A – Independence for Audit and Review Engagements . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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The effectiveness of audits in reducing information risk and improving intended user confidence in the financial statements is dependent on the credibility of the audit and the auditor’s report. Assessments of credibility reflect perceptions of the auditor’s integrity or ethics. Two key aspects of ethics concerning auditors in the independent audit of financial statements are (1) the direct engagement of auditors in unethical behaviors, such as aiding or abetting fraudulent misstatements in financial statements and (2) circumstances that impair or threaten the auditor’s objectivity (independence) in their audit judgments or reporting decisions. Audit standards and ethics codes have sought to provide guidance to auditors as to the G. Shailer Australian National Centre for Audit and Assurance Research, and Research School of Accounting, The Australian National University, Canberra, ACT, Australia e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_19

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sources of threats to auditor objectivity and credibility, and to provide some guidance on ameliorating such threats. Research regarding threats to auditor independence provides mixed results with respects to both actual and perceived impairments in audit outcomes, but regulators have been motivated by major cases of audit failures to regulate against some such threats (such as long auditor–auditee relationships that may create familiarity and self-interest threats and the provisions of nonaudit services that may create self-interest threats). Keywords

Audit Ethics · Auditor Independence · Code of Ethics

Introduction All countries with publicly traded equities require the independent audit of the annual financial statements of publicly listed corporations. The basic rational for this requirement is to provide assurance as to the credibility to the financial statements produced by the managers of corporations. This is necessary because the usefulness of financial statements is dependent on users’ perceptions of their reliability, but financial statements are produced by managers who may have incentives to manipulate financial disclosures for either private benefit or to influence the availability and cost of capital. Awareness of such incentives contributes to perceptions of information risk. The intention in mandating independent audits is to improve user confidence in the financial statements by reducing this information risk, and thus contribute to capital market efficiency. Auditing is necessarily judgmental. Many factors influence auditors’ attitudes and decisions and there can be tension between these factors, as auditors are faced with competing priorities. Independence in auditing means the auditor remains unbiased in designing and performing audit tests, evaluating the results, and issuing the audit report. If an auditor is an advocate for or influenced by the auditee’s personnel or management, or by any transacting party, or by any individual’s personal interests, the auditor cannot be considered independent. For auditor reports to be credibile, it is essential that auditors are independent in fact and independent in appearance. Achieving independence in fact requires the auditor to actually maintain an unbiased attitude throughout the audit, whereas independence in appearance depends on observers’ perceptions of the situation. Even if auditors are independent in fact, if users perceive them to be advocates for their client, much of the value of the audit function (which depends on increasing users’ confidence in the audited statements) will be lost. The effectiveness of audits in reducing information risk and improving intended user confidence in the financial statements is dependent on the actual and perceived quality of the audit work (auditor competence) and the credibility of the resultant audit report. Problems with observability make it difficult for financial statement users to gauge audit quality and report credibility, but there is some commonality in

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researchers’ and regulators’ conceptualization of audit quality as being a product of the likelihood of an audit detecting material misstatements (including omissions) in financial statements and the likelihood of the auditor reporting misstatements that remain uncorrected. The likelihood of detection is a reflection of the auditor’s competence and their maintenance of professional skepticism, and reporting decisions are reflections of the auditor’s integrity or ethics. A continuing cycle of financial reporting scandals and associated audit failures perpetuate and enlarge concerns that auditors are conflicted by the commercial culture in which they operate. These are not merely academic concerns or questions of perceptions; litigation and prosecutions, regulatory sanctions, and public criticisms in formal reviews and the news media abound in all the major markets of the world. These costly consequences do not seem to have a strong deterrence effect in relation to audit failures that can be attributed to auditing and reporting decisions made by auditors. This chapter discusses the main sources of threats to auditors satisfying the ethical expectations the public and investors hold of the audit profession, and how regulators have responded.

Ethics Issues for Auditors There are two key aspects of ethics concerning auditors in the independent audit of financial statements. One is the direct engagement of the auditor or a member of the audit team in unethical behaviors, such as aiding or abetting fraud – most commonly in relation to willful misstatements in financial statements. The other is when circumstances induce the auditor or a member of the audit team, either consciously or subconsciously, to fail in being truly objective in their judgments or decisions. Fraudulent behaviors include colluding with the auditee’s management to present misstated financial statements, concealing or destroying evidence of misstatements or deficiencies in the auditor’s previous work. It is generally acknowledged that individual failings in this regard can have serious implications for audits in general, as the revelation of fraudulent activity undermines general confidence in the work of auditors. Most threats to the objectivity (or independence) of auditors arise from one or more of the following sources: • Self-interest – which arises when the financial interests of the auditor or a related party are involved • Inappropriate firm culture – which arises when the firm is not dominated by a culture of independence, skepticism, and challenge that are fundamental to effective auditing • Self-review – which arises when the auditor evaluates a situation that is a consequence of a previous judgment or advice by the auditor or the auditor’s firm • Advocacy – which arises when the auditor’s previous promotion of a position or opinion now compromises the auditor’s objectivity

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• Familiarity – which arises when an auditor has become too sympathetic to the interests of another party, or auditor complacency arises, because of their long or close association • Intimidation – which arises when an auditor’s actions are compromised by actual or perceived threats Each of these is briefly described below, followed by a discussion of some research evidence linking these ethical issues to actual or perceived audit quality.

Self-Interest A fundamental threat to public confidence in auditor integrity and the credibility of the audit report is the financial interests of auditors in their relations with their auditees (their effective clients). Although there is an appearance of shareholder involvement in appointing auditors in many countries, most commonly by voting to accept the auditor proposed by the board of directors, this is largely illusionary. The predominant case is that the board (or its audit committee) selects the auditor and negotiates audit fees. Thus, acquiring and retaining a client is dependent on the auditor’s relationship with auditee management; the same parties that are ostensible authors of the financial statements the auditor has been hired to audit. The commercial interests of auditors increase the risk of them colluding with the auditee managers, or acquiescing to the auditee managers’ preferences, who are the effective source of the auditor’s income. The auditor’s financial interests in maintaining positive relations with auditee management are exacerbated when auditors’ firms are also engaged in the provision of potentially high-margin nonaudit services, such as accounting, tax, systems analysis and design, internal audit, and management consulting services to their audit clients. The provision of nonaudit services to auditees can also contribute to problems associated with self-review, advocacy, and inappropriate firm culture. The auditor’s commercial interests are also affected by both fee pressure and excessive fees. If auditee management, in negotiating audit fees, are less interested in audit quality (or being challenged by auditors) than in minimizing costs, then auditors may struggle to obtain the fees necessary to finance all the necessary audit work and the consequential cost and budget pressures may compromise auditors’ decisions. At the other end of the fee scale, auditors’ judgments may be compromised by the desire to retain particularly profitable engagements, and auditees’ managers may be willing to pay excessive audit fees (or purchase additional nonaudit services) to encourage a higher degree of auditor acquiescence. The self-interest threats to auditor independence are aligned with the importance of the fees from the auditee to the auditor. Often referred to as “fee dependence,” the threat to auditor independence is amplified when a particular client is the source of a significant proportion of the total income for the auditor or the firm.

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Self-interest threats also arise if audit team members are interested in potential employment with the auditee, or have a financial interest in, or relationship with, the auditee (or a financial relationship with any of its officers), including loans.

Audit Firm Culture Every firm has a culture. The nature of this culture is best understood from practices and employees’ shared beliefs, regardless of written policies and guidelines. In this regard, there is no reason to believe audit firms are different from other organizations. Junior auditors are likely to emulate the professional ethics practices of their managers and partners; managers are likely to look to their partners, and partners will influence and monitor each other – directly and through their firm’s leadership hierarchy. How the firm rewards and promotes people will send strong signals of what is most valued in the firm. It is generally recognized that it is important that audit firms develop a culture in which high-quality audit work is valued and rewarded, and which emphasizes “the importance of ‘doing the right thing’ in the public interest” (Financial Reporting Council 2018). An audit firm culture of independence, skepticism, and challenge is fundamental to achieving the intended objectives of the audit. This necessary “audit culture” is threatened when audits are not the dominant business of the firm. In some markets, some large firms are seen more as consulting firms than as audit firms, and many of these have nonauditors dominating the most senior management positions; this situation increases concerns that the “tone-at-the-top” of these firms might not be consistent with an “audit culture.” The concern in such cases is that the desired audit ethos will be suppressed by consultancy marketing culture that emphasizes margins and client value-adding contributions over audit credibility of the necessity of being prepared to challenge auditee assertions.

Self Review Self-review threats arise when an auditor must evaluate a situation that is a consequence of previous work, judgments, or decision by the auditor or their firm. Some general examples of when this might occur include the following: • The auditor’s firm may have performed a service for a client that directly affected matters that the auditor has to evaluate during the audit engagement. This includes data preparation work that feeds into the financial reports, involvement in the design or implementation of information systems or control systems, the provision of internal audit services, advice on the structuring of transactions (including some aspects of tax planning), or recruitment services for senior officers, accountants, or internal auditors. • A member of the audit team has been previously employed by the client in a position that has influenced the subject matter of the engagement. • Reevaluation of the work of an auditor reveals significant error.

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Advocacy Threats An advocacy threat to auditor independence or objectivity arises when the auditor’s firm promotes a position or opinion pertaining to the auditee. This includes situations where the auditor’s firm has been involved in promoting shares or other securities in the auditee, supports the auditee in negotiating debt financing (other than through the provision of an audit or assurance report), or has acted as an advocate or supporting witness on behalf of the auditee in litigation or disputes with third parties. An advocacy threat might also arise in cases where the auditor or the auditor’s firm has commented publicly on future events that impact on the auditee. Some sources of advocacy threats also embody self-interest elements. The essential feature of an advocacy threat is that the auditor or the auditor’s firm has aligned themselves with a particular position or opinion that may be perceived as serving the interests of the auditee.

Familiarity Threats Various circumstances can cause the auditor be overly sympathetic to the interests of another party, or to be too complacency in relation to auditee or auditee personnel, because of their long relationship with the auditee or the nature of their association with individuals. For example, this may occur when: • An audit team has a family relationship or other close relationship with a director or other officer of the auditee, or with an employee who can have significant influence on the subject matter of the audit • A previous member of the audit firm now works for the auditee as a director, or officer, or as an employee who can significantly influence the subject matter of the audit • An auditor accepts nontrivial gifts (including invitations to social functions or events) or preferential treatment from an auditee • Senior audit personnel have a long association with the audit client, which often arises when the auditor has had the same client for many years (i.e., long auditor tenure)

Intimidation Threats An auditor’s judgment may be impaired by actual or perceived threats. This may occur when an auditor believes they are being threatened with dismissal from the engagement, being threatened with litigation, or being pressured to reduce the extent or scope of their audit work in order to reduce costs.

