Sustainable Finance and Financial Crime 3031287517, 9783031287510

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Sustainable Finance

Michel Dion   Editor

Sustainable Finance and Financial Crime

Sustainable Finance Series Editors Karen Wendt, CEO. Eccos Impact GmbH, President of SwissFinTechLadies, President Sustainable-Finance, Cham, Zug, Switzerland Margarethe Rammerstorfer, Professor for Energy Finance and Investments, Institute for Finance, Banking and Insurance WU Vienna, Vienna, Austria

Sustainable Finance is a concise and authoritative reference series linking research and practice. It provides reliable concepts and research findings in the ever growing field of sustainable investing and finance, SDG economics and Leadership with the declared commitment to present the theories, methods, tools and investment approaches that can fulfil the United Nations Sustainable Development Goals and the Paris Agreement COP 21/22 alongside with de-risking assets and creating triple purpose solutions that ensure the parity of profit, people and planet through choice architecture passion and performance. The series addresses market failure, systemic risk and reinvents portfolio theory, portfolio engineering as well as behavioural finance, financial mediation, product innovation, shared values, community building, business strategy and innovation, exponential tech and creation of social capital. Sustainable Finance and SDG Economics series helps to understand keynotes on international guidelines, guiding accounting and accountability principles, prototyping new developments in triple bottom line investing, cost benefit analysis, integrated financial first plus impact first concepts and impact measurement. Going beyond adjacent fields (like accounting, marketing, strategy, risk management) it integrates the concept of psychology, innovation, exponential tech, choice architecture, alternative economics, blue economy shared values, professions of the future, leadership, human and community development, team culture, impact, quantitative and qualitative measurement, Harvard Negotiation, mediation and complementary currency design using exponential tech and ledger technology. Books in the series contain latest findings from research, concepts for implementation, as well as best practices and case studies for the finance industry.

Michel Dion Editor

Sustainable Finance and Financial Crime

Editor Michel Dion École de gestion Université de Sherbrooke Sherbrooke, QC, Canada

ISSN 2522-8285 ISSN 2522-8293 (electronic) Sustainable Finance ISBN 978-3-031-28751-0 ISBN 978-3-031-28752-7 (eBook) https://doi.org/10.1007/978-3-031-28752-7 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 This work is subject to copyright. All rights are solely and exclusively licensed 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

Introduction

Sustainable finance is holistic approach of ESG-factors, so that the interdependence between environmental, social, and governance issues is unveiled. Sustainable finance makes possible to take various challenges following from social change and sustainability, the evolution of capital markets, and the development of efficient risk management practices into account. Governance issues are an integral part of sustainable finance. However, academic literature has generally neglected to consider strategies to prevent/fight financial crimes as a crucial component of sustainable finance. The aim of this book is to focus on the interconnectedness between sustainable finance and preventing/fighting financial crime, not only as a crucial governance issue, but also as a deep challenge for social and even environmental issues. There is no “really sustainable” finance without developing strong and efficient means to prevent and combat financial crimes.

Structure of the Volume This volume is divided into three parts that address the main topics related to the interconnectedness of sustainable finance and financial crime: sustainable finance, cooperation, and ethical leadership (Part I); sustainable finance, corporate governance, and the challenge of preventing financial crime (Part II); sustainable finance and the challenge of combating financial crime (Part III).

Part I: Sustainable Finance, Cooperation, and Ethical Leadership In chapter “The Role of Impact Finance in Targeting Social Justice,” Mario La Torre, Mavie Cardi, Jennie Daniela Salazar Zapata, and Aliessa Palma explain that v

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UN Sustainable Development Goals are a useful tool for improving capacities to set up and enhance environmental and social impact projects. However, further strategies could allow organizations and institutions to go a step further, in favoring public–private partnerships and make the process of selecting environmental and social impact projects more efficient and strongly oriented toward social justice. In chapter “The Impact of Financial Institutions on Sustainable Value Creation in Companies’ Business Models,” Magdalena Ziolo, Iwona Bak, and Anna Spoz analyze how the size of given companies (N = 120) and the particularities of their industry (in Poland) could influence the degree of cooperation with financial institutions, in the context of sustainability issues and challenges. It seems that such influence is stronger in large companies (in the manufacturing sector) than in microenterprises. Authors explain that such phenomenon could stem from the challenges related to complex financial products and to the strong demand for financial and sustainable innovations. Indeed, those challenges are much more significant for large enterprises than for micro-enterprises. In chapter “Sustainable Finance: Banks, Sustainability, and Corporate Financial Performance,” Rosella Carè and Olaf Weber explain how sustainable banking has been historically aware of various risks and opportunities for the financial industry. However, risks related to climate change could make banks much more accountable to their stakeholders. Sustainable banks assume their responsibilities toward climate change issues, while analyzing the potential impact of climate change on financial stability, both on the national and the international scale. Climate change issues constitute important financial risks as well as opportunities, at least for sustainable banking activities and operations. In chapter “International Informal Capital Flows and Sustainable Finance: China’s Regulatory Approach,” David Chaikin deals with the way China implements the FATF International Standards through its Anti-Money Laundering Regulation. The control of substantial capital inflows in China is at stake. Although China has foreign exchange regulations that favor long-term economic development, it does not affect criminals’ propensity to choose China as an effective area for money laundering activities. Chaikin argues that China must increase the level of transparency among its institutions and international cooperation for combatting money laundering. In chapter “The Environmental Performance of Firms and the Probability of Environmental Events,” Claudia Champagne, Samuel Chrétien, Frank Coggins, and Hajer Tebini analyze positive and negative environmental events occurring between 2000 and 2014 (based on articles published in the Wall Street Journal). They found that there is a higher probability of negative environmental events when companies have both positive and negative environmental activities. Those companies could attempt to improve their corporate reputation (and thus reduce their reputation risk) in realizing positive environmental activities. Nonetheless, such compensation effect does not reduce the probability of negative environmental events for those firms. In chapter “Ethical Leadership as a Prerequisite for Sustainable Development, Sustainable Finance and ESG Reporting,” Maria Krambia-Kapardis, Ioanna

Introduction

vii

Stylianou, and Christos S. Savva explore a theoretical link between ethical leadership, sustainable development, and sustainable finance. Moreover, their empirical study (in 24 countries and 11 industries) confirm that ethical leaders may drive a strong corporate ethical culture and favor sustainable finance. In chapter “Ethical Leadership and Ethical Organizational Culture: Two Pillars for Fighting Against Corruption in the Organizations,” Carole Doueiry Verne explains how ethical leadership may be institutionalized through an ethical organizational culture. Ethical leadership contributes to enhance and strengthen sustainable finance. Verne argues that ethics and corruption are antinomic concepts. Corruption undermines private and public institutions. Anti-corruption strategies are thus closely related to ethical leadership and sustainable finance. In chapter “The Development of Sustainable Finance and the Axiological Strategies Against Corruption in Organizations: Enhancing Virtues, or Emphasizing Moral Duties?”, Michel Dion presents the axiological choice between a virtue ethics approach (Aristotle) and a moral normativity approach of strategies against corruption in organizations. He describes how such paradigmatic choice could affect the way sustainable finance could be developed and expressed in corporate moral/ethical discourse. The strategies for enhancing sustainable finance and fighting corruption in organizations may be different, when virtue ethics (emphasis on the ethical aim) is chosen, or when deontological ethics (emphasis on moral norms) is preferred.

Part II: Sustainable Finance, Corporate Governance, and the Challenge of Preventing Financial Crime In chapter “Corruption and Transactional Crime: Building Up Effective Accountable Inclusive and Transparent Institutions as Ground for Sustainable Finance,” Mohammad Refakar and Gilberto Cardenas Cardenas explain that social trust is a qualitative factor that could exert a strong influence on corruption. It is related to formal and informal institutions of a given country. It is particularly true for political, bureaucratic, juridical, and economic institutions. Moreover, inefficient institutions may negatively affect the quality of ESG disclosure. In chapter “Rationalization of Corruption: A Discursive Legitimation Approach,” Shoeb Mohammad and Sofiane Baba explore how Algerian entrepreneurs develop their line of reasoning about corruption issues through discursive legitimation. Five legitimation strategies are used to justify corrupt practices: moralization (value systems as reference patterns), rationalization (cognitive validity), normalization (common behaviors in Algeria), authorization (authority of persons who allow or tolerate corrupt practices), and mythopoesis (the use of narrative and stories to make corrupt practices justified). In chapter “Financial Crime in OTC Markets,” Alexis Stenfors and Lilian Muchimba describe three different cases of financial market abuse, manipulation, and misconduct in the OTC markets. They describe how the OTC markets may be