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Research into Ethical Threats The research concerned with ethical threats to audit independence (and thus audit quality) constitutes a very large literature, and only selected recent elements are briefly considered here. While there is substantial diversity in approaches, the literature is somewhat dominated by archival studies of auditor tenure effects and the consequences of auditors providing nonaudit services (NAS) to auditees – but client importance (economic dependence) and auditor–client affiliations have also received some attention. These emphases are products of data availability (observability), rather than agreement as to conceptual importance of these issues. This literature largely studies whether threats to auditor independence affects implied audit quality by examining the properties of accounting numbers or auditor reporting behavior, or whether threats to auditor independence affect perceptions of audit quality by examining investor or analyst responses to the audited accounting reports. A useful review of research on some issues related to ethics (prepared for the IESBA) is presented in Hay (2017), which selectively reviews research on audit fee levels, the auditor’s dependence of fees from a particular client, the importance of NAS fees, and accounting firms that provide audits but have a significant NAS business. This review reports that there is consistent evidence that audit fees for new engagements are lower (consistent with concerns about low-balling) and that NAS affect independence in appearance. Hay (2017) also indicates some studies report evidence that auditor-provided NAS are associated with proxies for lower audit quality, consistent with a loss of auditor independence, even though many studies do not support this conclusion. Hay (2017) reports that there is some evidence that audit quality is lower in firms that have more extensive nonaudit businesses, consistent with some of the concerns that have been expressed regarding the importance of firms’ audit culture. In general, Hay (2017) concludes that, although audit fee research does not identify widespread ethics problems, the body of research shows that there are some areas of risk in this regard.

Auditor Tenure The consequences of ethical threats can be subtle and complex. For example, it has long been debated whether (in fact or perception) long auditor tenure is a source of familiarity, complacency, or fee dependency that threatens auditor independence, or whether audit quality is improved by the auditor being able to acquire more knowledge of the auditee. Views on this may differ according to whether the issue is audit partner tenure or audit firm tenure. Whether longer auditor tenure is associated with better audit quality (through improved knowledge of the auditee) or reduced audit quality (through reduced independence or complacency as a consequence of familiarity) has been examined in terms of outcomes based on measures of financial reporting quality, auditor opinions, and in terms of perceptions (as reflected in measures such as earnings response coefficients or differences in the implied cost of capital).

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The results of examinations between auditor tenure and financial reporting quality are not particularly revealing with respect to ethics but they do shed some light on possible auditor learning effects because many studies conclude that longer auditor tenure improves audit quality (DeFond and Zhang 2014). However, most of these studies were unable to calibrate the extent to which audit quality is expected to be improved with a continuing auditor, had there not been any independence impairment threat. If independence is actually impaired, empirical researchers could merely reveal such impairments indirectly by testing whether the observed difference in audit quality between a continuing auditor and a new auditor is less than the theoretically expected difference in audit quality without such an impairment (Patterson et al. 2019). Based on data from the internal assessments of audit quality within a single Big 4 audit firm in the USA, Bell, Causholli, and Knechel (2015) find evidence that engagements have lower assessments of audit quality in the first year with the auditor firm compared to following years. Singer and Zhang (2018) examine the relations between audit firm tenure and the timeliness of the discovery and correction of misstatements. They find that longer tenure leads to less timely discovery and correction of misstatements, and that this negative association is mainly present in the first 10 years of an audit engagement. In addition, using the nonvoluntary auditor change following the demise of Arthur Andersen in 2002 as a natural experiment, they show that the misstatements of Arthur Andersen’s former clients were discovered faster than those of comparable auditees who had not had a change in their auditors throughout the misstatement (that is, misstatements were discovered faster in the corporations that were forced to change their auditor during the misstatement period). This research cannot reveal whether familiarity arising from longer tenure reduces auditor independence or increases complacency. While the weight of evidence suggests that longer auditor tenure is associated with improved audit quality, irrespective of whether independence is reduced, there is some evidence that financial statement users’ judgments of the credibility of audited financial reports may be sensitive to the theorized effects of longer auditor tenure impeding independence. Azizkhani, Monroe, and Shailer (2013) show that this relation may not be linear. They find that, for non-Big 4 firms only, both audit firm tenure and audit partner tenure in Australia (prior to mandatory partner rotation) is initially associated with reductions in the implied cost of equity (based on the PEG model), suggesting perceived audit quality is improving, but as tenure becomes long, this turns to an increasing implied cost of equity, suggesting audit quality is perceived to be decreasing, consistent with expectations of increasing complacency or diminishing independence.

Nonaudit Services While, historically, there is little direct evidence that the contemporaneous provision of NAS reduces auditor independence in fact (Francis 2006), Causholli, Chambers, and Payne (2014) provide strong evidence that audit quality suffers when clients are willing to purchase NAS from their auditor in the future. Campa and Donnelly (2016) investigate the relation between the

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simultaneous provision of audit services and NAS to clients and discretionary accruals (in the UK) and find that auditor independence may be compromised by large NAS fees, particularly for clients who pay below their predicted level of audit fees. These effects may be compounded by audit fee pressure (see “Fee Pressure” below). Regarding the impact of NAS on perceptions, a meta-analysis by Habib (2012) suggests NAS fees and investors’ perceptions of auditor independence (as reflected in earnings response coefficients) are negatively related (e.g., Francis and Ke 2006). This is consistent with early survey and experimental perceptions research that pointed to potential independence problems in this regard (Francis 2006).

Client Importance Individual clients may be more important to auditors because of the direct economic importance (total fees) or because they confer prestige that may enhance the auditor’s ability to attract other clients. Both reasons may present self-interest threats and may enable clients to more effectively intimidate auditors. The economic importance encompasses both audit fees and NAS fees. Chi, Douthett, and Lisic (2012), using Taiwan data, present evidence that non-Big 4 audit partners (but not Big 4 audit partners) compromise their independence (based on abnormal accruals, propensity to issue modified audit opinions, and the probability that clients meet or just beat earnings targets) for economically important clients. Hossain, Monroe, Wilson, and Jubb (2016) examine client importance in terms of client networks, which arise when an auditor’s clients share a common audit committee member. They find that the likelihood of an audit partner issuing a firsttime going-concern modified audit report is reduced, and the absolute value of discretionary accruals is increased, by audit partners’ network fee dependence (where fee dependence is based on the audit partner’s fees generated from the networked clients). Fee Pressure Ettredge, Fuerherm, Guo, and Li (2017) investigate whether auditors’ independence during the recession of 2007–2009 was compromised for clients putting downward pressures on audit fees and find that auditors are less likely to issue first-time goingconcern opinions to such clients in the heart of the recession, 2008. They suggest their results may be a consequence of reflect the economic stringency of the recession having weakened auditor independence from clients that can exert audit fee pressure. They also find that, for such clients, compensating payments (expected total fee increases or high current-year NAS fees), strengthened the negative relation between fee pressure and auditors’ GC opinions. This latter effect is consistent with Beardsley, Lassila, and Omer (2019), which finds a positive association between audit fee pressure and changes in NAS (at the audit office level), and increased rates of client misstatement for audit offices that increase focus on NAS in the presence of audit fee pressure, compared to audit offices that do not.

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Auditor–Client Affiliations There is little available evidence regarding the circumstances under and frequency with which familiarity threats might arise. Nonetheless, Lennox and Park (2007) report that the probability of a corporation selecting a particular auditing firm is higher if some of the corporation’s officers are alumni of the audit firm; this might be linked to an independence problem because Ye, Carson, and Simnett (2011) find that (in Australia) auditors are less likely to issue going-concern opinions where the auditee’s directors have an alumni affiliation with the audit firm. Relatedly, Lennox (2005)finds that auditors are more likely to issue clean audit opinions where the auditor and the auditee’s executives have an historical affiliation through employment or alma mater (compared to cases without such affiliations).

Addressing Threats to Auditor Independence Auditor ethics or integrity (along with other factors important to audit quality) has long attracted the attention of policymakers and regulators who are concerned with promoting user confidence in audited financial reports. At various times, and often in response to a crisis or a wave of financial scandals, national regulators have acted to restrict auditors’ behaviors and international standard setters have sought to strengthen relevant guidance and standards.

Government Regulatory Responses At various times, governments have responded to concerns regarding the reliability of audits in enhancing the credibility of financial statements with changes to regulations. Two recent stimuli in this regard were the waves of financial reporting scandals after the turn of the century (including Enron, Worldcom, Qwest, Sunbeam, and Parmalat, among others), and then the global financial crisis of 2007–2010. In the USA, self-regulation was supplanted by the Sarbanes–Oxley Act of 2002 (SOX), which requires the independent inspection of audit firms by a new and powerful regulator, the Public Company Accounting Oversight Board. The UK also lessened the role of self-regulation by widening the scope and powers of the Financial Reporting Council and by creating its subsidiary professional oversight board for accountancy. Many other countries also increased regulatory oversight of auditors. Similar moves towards agencies that are independent of the profession monitoring audit quality and auditor behavior are widespread. Two auditor independence–related issues of regulatory emphasis have the provision of NAS and auditor tenure, and these are briefly discussed below. Some countries have also broached auditor selection issues; for example, since 1991, the regulatory authority

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in South Korea has nominated external auditors for companies that the regulator deems to have strong incentives or potential for accounting manipulations, with the intention of enhancing auditor independence and audit quality, having been embraced by the EU Eight Directive and the US and UK approaches.