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vulnerable to financial crime, particularly throughout the development of technological tools. They have shown that the OTC markets should be more strongly regulated. Organizational and institutional self-regulation is powerless, when the OTC market is deeply affected by manipulative and abusive behaviors. In chapter “Does Fiscal Pressure Influence Shadow Economy? A Panel Data Analysis for the OECD Countries,” Monica Violeta Achim, Viorela-Ligia Văidean, Sorin Nicolae Borlea, and Decebal Remus Florescu analyze the impact of fiscal pressure on tax frauds in 38 OECD countries, while distinguishing old OECD countries (official founding members and countries that joined OECD before 2010) and new OECD countries (that joined OECD since 2010). Authors have found that fiscal policies play a major role in the development of a shadow economy, particularly in OECD countries which have weak systems of governance. In chapter “A Bidirectional Causality Between Shadow Economy and Economic and Sustainable Development,” Eugenia Ramona Mara, Monica Violeta Achim, and Sandra Clement examine how shadow economy may have an impact on economic and sustainable development for 185 countries (2005-2017). The findings of this study could encourage governments to develop long-term strategies for reducing socioeconomic inequalities and thus the expansion of the shadow economy. In chapter “Sustainable Finance and the Role of Corporate Governance in Preventing Economic Crimes,” Etienne Develay and Stephanie Giamporcaro developed the concept of sustainable corporate governance that is structured by two main incentives for executives to choose a long-term and sustainable orientation: CSR contracting and the CSR board committee. Those inventive alignment mechanisms could allow an organization to put sustainability issues in the decision-making and strategic processes as well as in the whole corporate culture. Developing a sustainable corporate governance allows organization to prevent economic crimes much more efficiently, since the promotion of sustainability practices enhances the fight against economic crimes.

Part III: Sustainable Finance and the Challenge of Combating Financial Crime In chapter “The Financial Fraud of the German Fintech Company WireCard: Structural Causes and Failures of the Supervisory Authorities,” Michael Aßländer and Eckhard Burkatzki analyze the case of the German Fintech WireCard (financial fraud), particularly the structural causes of the scandal, the failures of supervisory authorities, and even the role of accountants, fund managers, and market analysts. They conclude that deep changes are required to prevent such scandals in the future. Various social actors play a decisive role in the WireCard scandal. Their systemic interconnectedness unveils the long-term challenge to transform business practices for each of those social actors.

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In chapter “Reducing Financial Crime Convenience for Sustainable Finance: A Case Study of Danske Bank in Estonia,” Petter Gottschalk explains how reduction in crime convenience may contribute to sustainable finance. Some arguments about convenience reduction are suitable to the objectives of sustainable finance decisions, particularly transparency in accounting, corporate social responsibility, protection of whistleblowers, reduction in ethical climate conflict, and avoidance of crime networks. Those factors of convenience reduction contribute to favor sustainable finance decisions. In chapter “How the Battle Against Cybercrime Strengthens Sustainable Finance,” Avner Levin analyzes the ESG consequences of various cybercriminal activities and infrastructure, more particularly their social and corporate governance consequences. Levin argued that strategies for combating cybercrime and its technological tools should emphasize the ESG consequences. In doing so, those strategies could enhance and strengthen sustainable finance activities and goals. In chapter “Terrorism Financing, the United Kingdom, and the Financial Action Task Force: A Series of Omissions or Missed Opportunities?”, Dominika Benton and Nicholas Ryder consider that there are important weaknesses in the UK counterterrorism financing strategies. Terrorist organizations may adapt their own activities and strategies to various technologies related to crypto-assets and blockchains. Crypto-transactions then become a privileged “locus” of new criminal schemes and provide further potentialities for terrorist financing activities.

Conclusion In this book, the interconnectedness of sustainable finance and preventing/combating financial crime is considered as an issue of context, typology of crimes, and means to favor sustainable finance and prevent/fight financial crime. Firstly, such interconnectedness may be addressed in various contexts: the organizational context, the industry context, the societal/international context. Secondly, the most important types of financial crime which should be the focus of prevention/regulatory strategies are the following ones: corruption, fraud, market manipulation, money laundering, cyber-crime, and the financing of terrorist organizations. The diversity of contexts and financial crimes constitutes a major challenge for favoring sustainable finance decisions and enhancing the cultural embeddedness of sustainable finance ideals into organizations, social institutions, societies, and international organizations. Thirdly, the various means to prevent/fight financial crime may be developed in given societal, cultural, economic, and political contexts. In this book contributors have unveiled six basic means which could be tools for decision-makers, when favoring sustainable finance decisions and preventing/fighting financial crime: (a) be aware that shadow economy is a stumbling block for sustainable finance: shadow economy should then be an important ethical concern for Governments and regulators; (b) develop more efficient regulations about technologies that may be used for financial crimes (particularly, cyber-crime and crypto-transactions); (c) adopt an

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ethical leadership style that enhances sustainable finance objectives and prevent/ fight financial crime in the organizational milieu; (d) increase the level of transparency in financial markets and institutions to favor sustainable and ethical finance decisions and to reduce the propensity of organizational members to commit financial crime; (e) strengthen cooperation of financial institutions for sustainability issues to improve their knowledge about sustainable finance decisions and to prevent/fight financial crime more efficiently; (g) select environmentally and socially sound projects that favor social justice (as an objective of any sustainable finance decision). Those six means to favor sustainable finance and prevent/fight financial crime are not exhaustive. However, they clearly reflect how sustainable finance and prevention/fight of financial crimes may be interrelated.

Contents

Part I

Sustainable Finance, Cooperation, and Ethical Leadership

The Role of Impact Finance in Targeting Social Justice . . . . . . . . . . . . . Mario La Torre, Mavie Cardi, Jenny Daniela Salazar Zapata, and Alessia Palma

3

The Impact of Financial Institutions on Sustainable Value Creation in Companies’ Business Models . . . . . . . . . . . . . . . . . . . . . . . . Magdalena Ziolo, Iwona Bak, and Anna Spoz

23

Sustainable Finance: Banks, Sustainability, and Corporate Financial Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rosella Carè and Olaf Weber

41

International Informal Capital Flows and Sustainable Finance: China’s Regulatory Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . David Chaikin

63

The Environmental Performance of Firms and the Probability of Environmental Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Claudia Champagne, Samuel Chrétien, Frank Coggins, and Hajer Tebini

83

Ethical Leadership as a Prerequisite for Sustainable Development, Sustainable Finance, and ESG Reporting . . . . . . . . . . . . . . . . . . . . . . . . 107 Maria Krambia-Kapardis, Ioanna Stylianou, and Christos S. Savva Ethical Leadership and Ethical Organizational Culture: Two Pillars for Fighting Against Corruption in the Organizations . . . . . . . . . . . . . . 127 Carole Doueiry Verne The Development of Sustainable Finance and the Axiological Strategies Against Corruption in Organizations: Enhancing Virtues or Emphasizing Moral Duties? . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Michel Dion xi

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Part II

Contents

Sustainable Finance, Corporate Governance, and the Challenge of Preventing Financial Crime

Corruption and Transactional Crime: Building up Effective Accountable Inclusive and Transparent Institutions as Ground for Sustainable Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Mohammad Refakar and Gilberto Cárdenas Cárdenas Rationalization of Corruption: A Discursive Legitimation Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 Shoeb Mohammad and Sofiane Baba Financial Crime in OTC Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 Alexis Stenfors and Lilian Muchimba Does Fiscal Pressure Influence Shadow Economy? A Panel Data Analysis for the OECD Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221 Monica Violeta Achim, Viorela-Ligia Văidean, Sorin Nicolae Borlea, and Decebal Remus Florescu A Bidirectional Causality Between Shadow Economy and Economic and Sustainable Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 Eugenia Ramona Mara, Monica Violeta Achim, and Sandra Clement Sustainable Finance and the Role of Corporate Governance in Preventing Economic Crimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 Etienne Develay and Stephanie Giamporcaro Part III