Nonaudit Services SOX also sought to enhance auditor independence by restricting the provision of NAS to audit clients, and requiring NAS fee disclosures, pre-approval of NAS by the audit committee, disclosure of auditor–client relationships to the audit committee, and a one-year “cooling off” period before auditors can take particular designated employment positions with an audit client. In the EU, Regulation (EU) No 537/2014 prohibits accounting firms from providing of most types of NAS to their audit clients. Some countries have adopted a softer approach; for example, Australia does not. Auditor Tenure (Rotation) Auditor rotation requirements are intended to reduce the possible impairment of independence from auditor tenure. Countries have variously considered audit partner rotation and audit firm rotation, where the latter is regarded as more costly and more contentious in its potential impact on audit quality (because of the implied loss of auditor knowledge of the auditee). EC Directive 2006/43/EC requires member states to mandate auditor partner rotation every 7 years, or shorter. Most EU members have a seven-year partner rotation requirement, but some have adopted five-year limits (Austria, Bulgaria, Poland, Ireland, Lithuania, Slovakia, and the UK) and France has a six-year partner tenure limit. Although, under their earlier self-regulation regimes, the USA and Australia had notional limits of 7-years tenure for an audit firm (which was often breached), government reforms of the audit industry in the USA (under SOX) and Australia (under the Corporate Law Economic Reform Program (Audit Reform & Corporate Disclosure) Act2004) both rejected the idea of mandating audit firm rotation and opted for mandatory audit partner rotation (within the audit firm) after 5 years of tenure. Other countries with five-year partner rotations include China, Singapore, and Turkey. EU audit legislation (Directive 2014/56/EU) requires member states to introduce rules whereby public interest entities (PIEs) in the EU change their statutory audit firm after 10 years (effective from 2016) – but member countries can opt for shorter periods; Italy already had a statutory requirement for audit firm rotation every 9 years. The EU partner rotation requirement remains in effect along with the audit firm rotation requirement. Iran has adopted the most extreme position, requiring companies to change audit firms every 3 years (from 2011).

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International Standard Setters’ Responses In 2014, the International Auditing and Assurance Standards Board (IAASB) released its Framework for Audit Quality: Key Elements that Create an Environment for Audit Quality. The framework distinguishes inputs, processes, outputs, interactions within the financial reporting supply chain, and contextual factors that may impact on audit quality. The framework emphasizes that a quality audit is likely to have been achieved when an engagement team: • exhibits appropriate values, ethics, and attitudes [emphasis added] • is sufficiently knowledgeable, skilled, and experienced, and has sufficient time allocated to perform the audit work • applies a rigorous audit process and quality control procedures that comply with law, regulation, and applicable standards • provides useful and timely reports • interacts appropriately with relevant stakeholders The IAASB also issues International Standard on Quality Control 1 (ISQC1), Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and other assurance and related services engagements. ISQC 1 (issued in 2009) requires an accounting firm that provides audits to establish policies and procedures that will provide it with reasonable assurance that the firm and its personnel and others (including network firm personnel) maintain the required level of independence. ISQC1 must be read in conjunction with the ethical requirements relevant to the jurisdiction. Direct guidance on ethics is provided by the International Ethics Standards Board for Accountants (IESBA), which issues the APES 110 International Code of Ethics for Professional Accountants (including International Independence Standards). This Code was updated and reissued in 2018 and is effective from 2020 in most jurisdictions that have adopted the Code. The International Federation of Accountants (IFAC – which is umbrella organization of professional accounting bodies) examined 130 jurisdictions of its member bodies and reports that 90% of them have adopted the Code (although it appears some adoptions might only be partial). The Code is intended to provide a consistent framework of ethical behavior for professional accountants in their provision of any professional service, including independent assurance services. It sets out the following six fundamental principles of ethics for professional accountants, reflecting the profession’s recognition of its public interest responsibility: integrity, objectivity, professional competence and due care, confidentiality, and professional behavior. The Code provides a conceptual framework that professional accountants are to apply in order to identify, evaluate, and address threats to their compliance with the fundamental principles. In the case of audits, the Code sets out its International Independence Standards (in Part 4A of the Code), established by the application of the conceptual framework to threats to independence in relation to these engagements. Part 4A is comprised of 16 sections,

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of which 14 sections (410–600) with particular sources of threats to auditor independence in the audit of published financial statements are summarized below.

APES 110 PART 4A – Independence for Audit and Review Engagements Section 400 Applying the Conceptual Framework to Independence for Audit and Review Engagements This section explains audit firms obligations to comply with funadamental ethics principles and be independent. It provides guidance how to apply the conceptual framework (section 120) to maintain independence by describing facys and circumstances that might threaten independence, potential actions to address such threats, and some situations where threats cannot be adequatly countered. Section 410 Fees This section sets out specific requirements and application material when the nature and level of fees or other types of remuneration might create a self-interest or intimidation threat. Section 411 Compensation and Evaluation Policies This section sets out specific requirements and application material when a firm’s evaluation or compensation policies might create a self-interest threat. Section 420 Gifts and Hospitality This section sets out a specific requirement and application material when accepting gifts and hospitality from an audit client might create a self-interest, familiarity, or intimidation threat. Section 430 Actual or Threatened Litigation This section sets out specific application material when occurring or likely litigation with an audit client creates self-interest and intimidation threats. Section 510 Financial Interests This section sets out specific requirements and application material when holding a financial interest in an audit client might create a self-interest threat. Section 511 Loans and Guarantees This section sets out specific requirements and application material when a loan or a guarantee of a loan with an audit client might create a self-interest threat. Section 520 Business Relationships This section sets out specific requirements and application material when a close business relationship with an audit client or its management might create a selfinterest or intimidation threat.

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Section 521 Family and Personal Relationships This section sets out specific requirements and application material when family or personal relationships with client personnel might create a self-interest, familiarity, or intimidation threat. Section 522 Recent Service with an Audit Client This section sets out specific requirements and application material when a selfinterest, self-review, or familiarity threat might be created because an audit team member has recently served as a director or officer, or employee of the audit client. Section 523 Serving as a Director or Officer of an Audit Client This section sets out specific requirements and application when serving as a director or officer of an audit client creates self-review and self-interest threats. Section 524 Employment with an Audit Client This section sets out specific requirements and application material when employment relationships with an audit client might create a self-interest, familiarity, or intimidation threat. Section 525 Temporary Personnel Assignments This section sets out specific requirements and application material when the loan of personnel to an audit client might create a self-review, advocacy, or familiarity threat. Section 540 Long Association of Personnel (Including Partner Rotation) with an Audit Client This section sets out requirements and application material when familiarity and selfinterest threats might be created because an individual is involved in an audit engagement over a long period of time. Section 600 Provision of Nonassurance Services to an Audit Client This section sets out requirements and application material relevant to applying the conceptual framework to identify, evaluate, and address threats to independence when providing nonassurance services to audit clients. The subsections set out specific relevant requirements and application material when a firm or network firm provides particular nonassurance services to audit clients and indicate the types of threats that might be created as a result. Some of the subsections include requirements that expressly prohibit a firm or network firm from providing certain services to an audit client in certain circumstances because the threats created cannot be addressed by applying safeguards. Subsection 601 – Accounting and Bookkeeping Services Subsection 602 – Administrative Services Subsection 603 – Valuation Services Subsection 604 – Tax Services

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Subsection 605 – Internal Audit Services Subsection 606 – Information Technology Systems Services Subsection 607 – Litigation Support Services Subsection 608 – Legal Services Subsection 609 – Recruiting Services Subsection 610 – Corporate Finance Services Section 600 identifies the following factors as relevant in evaluating the level of threats created by providing a nonassurance service to an audit client: • The nature, scope, and purpose of the service • The degree of reliance that will be placed on the outcome of the service as part of the audit • The legal and regulatory environment in which the service is provided • Whether the outcome of the service will affect matters reflected in the financial statements on which the firm will express an opinion, and, if so: – The extent to which the outcome of the service will have a material effect on the financial statements – The degree of subjectivity involved in determining the appropriate amounts or treatment for those matters reflected in the financial statements • The level of expertise of the client’s management and employees with respect to the types of service provided • The extent of the client’s involvement in determining significant matters of judgment • The nature and extent of the impact of the service, if any, on the systems that generate information that forms a significant part of the client’s: – Accounting records or financial statements on which the firm will express an opinion – Internal controls over financial reporting • Whether the client is a public interest entity. For example, providing a nonassurance service to an audit client that is a public interest entity might be perceived to result in a higher level of a threat.

Section 800 Reports on Special Purpose Financial Statements that Include a Restriction on Use and Distribution (Audit and Review Engagements) This section sets out modifications to Part 4A that are permitted in particular circumstances involving audits of special purpose financial statements where the report includes a restriction on use and distribution. In general, the Code identifies two broad categories of safeguards that can reduce ethical threats to an acceptable level. These are safeguards attributable to: • The profession, legislation, and regulation – these include education, training and continuing professional development requirements, corporate governance

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regulations, professional standards, and professional or regulatory monitoring and enforcement. • The work environment – which relies substantially on the culture and processes developed in an audit firm.

Conclusion The audit literature concerned with auditor ethics is largely focused on independence threats and mostly address this issue in terms of financial dependence and the closeness of auditor–auditee relationships or tenure. Although audit standards such as the IESBA Code of Ethics for Professional Accountants require auditors to be aware of, and take action to avoid exposure to, these threats, including the need for a string ethical culture in firms, however, countries’ regulatory mechanisms are largely focused on auditor tenure, with rotation as the regulatory solution, and the auditorprovided NAS, with restrictions as the regulatory solution; these regulatory pressures might encourage practitioners to focus on process rather than encouraging a more culture that values more ethical behaviors. A more recent regulatory direction has been the IAASB’s promulgation of a new audit reporting standard that substantially reforms and extends the auditor’s disclosures in their report. While the expanded disclosures are about engagement-specific risk factors and the auditor’s approach to addressing them, and thus are not focused on ethics issues, they offer some prospect of revealing more about audit quality. It is plausible, but far from obvious, that this increased disclosure about audit work might encourage more ethical behavior – perhaps by enhancing the audit culture within the firm. While regulators and researchers exhibit substantial and enduring concerns about auditor ethics, and particularly independence, research on auditor ethical issues is challenged by difficulties in observing auditor behavior. The body of archival research focused on threats to independence presents mixed results but does provide evidence that some concerns may be justified. Particular cases of auditor wrongdoing that have resulted in prosecutions or regulatory penalties have prompted many of the publicly expressed concerns and are persuasive evidence that ethical failings can have significant market consequences. However, the extent of financial statement users’ (particularly investors’ and analysts’) sensitivity to auditor integrity is not sufficiently understood. As discussed above in relation to “research into ethical threats,” there is some evidence that financial statement users’ implied assessments of the credibility of audited financial reports are sensitive to some observable independence threats – particularly the selfinterest threats of NAS and, to a lesser extent, the familiarity threats of long auditor tenure. This does not mean that less observable threats to auditor integrity and objectivity are a lesser problem.

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References Azizkhani M, Monroe GS, Shailer G (2013) Audit partner tenure and cost of equity capital. Audit J Pract Theory 32(1):183–202 Beardsley EL, Lassila DR, Omer TC (2019) How do audit offices respond to audit fee pressure? Evidence of increased focus on nonaudit services and their impact on auditquality. Contemp Account Res 36(2):999–1027 Bell TB, Causholli M, Knechel WR (2015) Audit firm tenure, non-audit services, and internal assessments of audit quality. J Account Res 53:461–509. https://doi.org/10.1111/1475-679X. 12078 Campa D, Donnelly R (2016) Non-audit services provided to audit clients, independence of mind and independence in appearance: latest evidence from large UK listed companies. Account Bus Res 46(4):422–449 Causholli M, Chambers D, Payne J (2014) Future non-audit service fees and audit quality. Contemp Account Res 31(3):681–712 Chi W, Douthett EB Jr, Lisic LL (2012) Client importance and audit partner independence. J Account Public Policy 31(3):320–336 DeFond M, Zhang J (2014) A review of archival auditing research. J Audit Econ 58(2–3):275–326 Ettredge M, Fuerherm EE, Guo F, Li C (2017) Client pressure and auditor independence: evidence from the “great recession” of 2007–2009. J Account Public Policy 36(4):262–283 Financial Reporting Council (2018) Audit Culture Thematic Review: Firms’ activities to establish, promote and embed a culture that is committed to delivering consistently high quality audits. London: Financial Reporting Council Limited Francis J (2006) Are auditors compromised by nonaudit services? Assessing the evidence. Contemp Account Res 23(3):747–760 Francis JR, Ke B (2006) Disclosure of fees paid to auditors and the market valuation of earnings surprises. Rev Account Stud 11:495–523. https://doi.org/10.1007/s11142-006-9014-z Habib A (2012) Non-audit service fees and financial reporting quality: a meta-analysis. Abacus 48:214–248. https://doi.org/10.1111/j.1467-6281.2012.00363.x Hay DC (2017) Audit fee research on issues related to ethics. Curr Issues Audit 11(2):A1–A22 Hossain S, Monroe GS, Wilson M, Jubb C (2016) The effect of networked clients’ economic importance on audit quality. Audit J Pract Theory 35(4):79–103 Lennox C (2005) Audit quality and executive officers’ affiliations with CPA firms. J Account Econ 39(2):201–231 Lennox C, Park CW (2007) Audit firm appointments, audit firm alumni, and audit committee independence. Contemp Account Res 24:235–258 Patterson ER, Smith JR, Tiras SL (2019) The effects of auditor tenure on fraud and its detection. Account Rev 94(5):297–318 Singer Z, Zhang J (2018) Auditor tenure and the timeliness of misstatement discovery. Account Rev 93(2):315–338 Ye P, Carson E, Simnett R (2011) Threats to auditor independence: the impact of relationship and economic bonds. Audit J Pract Theory 30(1):121–148

Ethical Considerations About the Implications of Artificial Intelligence in Finance Raphael Max, Alexander Kriebitz, and Christian Von Websky

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Normative Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Opportunities and Benefits of AI for the Financial Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decent Work and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Strong Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Market Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ethical Challenges of AI in Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-maleficence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Justice and Discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Autonomy and the Replacement of Human Beings by AI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Autonomy and Data Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Normative Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actions by the State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actions by Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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New technological possibilities with artificial intelligence (AI) are about to disrupt the financial system. The changes will bring about many opportunities and benefits for the industry, its customers, and the society. The savings in costs and efficiency gains, the more reliable adherence to compliance guidelines, and the improvement of the service offers for customers would be examples of the R. Max (*) · A. Kriebitz Peter Loescher Chair of Business Ethics, TUM School of Governance, Technical University of Munich, Munich, Germany e-mail: [email protected]; [email protected] C. Von Websky Research Group on Sustainable Finance, University of Hamburg, Hamburg, Germany e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_21

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advantages. In this chapter, we describe the ethical implications of AI on finance. The use of AI in the financial industry does not only raise questions of ethical responsibility and legal accountability, but also include more general issues. Other ethical challenges that must be addressed in a discourse in society are the individualization of service offerings, the ownership and security of data collections, the destruction of numerous jobs in the financial industry, and the systemic risks arising from consolidation using AI. Based on this comparison, we derive normative implications that we hope will contribute to the discourse on how to deal with AI in society. Keywords

Artificial intelligence · AI · Finance · Business ethics

Introduction Tesla founder Elon Musk said in an interview that “with artificial intelligence, we are summoning the demon” (McFarland 2014). The praise of technical improvements and the warning of catastrophic developments are part of the debate about the effects of artificial intelligence (AI). However, in many regards AI does not depict an unforeseen novelty. In fact, it has already been existing for several decades. Due to the sheer amount of stored data, the enhancing computing power of the hardware, and the increasing interaction of different devices, AI has reached a new level and sparked interest in many distinct research fields in recent years ranging from neuroscience to economics. More and more devices of everyday life pertain algorithms that can be called artificially intelligent. Speech processing and technical assistant services simplify life just as much as autonomous driving cars. A discussion that analyses and deals with ethical change through AI-supported systems is essential. Questions about technical changes through intelligent algorithms have special ethical relevance, since they will bring about a global change at a speed rarely experienced so far, which no one can escape, and which requires socially, economically, and politically rapid answers. The aim of this chapter is to contribute to this discourse as well as to gather and critically discuss the ethically relevant arguments on AI in the financial industry. Due to the fact that the financial industry has always been part of the avant-garde of technical innovation, the relatively high homogeneity of the financial industry compared to other industries and because developments in the financial industry have a strong impact on the whole economic system, we focus in this chapter on the opportunities and risks of AI on the ethics of the financial industry. AI will reshape the financial industry in the following areas, among others: in customer service, marketing, asset management, portfolio management, and treasury or securities trading. The most significant changes will be visible in the analysis of customer and market data, the analysis for mortgage, loan or mutual fund

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applications, the dismissal or transfer of bankers, analysts and advisors, and evolution of algorithm-based trading. Due to the complexity and velocity of technological change, the problem of regulatory gray areas will increase significantly. The question we deal with in this chapter is how AI could affect finance and what ethical consequences it could have. Based on the defined areas by Boatright (2010), we concentrate in this chapter on the effect of AI on personal finance and corporate finance. In this chapter, we will develop the normative framework for our chapter. In a next step, we describe what changes AI will have on the financial industry and in which degree it might generate positive impacts. In a further step, we describe the ethical opportunities and challenges that could be associated with technical developments. In the final chapter, we try to derive normative implications from the previous sections and then finalize our argumentation with concluding remarks.

Normative Framework Ethicists encounter typically a plethora of different theories for evaluating the goodness or badness of practices conducted by individuals or technologies invented by human beings. The concepts and theoretical instruments we use range from deontological approaches, to virtue ethics, and to utilitarian considerations. The implications of these concepts on human behavior are often contradictory and at odds with each other. Given this starting point, we choose not to look for a traditional approach, but rather to identify the minimum consensus on AI ethics, which we will use in turn to develop implications of AI ethics and finance. In “A Unified Framework of Five Principles for AI in Society,” Floridi et al. (2018) have developed a conceptual framework for outlining principles and challenges of AI. These principles include beneficence, non-maleficence, autonomy, justice, and explainability and were largely derived from research ethics. However, due to the complexity of AI and the importance of understanding the way decisions are made by AI devices, Floridi et al. (2018) added explainability as another structural principle for AI ethics. In the following, we will provide a short overview of the principles: • Beneficence: AI should “be developed for the common good and the benefit of humanity.” (UK House of Lords 2018, p. 125) • Non-maleficence: “The power conferred by control of highly advanced AI systems should respect and improve, rather than subvert, the social and civic processes on which the health of society depends.” (Future of Life Institute 2017) • Autonomy: “Humans should choose how and whether to delegate decisions to AI systems, to accomplish human-chosen objectives.” (Future of Life Institute 2017) • Justice:

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“AI systems should be designed and operated so as to be compatible with ideals of human dignity, rights, freedoms, and cultural diversity.” (Future of Life Institute 2017) • Explainability: “We believe that the development of intelligible AI systems is a fundamental necessity if AI is to become an integral and trusted tool in our society.” (UK House of Lords 2018, p. 128). The advantage of this framework is that it is based on the comparison of already existing guidelines on AI such as the Montreal Principles the Asilomar Principles or the UK House of Lords Artificial Intelligence Committee’s Report (cf. Floridi and Cowls 2019). On the other side, it leaves room for the flexible interpretation of the principles, which matters for streamlining ethical principles to AI applications. In the sense of its inventors, we regard these principles not as strict normative guidelines, but rather as “architecture” helping us to frame the debate and to discuss the relevant aspects of AI in finance and its ethical approach. The further build-up of our contribution orients itself therefore on the follow structure. In the first section, we will deal with linking the beneficence criterion to the benefits and opportunities of AI. The normative implication of this part is to highlight areas, where companies can do more to advance ethically relevant topics. In the second section, we will deal with the risks, which can be attributed to AI. Relying on the framework of Floridi et al. (2018), we will emphasize the impact of AI in terms of non-maleficence, human autonomy, and justice. When we deal with the normative implications, we will emphasize on how to use explainable AI to mitigate the risks described in the second part, but also on other institutional measures, which need to be taken in order to facilitate an ethical conduct of AI.

Opportunities and Benefits of AI for the Financial Industry In this section, we discuss the changes through intelligent algorithms that have a positive effect on individual groups or the society as a whole. This connects to the aforementioned principle of beneficence, according to which AI development should be in line with normative goals and should provide clear benefits for human beings (Floridi et al. 2018; Floridi and Cowls 2019). In difference to the other four principles, beneficence illustrates the positive direction of AI research and enhancement. We argue that as a rule of thumb companies should provide a benefit to their stakeholders, when they are using AI. In order to illustrate the teleological purpose of AI development, we will link the beneficence criterion with some of the United Nation Sustainable Development Goals (UN SDGs). We have selected the UN SDGs due to their universal acceptance and owing to the fact that many international organizations such as the OECD or G20 have suggested to streamlining AI ethics to the UN SDGs (OECD 2019).

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Decent Work and Economic Growth The most important change for the financial industry and thus indirectly for the economy is the optimization of processes and the resulting increases in corporate productivity and economic growth. This in turn links up to the United Nation Sustainable Development Goal 8 “Decent Work and Economic Growth” and United Nation Sustainable Development Goal 9 “Industry; Innovation and Infrastructure.” The concept of beneficence indicates here that the use of AI in the financial industry should enhance economic efficiency and spur innovations, which benefit customers and other stakeholder groups. In general, AI might simplify many processes, increase the speed of data processing, and thus greatly reduce the costs of financial institutions. Cost reduction takes place with the saving of employees or the technical administration. According to Klein (2017), the average cost of data storages measured in cost per Gigabyte for hard drives decreased by 45% from 2009 to 2017. The efficiency gains also apply for the financial industry. Studies claim that the introduction of AI in China’s financial sector might result in the reduction of working hours by 27% between 2017 and 2027, what comes along with a 38% increase in per capita efficiency (He et al. 2018). Delegating simple processes has many advantages for the public. Floridi et al. (2018, p. 691) describe this argument as one of the biggest advantages of AI. The use of AI helps people to achieve self-realization and helps to get “the ability for people to flourish in terms of their own characteristics, interests, potential abilities or skills, aspirations, and life projects.” By simplifying processes, economies of scale and thus reducing costs, an increase in productivity can be achieved that increases the overall economic output.