Sustainable Finance and the Challenge of Combating Financial Crime

The Financial Fraud of the German Fintech Company WireCard: Structural Causes and Failures of the Supervisory Authorities . . . . . . . . 291 Michael S. Aßländer and Eckhard Burkatzki Reducing Financial Crime Convenience for Sustainable Finance. A Case Study of Danske Bank in Estonia . . . . . . . . . . . . . . . . . . . . . . . . 307 Petter Gottschalk How the Battle Against Cybercrime Strengthens Sustainable Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 Avner Levin Terrorism Financing, the United Kingdom, and the Financial Action Task Force: A Series of Omissions or Missed Opportunities? . . . 353 Dominika Benton and Nicholas Ryder

List of Figures

Chapter 1 Fig. 1

Useful links on SDG 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7

Chapter 2 Fig. 1

Fig. 2

Fig. 3

Fig. 4 Fig. 5

The role of financial institutions and the concept of sustainable development. Source: Whitney A., Grbusic T., Meisel J., Cid A.B., Sims D., Bodnar P., State of Green Banks 2020, Rocky Mountain Institute, 2020, https://www.nrdc.org/sites/default/files/state-greenbanks-2020-report.pdf . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Examples of sustainable banking products. Source: Carè, R. (2018). Sustainable Banking. Issues and challenges. Cham: Palgrave Pivot . .. . . .. . . . .. . . . .. . . .. . . . .. . . . .. . . .. . . . .. . . . .. . . .. . . . .. . . . .. . . .. . . . .. . . Potential channels of impact of regulations on sustainable finance on enterprises and financial institutions. Source: own elaboration based on: Perspektywy rozwoju zrównoważonego finansowania— implikacje dla sektora przedsiębiorstw finansowych i niefinansowych w Polsce (Prospects for the development of sustainable finance—implications for the financial and nonfinancial enterprise sector in Polan), Deloitte, Warsaw 2019 . . . Eigenvalue: Elbow criterion . .. . . . .. . . . .. . . . .. . . . .. . . . .. . . . .. . . . .. . . . .. . The diagram of a hierarchical classification of variable categories performed with the use of the Ward method. Source: own elaboration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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28 33

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Chapter 9 Fig. 1

Causes and consequences of corruption. Source: Rose-Ackerman and Palifka (2016) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

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Fig. 2

List of Figures

GDP Per Capita vs. Corruptions Perceptions Index, 2018. Source: https://ourworldindata.org/grapher/gdp-per-capita-vs-corruptionperception-index?time=latest (based on World Development index and Transparency International) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

Chapter 12 Fig. 1 Fig. 2 Fig. 3 Fig. 4 Fig. 5 Fig. 6 Fig. 7 Fig. 8 Fig. 9 Fig. 10

The evolution of shadow economy for OECD countries, 2005–2020. Source: Authors’ processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The evolution of total tax revenues (as % in GDP) for OECD countries, 2005–2020. Source: Authors’ processing . . . . . . . . . . . . . . . . . The evolution of taxes on personal income (as % in GDP) for OECD countries, 2005–2020. Source: Authors’ processing in Excel . . . . . . . The evolution of taxes on corporate profits for OECD countries, 2005–2020. Source: Authors’ processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The evolution of social security contributions (as % in GDP) for OECD countries, 2005–2020. Source: Authors’ processing . . . . . . . . The evolution of payroll taxes for OECD countries (as % in GDP), 2005–2020. Source: Authors’ processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The evolution of property taxes for OECD countries, 2005–2020. Source: Authors’ processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The evolution of taxes on goods and services for OECD countries, 2005–2020. Source: Authors’ processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plots of taxes against SE, linear approach. Source: Authors’ processing .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . Plots of taxes against SE, parametric approach. Source: Authors’ processing .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. .

226 227 228 228 229 229 230 230 234 235

Chapter 14 Fig. 1

Matrix for economic crime prevention through governance effectiveness and orientation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281

Chapter 16 Fig. 1 Fig. 2

Convenience themes for Danske Bank money laundering . . . . . . . . . . 311 Convenience themes for Danske Bank fraudulent debt collection . .. . .. . .. . .. . .. . .. . .. .. . .. . .. . .. . .. . .. . .. . .. . .. .. . .. . .. . .. . .. . .. . 320

List of Tables

Chapter 1 Table 1 Table 2

Relevant KPIs for SDGs 16 . . .. .. . .. . .. .. . .. . .. .. . .. .. . .. . .. .. . .. . .. .. . Synthetic map of SIB projects tackling criminal justice . . . . . . . . . . . . .

8 16

Singular values and eigenvalues together with the degree of explanation of the total inertia in the original and modified versions . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

33

Sustainable banking and/or green policies . . . . . . .. . . . . . . . . . . . . . .. . . . . .

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Chapter 2 Table 1

Chapter 3 Table 1 Chapter 5 Table 1 Table 2 Table 3 Table 4

Impact of environmental performance on the probability of environmental event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impact of environmental strengths and concerns on the probability of environmental event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Probability of environmental event conditional on environmental performance level and category . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decomposition of environmental categories . .. . .. .. . .. .. . .. .. . .. .. . ..

95 97 98 99

Chapter 6 Table 1 Table 2 Table 3

Country where the Head Office of the ethical companies is located . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 Industry profile of the most ethical companies . . . . . . . . . . . . . . . . . . . . . . . 119 Panel estimation results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

Chapter 9 Table 1

Various types of corruption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 xv

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List of Tables

Chapter 11 Table 1 Table 2 Table 3 Table 4 Table 5

Examples of LIBOR manipulation by Deutsche Bank . . . . . . . . . . . . . . Manipulation by RBS of the WM/Reuters 4 p.m. fix (conversations) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manipulation by RBS of the WM/Reuters 4 p.m. fix (trading activity and FX spot movement) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . JP Morgan spoofing example from 3 June 2010 . . . . . . . . . . . . . . . . . . . . . Examples of communications regarding unlawful trading . . . . . . . . . .

208 211 212 214 215

Chapter 12 Table 1 Table 2 Table 3 Table 4 Table 5

Summary statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Correlation matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shadow economy (SE), OECD_All, as a function of taxes . . . . . . . . . Shadow economy (SE), OECD_old, as a function of taxes . . . . . . . . . Shadow economy (SE), OECD_new, as a function of taxes . . . . . . . .

231 233 236 237 238

Chapter 13 Table 1 Table 2 Table 3 Table 4 Table 5 Table 6 Table 7

Panel unit root test results . . . . .. . . . . .. . . . .. . . . . .. . . . .. . . . . .. . . . .. . . . . .. . Results for Kao Panel cointegration test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Results of panel Granger causality tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Empirical results based on FMOLS (Eq. 1) . . . . . . . . . . . . . . . . . . . . . . . . . . Empirical results based on FMOLS (Eq. 2) . . . . . . . . . . . . . . . . . . . . . . . . . . Empirical results based on FMOLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Empirical results based on FMOLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

251 252 254 254 255 256 257

Chapter 14 Table 1

Summary of the two cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280

Part I

Sustainable Finance, Cooperation, and Ethical Leadership

The Role of Impact Finance in Targeting Social Justice Mario La Torre, Mavie Cardi, Jenny Daniela Salazar Zapata, and Alessia Palma

1 Introduction Generating a positive social impact is not an easy task; among other components, finance is needed to foster initiatives aiming at social goals (Migliorelli 2021). Social justice, in particular, is among the most relevant dimensions of welfare state, and it is generally promoted and financially supported by public governments, at national and local levels.1 The financial crisis and the subsequent pandemic crisis have largely reduced the amount of public money that governments can dedicate to national welfare and have drawn attention to new forms of finance, mostly based on public– private partnership schemes. Sustainable finance, and more specifically the niche of impact finance, results in the most suitable financial solution in order to channel additional resources toward social impact-oriented investments. The chapter aims to clarify how the typical financial architectures of impact finance have been used in financing social impact investments (SIIs) targeting social justice. In Sect. 2, we put social justice in the context of sustainable growth—addressing the link between social justice and the Sustainable Development Goals (SDGs) developed by the United Nations and focusing on the specific key performance indicators (KPIs)