Strong Institutions The positive implications of AI, however, do not only connect to direct economic effects, but entail institutional factors as well. This affects in particular the dimension of legal compliance, which deals with the prevention and mitigation of legal breaches. Improving the compliance architecture of the finance industry is important for realizing the goal of United Nations Sustainable Development Goal 16 “Peace, Justice and Strong Institutions” and for pushing topics like human rights forward. In the past years, compliance plays a more important role in the financial sector due to the enhancement of legislation and the relevance of international sanctions. Moreover, extraterritorial legislation such as the UK Modern Slavery Act requires companies to ramp up their due diligence measures in terms of human rights or children rights violations. However, compliance is not a merely legal business, but also bears important ethical considerations, as the enforcement of specific normative goals such as the realization of human rights or the prevention of terror attacks hinges on the control of financial transactions. As the financial sector interacts with all other business sectors ranging from agriculture to IT, it has to deal with complex legal, reputational, social, and environmental risks, ranging from money laundering and

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financing of terrorism to compliance with embargoes and international sanctions. The checking of customer identities, monitoring international cash flows, counterfeit and unjustified claims, or credit card fraud belong therefore to the daily business of financial service providers. Reports have also underscored AI’s role in detecting and fighting financial crime and money laundering as well as in checking sanctions (Zimiles and Mueller 2019). Linking AI to compliance would therefore significantly boost the mechanisms for incentivizing human rights conduct and for realizing UN SDG 16.

Financial Market Stability A significant increase in connected devices will enable financial intermediaries to learn more about customers’ behavior, what facilitates the creation of customer friendly offers such as travel insurances. At the same time, risk management and the evaluation of credit scores can be enhanced by algorithms, which measure the creditworthiness of individuals, but also of companies (He et al. 2018). To further enhance risk management AI systems will be used to calculate the likelihood for bank customers to repay a loan by analyzing real customer data from the past. Thereby credit default risks (for the banks) could be significantly reduced (Agrawal et al. 2017), what in turn enhances the stability of financial markets. The idea of financial market stability connects to UN SGD 8 and to UN SDG 16. This risk analysis capability of AI might matter for insurance companies, as well, supporting them in the detection of fake claims. For example, software could help to check damage pictures for authenticity and duplicates, leading to reduced costs and premiums. Justified claims on the other hand can be settled much faster than today. The calculation of the right premiums will be more precise and faster and might also result in enhanced methods to prevent insurance cases (Balasubramanian et al. 2018). The key task for companies is therefore to integrate and use AI solutions in such a way that it enhances relevant ethical goals, which connect to the direct environment of financial markets with the overarching normative priorities elaborated in international frameworks such as the UN SDGs.

Ethical Challenges of AI in Finance The changes and improvements described above might not only create new opportunities, but also ethical challenges. A study conducted by Kirchner (2018) in Germany aimed to examine people’s expectations and perceptions of digitization. Although the respondents to the study opined that digitization will improve people’s lives sustainably and has already significantly improved over the past 10 years, many concerns remain. The main concern is that people’s needs are not at the center of digital technology development and that new smart technologies will lead to greater income inequality. This chapter explains to what extent such concerns are justified and what ethical challenges arise in particular when intelligent algorithms are used in the financial

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industry. We can categorize the chapter broadly in three aspects, which deserve ethical attention: • Non-maleficence: AI should not result in devastating consequences for individuals and the society. • Justice and Discrimination: AI should treat all individuals in financial markets in a fair way. • Autonomy and the Replacement of Human Beings by AI and Data Protection: AI should not result in breaches of consumer sovereignty or consumer protection.

Non-maleficence An important ethical challenge is the handling of errors in algorithms and the responsibility for action, which might entail negative consequences for uninvolved parties. AI ethics describes this problem typically as non-maleficence, implying that AI should not harm human beings. The principle belongs to one of the earliest AI principles and traces its history to the Asimov law of robotics. In fact, non-maleficence is not only problem confined to the financial sector, but it connects to the more general debate on AI. Due to the fact that the financial industry is at the center of all economic enterprises and is highly internationalized, negative effects can have a stronger impact on the economy than other sectors. This fact comes to the surface, when communication errors – for example in the case of chat robots – trigger misunderstandings and result in unintended decisions (cf. Ostojitsch and Willis 2018). An AI-operated fund might conflate correlations and causalities and might make a structural mistake leading to losses for customers. The problem might also extend to loans, which are issued or dismissed by the bank. Due to the high degree of standardized decision-making which accompanies the use of AI in finance, the wrong classification of customers or biased AI decisions could result in structural problems and threaten the entire stability. The case of the Knight Capital in 2012 might be a warning example illustrating that software failure can result in severe economic consequences (BBC 2012). Given the interconnectedness of financial markets, the failures of AI do not constitute an individual relationship between the bank and a single customer, but questions related to the common good. The problem of bank runs illustrates that individual behavior can easily result in the destabilization of entire financial systems. Too big to fail might indeed become too linked to fail. Moreover, traders or hackers might be able to exploit the decision-making patterns of AI to deliberately destabilize the financial system.

Justice and Discrimination The use of AI in financial institutions might bear complex implications for the general discourse on justice. This can be explained by the fact that AI changes the range of products and that it individualizes products and services. In general, offering individual products from banks and insurance companies changes the

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customer structure and culture, as the human interaction between client and bank is replaced by algorithmic decision-making. This aspect largely connects to the idea of price discrimination by algorithms, which has raised ethical concerns. Price discrimination, setting the price of a given product for each customer individually, benefits here from extensive information collected online on the customers and increases to profitability of e-commerce services. As a result, the price of the product offered is determined by the preferences of the individual and not by the scarcity of the item. In the case of insurances, this tendency might conflict with two normative concepts: The idea of the social welfare state and the concept of nondiscrimination. The idea of the welfare state implies the idea of solidarity between the members of the society and the idea that individual risks should be hedged by the social institutions. In this sense, the development of insurance is a central building block for the functioning of a welfare state and widespread prosperity (Graham and Marvin 2001), as it allows the individuals of a society to engage in business or to forego risky activities. In earlier centuries, personal protection against danger and evil was individually organized. Families and small groups helped each other in emergency situations. In the nineteenth century this small group mentality was replaced by solidarity in a large group, usually the nation state what finally culminated in the emergence of private and public insurances in Western countries (Lehtonen and Liukko 2011). In some constitutions, the principle of the welfare state was even enshrined as a constitutional principle (e.g., German Constitution Art. 20). The idea behind this concept is that all members contribute to the common good according to their own economic means and provide a social safety net for the least advantaged members of society. In case of misfortune or personal emergency, the insurance averts the caused damage. However, this form of insurance only works if there is sufficient solidarity between the members and if each member expects an economic advantage in participation or if the members are forced to participate in the system. The use of intelligent algorithms, however, makes it possible to determine exact risk profiles for each individual customer (Khandani et al. 2010). The effect of these tendencies has strong implications for fairness considerations. Paying a higher rate than others in order to distribute risks more equally might be acceptable if the risks cannot be quantified beforehand. The ability to determine individual rates and the likelihood of an adverse event, however, might have an adverse impact on the willingness to pay an extra-fee for supporting others. Professions with a strong physical commitment or a deliberately unhealthy lifestyle, for example, bear higher health risks than an average person, what in turn is decisive for calculating the premium to be paid. The fact that AI is able to create very individual risk profiles through different procedures and use of Big Data will lead to people with low risk being less willing to stand up for people with higher risk if they become aware of that and have an economic opportunity not to pay for these risks. As a result, AI might drive up distribution conflicts and reinvigorate ethical questions: Should the healthy pay for the unhealthy? Should the risk averse pay for the risk friendly? Should the wealthy pay for the poor? The question of the welfare state connects to the issue of discrimination, as an increasing degree of liberalization might result in the discrimination of particular groups. Nondiscrimination is considered as a fundamental right

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(Amiraux and Guiraudon 2014) and has been codified for instance also in Article 21 of the EU Charter of Fundamental Rights. Combined with the stated fairness and the justice considerations, the way how AI derives its decisions might, however, enhance the risks of unwanted forms of discrimination, as machine learning functions by learning algorithms through data and experience (Shalev-Shwartz and Ben-David 2014). The improper handling of data or the use of distorted or incomplete datasets could therefore result in biases against specific groups of customers (Data Ethics Commission of the Federal Government 2019). Cases of unwanted discrimination based on income or on race have surfaced for example in algorithms predicting the health status of individuals and shown a significant bias against black Americans (Obermeyer et al. 2019). Other studies (cf. Edelman and Luca 2014) have reported discrimination cases against black property owners in the online rental marketplace airbnb.com, where prices for black and nonblack hosts differed by 12%. Due to the public polarization and the important relationship of trust in financial markets, the critical examination of the databases and algorithms by banks and insurance companies is therefore not only a quality standard, but connects also to general fairness considerations. As the abovementioned fairness considerations and the existence of biases could reinforce each other, the justice debate appears to be a pivotal aspect of ethics in finance.