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The chapter is the result of a common work of the authors. Nevertheless, it can be attributed to Mario La Torre Sect. 3, to Mavie Cardi Sect. 2.1, to Jenny Daniela Salazar Zapata Sect. 4, and to Alessia Palma Sect. 2.2. M. La Torre (✉) · J. D. S. Zapata · A. Palma University of Rome La Sapienza, Rome, Italy e-mail: [email protected]; [email protected]; [email protected] M. Cardi Link Campus University, Rome, Italy e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_1

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related to SDGs 16 (“peace, justice, and strong institutions”). In Sect. 3, we outline the main features of social impact finance; Sect. 4 designs a map of the most relevant cases of impact finance dedicated to social justice; Sect. 5 concludes.

2 Social Justice and Impact Measurement 2.1

Social Justice and Sustainable Development Goals

The social justice theme——critically examined since the development of the welfare state from the latter part of the nineteenth century, when the need for a social framework that would, as far as possible, reconcile the individual welfare with the general interests, became a distinctive form of contemporary industrial society— has been declined over time into different models of “distributional considerations regarding utility” (Sen 1987). To this day, the concept of social justice takes on a multifaceted nature and opens the analysis to further contemporary ethical, financial, and institutional issues, expanding the notion to “common goods” that “must for reasons of equity belong to everyone: water, air, biodiversity, cultural heritage, the planet” (Tirole 2017). This approach is necessarily reflected in the identification of appropriate socio-economic strategies to foster broad and sustainable economic growth as a prerequisite for an overall social goal of promoting the well-being of individuals (but not their abuse at the expenses of others). Therefore, it is essential to ensure that growth is sustainable and that the integrity of the natural environment is respected; the conception of social justice must integrate these dimensions, starting with the right of all human beings to benefit from a safe environment. According to the United Nations (2006), “Social justice will only flourish if environmental preservation and sustainable development constitute an integral part of growth strategies now and in the future.” Thus, the search for an innovative economic and institutional paradigm that can combine efficiency, equity, and sustainability is the answer to the need to respect the common goods, incorporating both individual and collective dimensions. The Sustainable Development Goals (SDGs) developed by the United Nations in the 2030 Agenda call for strategies that foster economic growth while meeting social justice criteria and promoting greater equality of basic opportunities, such as education, health, social protection, and employment. Furthermore, the 2030 Agenda integrates the three dimensions of sustainable development by identifying 17 goals on the economic, environmental, and social spheres (United Nations 2015). In fact, the 17 Sustainable Development Goals are declined into five essential pillars (5 “P”) for sustainable development: . People . Planet