Autonomy and the Replacement of Human Beings by AI According to Floridi and Cowls (2019, p. 7), the realization of human autonomy depends on “balance between the decision-making power we retain for ourselves and that which we delegate to artificial agents.” This is also a valid point for social policy making, as human beings might be replaced by machines in future. A study carried out in 2015 calculated that 39.5% of bank employees’ and insurance specialists’ jobs in Germany are at risk. (Dengler and Mathtes 2015) The occupational group was classified in the category “medium substitutability potential.” This group is therefore far less at risk than, for example, employees who work in the direct production or quality control of products. However, in contrast to occupations in the health and social sectors, substitutability is quite high. For some job profiles with slightly lower requirements in the financial industry, such as accounting and bookkeeping, the study expects a substitutability potential of 69.5%. According to Frey and Osborne (2013) the substitutability potential of jobs in the financial industry is much higher. Insurance sales agents have a 92% probability that they will be replaced by algorithms. Bookkeeping, Accounting, and Auditing Clerks, Loan Officer, Insurance Appraisers, Order Clerks, Brokerage Clerks, Insurance Underwriters and New Accountant Clerks have even a probability of 98% or more. Frey and Osborne (2013, p. 39) conclude, that “a substantial share of employment, across a wide range of occupations [is] at risk in the near future.” The use of AI in the financial industry and the resulting job losses constitutes an important ethical challenge, as job losses entail individual and systemic consequences. At the individual level, job cuts might mean a drawback in personal

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development, social recognition, and personal identity. Given the distaste of human beings concerning losses, it will make a difference whether former employees are made redundant and lose their jobs and their daily vocation in the middle of a career or whether no new employees are hired in a sector in the future. At the systemic level, job losses pose major challenges to our social systems. New political ideas, such as a basic income, and the search for mechanism and institutions to mitigate social and political risks coming along with the implementation of AI have already entered the discussion on the future direction of the welfare state (Floridi et al. 2018). These consequences affect the financial sector in a special way, as the upper middle class in particular will lose their jobs in this sector. Although some might underline that job cuts are unevenly distributed across different sectors and generally do not create large unemployment in the near future, almost all agree that these automations affect the financial industry more than other industries (e.g., Bessen 2019). The comparison of digitization to previous ages illustrates that transformation processes might entail the emergence of new social cleavages.

Autonomy and Data Protection The increased use of AI could lead to a loss of autonomy or human self-determination, which had both been central aspects of enlightenment philosophy. Safeguarding human autonomy is therefore a crucial aspect of AI ethics as such. In difference to Floridi et al. (2018), we regard therefore the discourse on data protection not merely as an issue linked to non-maleficence but also as a special side aspect of human autonomy. We argue that the extreme accumulation of data and the feeling to be supervised might impede the freedom of human beings, which is why we include minimum standards of data protection in our concept of autonomy. This is in line with the report of the German Data Ethics Commission, which states “the right to privacy is intended to preserve an individual’s freedom and the integrity of his or her personal identity” (Data Ethics Commission of the Federal Government 2019). Recent legislation in the European Union of member states has highlighted the issue in terms of the regulation of AI. The basis of the advantages of the technical development is the generation, processing, and evaluation of data. The fundamental problem is that the use of AI in the financial industry generates, stores, and processes data on an unprecedented scale. When asked how great their personal concern is that Internet companies collect too much of their personal data, 72% of respondents to a study conducted in Germany by Kirchner (2018) answered that their concern is rather great or very great. With regard to AI in finance, this concern becomes particularly relevant as the data generated in this context are very personal and their indecent use can have serious consequences (Ejanthkarn 2012). The information on the scale of financial payments, the income and personal relationships might even cover a sizeable part of the financial relationships of a person. It records, whether you lend money to your spouse, what products you buy and which salary you earn. Exploiting this information can have serious consequences on an individual level.

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Normative Implications Based on the emerging opportunities and ethical challenges, we formulate the following call to action. We structure the recommendations for action into two parts. First, we explain the recommendations for action by the state or the legislators, then we list recommendations for companies or financial institutions. Based on the aforementioned framework, we argue that the focus of all actors should be directed to the realization of beneficence, non-maleficence, autonomy, justice, and explainability.

Actions by the State According to the study by Kirchner (2018), German citizens prefer the digitization being shaped by the state or politics. Due to the overarching positive benefits of AI to many normative goals such as the UN SDGs, national AI strategies need to emphasize areas, in which AI research should be prioritized. From an ethical perspective, AI should also be tied to enhance the stability of financial markets, what is crucial for economic growth and political stability. Regulations, however, need to address the potential ethical problems accompanying the enhancement of AI. Some measures which might be discussed in this section are the enhancement of the knowledge, budget, and personnel staffing of financial supervision authorities to detect noncompliance of legal frameworks. Moreover, the scope of the German financial supervision authority, BaFin, for example is still narrowed down to “Credit institutions, financial and payment service providers, insurers, pension funds, capital management companies and securities trading” (Bafin 2018). The increasing relevance of nonconventional players in financial markets such as eBay, Amazon, PayPal, and Google, however, will require nation states to broaden the radius of financial supervision beyond the traditional banks and insurers to cover all relevant players. The regulation of the state, however, not only is confined to financial market regulation, but also might involve antitrust regulations. Antitrust is of crucial importance, as free market competition produces the best economic outcomes and enhances the productivity of the economy. The mere breaking up of Tech companies, however, might not be sufficient, as we are dealing with fundamentally new types of monopolies. The application of solutions in the past might therefore not be the right approach to deal with the regulation of the financial industry. The combination of a monopoly position, however, in terms of data and in terms of financial possibilities and the dominance in different markets might require the focus of legislation on intra-institutional firewalls between the different organization units of the enterprise, so that data protection remains at a high level without sacrificing operational efficiency. Intra-institutional firewalls or so-called Chinese walls refer to an information barrier within an organization, which seek to prevent conflicts of interest. The mandatory use of Chinese walls might be important to prevent that data of customers is used by the wrong departments and reduces the risks of hacking attacks. The less

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access an individual employee has on all data, the less likely a hacking attack results in the exposure of all necessary data. Moreover, Chinese walls might regulate the level of concreteness of data, employees might access, and involve the separation between raw data, which can be accessed by quality controls and audit units, and a more general and anonymized level, which is open for the corporate decision makers and the strategy departments and shows the correlations which a relevant for the decision makers. At the same time, low market entrance barriers might be important to guarantee that newcomers are able to challenge established companies. This increases the pressure of the market and incentivizes financial actors to invest in consumer friendliness. Furthermore, regulation of the state could come into play when it comes to the testing of algorithms. Random stress tests of algorithms and certification mechanisms might be important tools to ensure compliance with legal frameworks. Stress tests for example could involve randomized versus real-life scenarios and extrapolate skewed mechanisms and potential biases. The steps of the ISO to establish quality criteria for AI solutions can therefore be seen as a step into the right direction. This aspect connects to legislation on consumer protection. As already mentioned before, consumer protection plays an integral role in financial markets, due to the importance of mutual trust between the bank and its clients. Tailoring consumer protection, antidiscrimination frameworks and fair-trade acts to the challenges of the digital age are therefore of crucial importance. An important aspect of elevating the status of consumers in the legal framework would be for example the anchoring of right to remedy in the use of AI to avert damage to individual customers and to incentivize the build-up of adequate compliance structures. Within these measures and especially when it comes to the right to remedy, it is important to debate the exact concepts of justice we use. In this chapter, we highlighted areas that might be problematic. Finally, social policies need to be adapted to the challenges of digitization and the growing use of AI in the financial sector. Here we particularly emphasize on the idea of explainability. The decisions made by AI need to be transparent, so that individuals, whether experts or not, are able to rationalize, why AI has been making one particular decision (cf. Data Ethics Commission of the Federal Government 2019). This concept is pivotal, when it comes to decisions, which might endanger the life and physical integrity, liberty, and property of individuals. One potential role model for illustrating the potential risks of AI could also be the product inserts which highlight the risks of the product and illustrate the way the product functions.

Actions by Financial Institutions The challenges of the digital era and AI on financial institutions do not only impact the level of legislation, but also the financial intermediaries themselves. The increase of AI legislation will therefore influence the design of the compliance architecture and guidelines aiming at the prevention of compliance cases. Especially during the transition period, mitigating such risks will be crucial for maintaining the trust of the customers and clients in an enterprise. Adapting the infrastructure is therefore not

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only an act of legal compliance but also of raising fulfilling customer expectations and increasing competitiveness. New access possibilities should be offered for people who do not want their personal data to be collected or processed. The companies should give them the opportunity to pay for the use of their services instead of paying with their data. In that manner, those people are not excluded from using those services as if search engines and AI providers can generate additional revenues. Providing understandable solution and enhancing transparency are therefore crucial to mitigate adverse impacts on individuals. The most important aspect of corporate governance on AI will include trainings for employees and leaders in the financial sector, so that they can anticipate the challenges AI solutions pose to ethical and legal questions and are knowledgeable about the company intern guidelines on AI. The focus on converting employees from more traditional workplaces to AI related tasks might be also part of this general transition and will prevent that the banks are losing human capital. The implementation of AI solutions on the Code of Conduct level might also be mandated to increase the awareness of employees on the topic and to hold employees accountable in cases of negligence or deliberate misuse of AI. The idea of a Hippocratic oath for the developers of AI solutions is therefore not so far-fetched as it relocates responsibility – not necessarily in strictly legal terms – to the individuals shaping this process. Further measures on behalf of companies might encompass ethical auditing by third parties, the formulation of an AI codex, which explains how companies ensure AI compliance with antidiscrimination frameworks and consumer protection laws and the use of certified and stress tested AI solutions. At the same time, companies might need to provide additional information on the impact of the AI solutions used. The German Data Ethics Commission (Data Ethics Commission of the Federal Government 2019) has enumerated “transparent, explainable and comprehensible systems,” as one of the key aspects of ethical governance on AI. This connects also to the “Report of the Special Rapporteur to the General Assembly on AI and its impact on freedom of opinion and expression,” which has emphasized that “companies should make explicit where and how artificial intelligence technologies” and to “signal to individuals when they are subject to an artificial intelligence-driven decision-making process” (United Nations General Assembly 2018, p. 21).

Conclusion The financial industry faces many changes in the coming years that go far beyond techniques that can be called AI. Within the typical framework of AI regulation, financial markets can therefore be regarded as a special case. New providers and technical developments such as cryptocurrencies will change the product range and the entire market structure. Given this competitive environment and the emergence of new players, the governance of AI in financial institutions will therefore evolve as one of the dominating topics in the industry and be one of the determining factors of success in financial markets.

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On a general level, we encounter that AI might benefit human beings in many ways. The screening of sanctions, the detection of money laundry, and other illicit activities might be enhanced by these facts. Moreover, AI might help to incentivize sustainability within the supply chain and among the customers of the bank. Making services more user-friendly, more secure, and more efficient is therefore the prioritized task of AI developers. The use of AI, however, still requires an overarching framework, which covers material aspects such as potential cases of maleficence, ethical questions pertaining to the transfer of responsibility to AI, justice and fairness considerations, and data privacy. Furthermore, the implications of technological progress on the balance between companies and regulatory supervision units might tip the balance in the first place to the enterprises, as they are more knowledgeable about the technology’s day use. To prevent a “Wild West” scenario in the sector of AI, it is therefore important that regulatory institutions keep up with technological expertise and well-trained employees capable of understanding AI. This applies in particular to the conduct of companies in terms of data protection and the use of customer data for commercial purposes. Regulations need to attach importance to the questions of responsibility and liability. Otherwise, we risk that enterprises will try to shift the blame to AI and are not incentivized to invest in compliance. For example, customers need to know whether they are interacting with a chatbot or not. Establishing an apt infrastructure for liability needs to proceed in such a way that developers are still incentivized to develop state of the art solutions and that the costs for quality standards are tolerable for all parties. The solution might therefore be some sort of insurance for developers, certification mechanisms, AI supervision by financial authorities, or institutions focused on AI and corporate reporting. In the course of discussing AI in finance, we identified much room for further research. We see confusion when it comes to balancing the different principles of AI such as beneficence, and non-maleficence. A further aspect, which deserves attention, is the question of how to deal with conflicting fairness and justice considerations when implementing AI solutions in finance.

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Stakeholder Accounting for Sustainability Applied to Nonfinancial Information in Banking Jose Luis Retolaza and Leire San-Jose

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Specific Nature of Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Social Impact of Financial Institutions from an Endogenous Perspective: Their Own Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Social Impact of Financial Institutions from an Exogenous Perspective . . . . . . . . . . . . . . Reporting Content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Who to Report to? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . How to Report [About How?] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . How Far to Go [How Much?] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Limitations of Nonfinancial Information: The Question of Attribution . . . . . . . . . . . . . . . . . . . The Problem of Attribution: Dividing the Indivisible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Question of Meaning: Value Ecosystems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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The importance of nonfinancial information has increased over the past years in the last years. It is relevant for stakeholders, not just shareholders, but also suppliers, employees, financiers, government, and society in general as they want to know what value is generated by the organization besides economic value. This also holds for financial institutions. In this chapter, this topic is analyzed from an ethical point starting from the first best world of Arrow-Debreu J. L. Retolaza (*) University of Deusto, Bilbao, Spain e-mail: [email protected] L. San-Jose Universidad del Pais Vasco, Leioa, Spain ECRI Ethics in Finance and Social Value Research Group, University of the Basque Country UPV/ EHU, Bilbao, Spain e-mail: [email protected] © Springer Nature Switzerland AG 2021 L. San-Jose et al. (eds.), Handbook on Ethics in Finance, International Handbooks in Business Ethics, https://doi.org/10.1007/978-3-030-29371-0_37

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with focus on the information systems needed. For this purpose, we will answer the following questions: who to report to, how to report, how far to go with the report, and what are the limitations of nonfinancial information. We indicate how financial institutions could show this information and check different accounting and information systems. We conclude that we need the following elements in this extended information system: a standard methodology that allows for the development of the monetization process; the systematic collection of data that look at final societal impact, which would help reduce unethical decisions and those induced by shortterm economical purpose. Moreover, the establishment of sector agreements in order to mark collective standards, and finally transparency of the data and the analysis and calculation processes behind these data. Finally, it is shown that an external certification by a neutral actor would provide added credibility. Keywords

Integrated social value · Stakeholders · Financial entities · Social purpose · Stakeholder accounting

Introduction The results of a recent analysis of future issues related to Ethics in Finance performed using the Delphi method (San-Jose and Retolaza 2018) indicated that integrated reporting, understood as accounting for nonfinancial issues (ESG factors) integrated into financial reporting, ranked among the most relevant topics in financial ethics. The demand for both voluntary and imposed nonfinancial information is on the rise in society, and growing numbers of companies and organizations of all types are reporting nonfinancial information as a complement to their financial accounts (Chiucchi et al. 2019; Grewal et al. 2019; Jackson et al. 2020). Although the initial intention of these reports was to identify and reduce future financial risks, the focus has gradually shifted to highlighting the value organizations generate for society as a whole, normally through stakeholder-distributed value. Within the context of this increasingly common approach, which has been adopted by 71% of companies operating in the financial sector (KPMG 2017), GRI standards (Global Reporting Initiative) is the most widely used method worldwide, and has been adopted by just under 80% of the world’s 250 largest organizations (GRI 2020) (In its 2017 edition, the KPMG report identified a mere 46%. This sharp hike is possible due to the real increase as well as a more optimistic interpretation by GRI. At all events, it is by far the most widely used standard.). As for financial institutions, practically 100% use GRI, which includes stakeholders as a materiality matrix dimension. The reality of nonfinancial information from a stakeholder perspective represents a radical change in comparison with neo-classical two-way economic principles.

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Firstly, because identifying social objectives in addition to economic goals is tantamount to admitting the failure of one of the principal axioms of microeconomics, namely the relationship between profit maximization (understood in the long term) and the social optimum (Krugman and Wells 2012; Tirole 2017), thereby opening up the way for multiple goals. Secondly, the adoption of the stakeholder theory by the majority of companies and financial institutions, or at least the largest of these, also allows these goals to be set not only by the shareholders but also by the other stakeholders. Consequently, instead of just one objective for a single stakeholder, there are now various social, economic, and environmental goals targeting multiple stakeholders: essentially shareholders, customers, employees, users, public administrations, local residents, citizens, suppliers, other companies within the sector, and shapeholders (Retolaza et al. 2016a). This would appear to aggravate the problem of ungovernance discussed by Jensen (2002, 2005). In turn, the limitations of the stakeholder theory must also be considered from a social perspective (Freeman 1984; Freeman et al. 2010), which focuses on the debate of the common good of the particular interests of all stakeholders, in contrast to the traditional vision of the gap between private and public good (Soma and Vatn 2014). At all events, we are faced with a context in which financial reporting targeting all stakeholders has become a key and central issue, which, by either action or omission, also affects financial institutions. However, in the case of the latter, the question arises as to whether they display any specific features that set them apart from other organizations. If this is not the case, there is no reason to consider them in any different way. This chapter will address this specific nature, as well as the most effective way of transferring it to nonfinancial reporting.

The Specific Nature of Financial Institutions According to its classical definition, “a bank is an institution whose current operations consist in granting loans and receiving deposits from the public” (Freixas and Rochet 2008: 1). In other words, banks mediate between those with surplus funds and those that have a need for them (Freixas and Rochet 1999; Stiglitz 2019). The grounds for their existence are based on their role in allocating resources, specifically capital (Merton and Perold 1993). Success in this task depends on companies’ ability to repay this capital with interest within the set deadlines. However, this system of verifying banks’ social function as a financial intermediary implies a fundamental problem, namely the possibility that the project that receives financing fails and the recovery of the capital and interests is obtained through other assets or guarantees. Although the banks will not suffer as a result of this, it can hardly be claimed that they have contributed to the sustainable generation of value, as the project that has received the funding has failed. The inclusion of guarantees in order to reduce risk distorts the correlation between the customer’s results and those of the financial institution, potentially leading to situations of moral risk or even the adverse

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selection of venture capital. It could be argued that banks’ sole interest lies in responding to their depositors, or in more colloquial terms, in their own profit, although in this case, reasonable doubts emerge regarding their concern for generating social value (Stiglitz 2019). Regardless of how banks really act, the discussion included in this chapter is clearly based on regulations, focusing on their function as mediators and on ways to obtain a greater understanding of their impact in relation to other industries or sectors. The most commonly used proxies for measuring bank return are as follows: return on equity (ROE), calculated by dividing net profit by equity; and return on assets (ROA), calculated by dividing net profit by total assets. The return on asset ratio (ROA) is crucial for understanding banks’ results (Athanasoglou et al. 2005) and is also one of the most commonly used ratios both in business economics and microeconomics. It is normally calculated as shown below: R:E: ¼ Economic profit=Total assets This figure expresses a company’s capacity for realizing the assets it controls – either its own or those of third parties. In other words, the amount of money earned for each monetary unit used. ROA : EBIT=Asset  Sales=Sales; RA ¼ EBIT=Sales  Sales=Asset ¼ Margin  Rotation EBIT : Earnings before interest and tax: ROA is useful when comparing companies within the same sector, as they share similar capitalization needs. Unlike ROE, the use of ROA includes risks stemming from leverage, and is therefore a more suitable ratio, especially for banks (Goddard et al. 2004). Numerous financial studies have used ROA as a banking profitability index (Rhoades 1995; Moore 1998; Berger 1995; Pilloff and Rhoades 2002; Petria et al. 2015). ROA, ROE, or quality funds are all potentially good indicators for banks’ expectations. However, they fail to provide direct information regarding the social impact of financial institutions, at least in terms of their financial mediation. In this sense, the key question lies in considering whether banks are responsible solely for their own results, or whether this responsibility also extends to those of their customers. We can therefore pose the following question: Can a bank show their social results understood separately from the results of the projects it finances? The answer is crucial in determining whether banking is similar to traditional businesses, which charge customers a price for the services they provide [an endogenous perspective]; or whether it is a business based on mediation in which the bank must look beyond its own business, assuming responsibility for the results of the financing it provides [an exogenous perspective]. The answer to this question is far from simple, and banking practice displays a clear failure to define its position regarding these two perspectives (Angur et al. 1999; Moudud-Ul-Huq 2019).

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The Social Impact of Financial Institutions from an Endogenous Perspective: Their Own Results From an endogenous perspective, a bank’s social function is similar to that of any service provider, where the social success of its actions is measured by its own results. In this sense, the added value generated by the difference between income and costs would provide a good indicator of the value the bank generates for society. It must be stressed that the distribution of this value is irrelevant in orthodox terms, as all solutions correspond to the efficient frontier. Seen from this perspective, good nonfinancial reporting on banking activity would be limited to the actual financial information (added value), as well as any possible externalities. While it is true that these externalities could be positive or negative, the truth is that to date, attention has focused far more on the negative aspects from a social perspective (Buchanan and Stubblebine 1962; Sandmo 1975; Ziolo et al. 2019). Any positive externalities have been considered as part of corporate monetization strategies, understood to be a transfer to externality prices. In the event of success, they have been included as added value for later financial years. The negative externalities pose two problems: on the one hand, the difficulties involved in their quantification; and on the other hand, the problem of assessing risk prevention: what the company should try to do to prevent the updating of the possible risk of externalization. What baseline calculation should be used? The optimum? The immediate past? Or the sector? These are just some of the questions for consideration when analyzing and incorporating bank externalities. It was typical of the old SRI world (exclusions as baseline SRI strategy) to show the negative externalities; however, nowadays the externalities turn to concentrate on positive impact, i.e., positive externalities for society (SDG impact) that do not necessarily translate into extra income for the bank. It is a different view but with similar questions to answer. This endogenous approach, based on Arrow-Debreu’s general equilibrium model, leads to a paradigm where banks have no specific function in the results obtained by society (Sonnenschein 2017). Furthermore, given the lack of differentiation in terms of monetary resources, they all present a similar offer in which profit is limited to standard perfect competition market; in other words, capital cost. This cannot be observed in bank account analysis (San-Jose et al. 2018), or in the importance the various agents place on these types of organizations. In the case of the financial system at least, there are two complementary ways of looking beyond the theoretical myth of equilibrium: on the one hand, the imperfect information paradigm, and on the other, the industrial organization approach that considers that banks not only offer capital, but also services, and therefore financial transactions are differentiated products. The inclusion of differential input and output and offering associated services would produce a situation of management differentiation among financial institutions, which, as indeed occurs, would lead to differential results. Following Stiglitz (2019), we are often under the impression that banks are eager to charge commission for mediation operations but are reluctant to assume responsibility for erroneous investment decisions; they wish to be acknowledged as key players in financial mediation, yet are not willing for the results of that mediation, in

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other words the efficient allocation of resources, to affect their economic results (Eichelberger 2014). The result is a generalized distrust of the banking system (43%) (Edelman Barometer Trust 2019), considerably higher than in other sectors. (In 2019, confidence rates in the financial sector stood at 57%, making it the sector that inspires least confidence, 8% below the energy sector, which ranked second lowest.) On a global scale, 73% of citizens believe that “A company can take specific actions that both increase profits and improve the economic and social conditions in the communities where it operates” (Edelman Barometer Trust 2019: 60). However, the data for North America, Europe, and Australia reveal that a mere 59% consider the financial sector to be capable of incorporating social goals that will improve the world’s situation, a figure that is considerably lower than the 77% corresponding to the other countries (Central and South America, Asia and Africa). The reason for this distrust lies in the paradox that the banking sector appears to obtain good results regardless of their borrowers’ circumstances; indeed, this may lead to situations of perverse incentives and adverse selection (Stiglitz and Weiss 1981) that optimize banks’ economic results in direct contrast to their social results. The new originate-to-distribute model (Bord and Santos 2012) has proved crucial in citizens’ perception of financial institutions in general and banks in particular. As Karnani (2011) states, the heartfelt desire that companies can do well by doing good [DWDG] – in other words, improve their contribution to society without it affecting their financial results – is a popular notion in business culture, albeit severely questioned in scientific circles (Chernev and Blair 2015; Kirmani et al. 2017; Lee et al. 2018). Regardless of whether the trade-off between endogenous and exogenous results is occasional or structural, the mere questioning of the alignment between both impacts leads to the conclusion that financial reporting alone is insufficient in order to transmit the banking sector’s goodness to society; in other worlds, the social value generated by banking activity. Indeed, this requires additional measurement instruments. Although this is true of all sectors, banks are unique in that reporting cannot be limited exclusively to their activity, but must also include that of its borrowers and the social value they generate, which in part is due to the financing banks provide.

The Social Impact of Financial Institutions from an Exogenous Perspective The analysis of financial accounting data from a social perspective is the first step in order to obtain an insight into the social function of financial institutions. A classical analysis of the distribution of added value reveals highly significant differences (Retolaza et al. 2015) in relation to the value distributed to each stakeholder group (see Fig. 1). If market value and nonmarket value are considered, the differences would be even more notable, as the distribution of nonmarket value is far less common. However, given that banks are essentially market organizations, the nonmarket value is likely to be far lower than the market value. The data shown in the figure

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Suppliers 17%

Retained value 47%

Retained value 25%

Suppliers 38%

Donations to the community 2% Capital payments 4% Taxes 17%

Donations to the community 1%

Staffing costs 26%

Staffing costs 14%

Capital payments 3%

Taxes 6%

Fig. 1 Value distribution in large financial institutions: BBVA and Laboral Kutxa. (Source: Authors’ own based on Retolaza et al. (2015))

indicate that nonmarket value input stands at just 2%, and however well this is managed, and even if it were possible to identify social externalities unrelated to expenditure, under no circumstances would this produce a considerable percentage in terms of value distribution. On the other hand, emotional value, understood as the consumer surplus for all stakeholders (customers and the remaining production factors), can entail differentiation in terms of the value generated by financial institutions and should therefore be a prominent feature of nonfinancial reporting. However, to date, it has not been systematically included in accountability, and the frequency is far lower in the case of monetization processes. However, creating value through financial mediation enables organizations to obtain clearly differentiated results, which can also enable them to comply their mission (Cowton 2002). This is the case of banks or funds specialized in certain sectors, such as Triodos Bank (Cowton and Thompson 2001), population segments – social impact bonds (Fraser et al. 2018), or activity – green bonds (Flammer 2020). Regardless of the impact of the mediation process on the financial institution, citizens in general are concerned with the potential impact for society as a whole. In the case of guarantee-free loans, a correlation between the results is likely. However, if there are guarantees, the results could be related, even inversely.

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Reporting Content This issue is normally addressed from the perspective of materiality (GRI); in other words, a series of variables are selected that are considered to be relevant for all stakeholders and the company itself. However, this entails leaving aside holistic and integrated information: abandoning an interpretative model in favor of compiling information with varying degrees of relevance. Essentially, it would be like be limiting accounting reports solely to parameters of interest, unrelated to the information provided through other variables. For businesses and organizations in general, reporting covers at least three areas: market, nonmarket, and emotional (Retolaza et al. 2015, 2016b). In the case of banks, a further aspect must be taken into consideration, namely the value generated by financial mediation (resource use selection). Market reporting is based on classic accounting standards, but there is a need for greater comprehensibility. From a traditional neo-classical microeconomic approach, it is possible to understand that the equivalence between the social optimum and value/profit maximization, accountability can be limited to the profits obtained (in the short or long term), for citizens who consider that the existence of a perfect market is a conditio sine qua non. For the time being, we will leave aside the question of whether this is due to circumstantial and therefore solvable factors, or permanent structural factors in various contexts. Due to the lack of confidence in the omnibus measurement of social results, other parameters must be analyzed such as added value or the acquisition impact on supply chains. Fully understanding value generation requires more than merely identifying breakage, as occurs in many value chain reports which limit their scope to identifying negative incidents instead of systematically reporting the value transferred to suppliers. This wider understanding of accounting value beyond profit must also include an insight into the value that is added or removed through nonmarket mechanisms. The only way of transferring value between organizations or between organizations and their customers or production factors does not depend on a price system; there are multiple forms of external transmission (externalities) which may be negative (pollution, corruption, etc.) or positive (culture, medical advances, etc.). An effective information system should be capable of identifying and returning systematic information on the processes for transferring nonmarket value. Whether this value should be monetized or not is an issue for future consideration (Sandel 2000). Finally, given that the equilibrium price never reflects the total value, the added or subtracted value for stakeholders attributable to banks must be estimated. From a psychological perspective, this value can be considered emotional, and as consumer surplus in microeconomic terms. It is important to rethink the economics valuation that always goes through consumer preferences, but what if nature has intrinsic value? We will not focus in this aspect in this chapter, not for that it stops being important. So far, similarities can be drawn between banks and other types of organizations: However, the specific nature of the banking sector as a mediator for capital positioning implies that it must also report on the value generated in this sense. In other

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words, it must explain how financial activity generates value for society, at least in terms of market value – through taxes, capital gains, production factor gains, supplier traction, positive externalities, etc. – or how it detracts value through negative externalities. However, maybe market value is not the unique neither correct one, because indicators in general are only approximations of a very complex reality, then in general, incomplete. On the one hand, it is important to use indicators to mark a line and continue getting better, but in other, we should be careful with them and not to reduce decisions to numbers of indicators, they could be perverse and inconsistent if the context is not taking into account (see performance paradox for example). The banking sector often claims that “bank secrecy” prevents it from releasing this information, although this is refuted by the detailed information ethical banks provide (San-Jose and Retolaza 2008; San-Jose et al. 2011) or Global Alliance (http://www.gabv.org/); in other cases, the omission of the value contributed by depositors is merely attributable to a lack of interest, as this information can be directly accessed by banks, which in fact use it for risk analysis, based on criteria that vary in terms of appropriateness.

Who to Report to? The answer seems obvious: all stakeholders. Yet the key does not lie in the reader but rather in the perspective adopted in the analysis. We are used to single-dimensional reporting that is the same for all. Nevertheless, accounting information is designed and produced for a privileged stakeholder group: the shareholders. Double-entry accounting was designed to calculate profit obtained in commercial terms; in other words, from the investor’s perspective, and despite its increasing sophistication, this premise has remained intact. In the banking industry at least, understanding the value generated for shareholders from the accounts presented is a fairly simple matter. However, understanding the value generated for administration is far more difficult, and understanding salary expenditure, which is always a liability, is even harder to understand as value generated by the company. If, as posited by Freeman (2017), the total value generated by a company is a function of the value created for the various stakeholders – customers, suppliers, financiers, employees, public administrations, users, and the community – a multidimensional accounting system is needed, capable of reflecting the value generated for all these groups. The current accounting model is designed essentially to reflect the resulting value at the end of a financial year, understood as the company’s residual value, which can be distributed among shareholders or used to boost company funds. Consequently, the value generated for employees or suppliers is considered expenditure and therefore is unlikely to be considered a value, at least in the positive sense of the term. It is hard to understand that increased staff costs alone can be classified as positive value distributed by the company. Our vision, and even more so in the case of accountants or financial analysts, is that “value” generated for employees, suppliers, public administrations, and even customers in the case of a fall

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Fig. 2 Shared “social” value by all stakeholders: the map. (Source: Authors’ own based on San-Jose et al. 2017: 239)

in revenue detracts rather than adds. Nevertheless, the stakeholder theory, which is currently part of corporate culture, considers all this expenditure as “value” distributed by companies among their various stakeholder groups, and therefore increasing this value/expense features among their objectives (see Fig. 2). In this model, companies are generators of value for various stakeholder groups (that we called social value for stakeholders and society), where part of this value is shared by two or more groups, and another part is exclusive to each. As the shared value increases, it becomes easier to align the interests of the various stakeholders, and in turn, any decrease in value will result in a rise in conflict between them. Rather than the single final value reflected in accounting, the result will be a differential value for each stakeholder group. In terms of the question of ungovernance posed by Jensen, the model allows for the consolidation of value distributed among the stakeholders as an optimization function: Furthermore, this function allows for the global control of the agent by a single principal (the shareholders) or several (multi-fiduciary approach). j A1 [ . . . [ A n j ¼

n X i¼1

j Ai j 

X   Ai \ A j  þ 1i