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. Prosperity . Peace . Partnership The 17 goals are divided into 169 subgoals, and the United Nations Agency of Experts Group on the SDGs has proposed a list of more than 230 indicators needed to monitor them in a common framework (Department of Economic and Social Affairs—United Nations 2020). With specific reference to the theme of Justice, SDG 16 (“peace, justice, and strong institutions”) is aimed at promoting legality at the national and international levels and institutions designed to promote access to justice, procedural fairness, accountability and openness, and certainty in the public sphere. The basic assumption is that some areas of the world benefit from stable conditions of peace and governance, while other regions are plagued by ongoing situations of conflict and ungovernability, giving rise to consequences of social injustice that impact most significantly on the most vulnerable groups (Ahmed 2021). This leads to the need to stimulate societies based on transparency and good governance also in order to ensure respect for individual and collective dignity. Overall, these are challenges that also need to be subjected to a sustainability assessment within the overall framework of available resources. The result is a relevant role of the private sector in achieving the various SDGs. In fact, as highlighted by the 17th SDG (“partnerships for the goals”), collaboration on a global basis between governments and public and private entities is essential to mobilize the required economic resources, as well as to share the assumptions and the achievement of the goals themselves. In other respects, governments will need to implement useful models to select projects, initiatives, and investments within a strategic plan that considers, on the one hand, priorities with respect to the SDGs and, on the other hand, the financing of the selected initiatives. Public projects inspired by the SDGs, and their respective impact indicators, enable local authorities to set their supply of goods, services, and projects according to priority needs for sustainable growth (La Torre et al. 2021). Financial architectures and partnerships allow investments to be framed according to existing public budgets. Moreover, monitoring the coherence of public investments with the strategic goals set forth by the SDGs is already planned in several administrations through Voluntary Local Reviews (VLRs), which is a tool for local and subnational governments to assess their contribution to the 2030 Agenda, with a view to pursuing positive social and environmental impacts. In light of the above, finance acquires a growing and significant correlation with the improvement of society conditions while pursuing ideals of integrity and rationality. Therefore, as will be seen below, the analysis of government programs, aimed at reducing social imbalances, necessarily requires reference to the evaluation of the finance impact in social justice, and therefore respecting sustainable criteria in the distributional public policies. Hence, the need to dwell the analysis also on the specificity of technical financial forms oriented to a fair balancing of interests

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between present and future generations, through an operational methodology aimed at a management of resources that respects human rights.

2.2

SDGs 16 and Relative KPIs

The SDGs propose a new systemic vision and, at the same time, summarize the synergies already available in terms of international legislation, creating a multidimensional and interconnected international regulatory framework. In particular, each SDG has a specific goal associated with a sustainability dimension, but when looking at the overall picture, the various goals are interrelated and interconnected (Miola et al. 2019). In this way, an improvement in one area will positively impact almost all the other sustainability goals, creating a multiplier effect on the systems (IAEG-SDGs 2020). In this context, social justice plays a double role: on the one hand, it represents a critical “enabler” to achieving any other SDGs—such as to end poverty, ensure education, or conserve oceans—and is, therefore, transversal to the other goals; on the other hand, it represents a fundamental goal to be achieved in and of itself and is contained in SDG 16 (Fig. 1). With SDG 16, the aims of governments are to “promote peaceful and inclusive societies for sustainable development, provide access to justice for all, and build effective, accountable and inclusive institutions at all levels.” The rationality behind this goal is that, to construct a peaceful, inclusive, and democratic society it is necessary to foster the principles of legality at international level and develop resilient and responsive institutions. In that way, SDG 16 aims at ensuring equal access to justice, putting an end to all forms of violence, promoting the participation of developing countries in the decision-making process, and facilitating sustainable development policies at the international level through the creation of accountable and transparent institutions. In particular, the goal is composed of 12 targets, to be achieved by 2030, and 24 indicators through which progress can be measured and monitored at national and global levels. The framework was developed by the Inter-Agency and Expert Group on Sustainable Development Goals Indicators (IAEG-SDGs) created by the United Nations Statistical Commission. Each one of the 24 indicators has a designated custodian agency that is responsible for methodological development and continuous refinement of the indicator and, in particular, for collecting data from national statistical systems and making them consistent in order to monitor national and global progress toward achieving the SDG. Table 1 shows, for each target, the related indicators and legal references— conventions, agreements, protocols, or treaties explicitly stated or inferred—as well as the SDGs most interconnected with SDG 16. In achieving this goal, the private sector plays a fundamental role, and companies should integrate in their internal codes some policies—against harassment, abuse, intimidation, and violence—and principles—such as the UN Guiding Principles on

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Fig. 1 Useful links on SDG 16

Business and Human Rights—to promote and share with all the employees a common, equal, and fair sustainable working environment. Moreover, in order to have a positive impact on the external context, companies should implement some activities to foster the development of these rights, such as offering free assistance to vulnerable groups, or choose not to invest in the arms industry, or in other controversial sectors, or, finally, establish public–private partnerships (PPP) with the public sector, nongovernmental organization, universities, and other companies, to implement projects aimed at promoting human rights and social justice.

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Table 1 Relevant KPIs for SDGs 16 Target 16.1: Significantly reduce all forms of violence and related death rates everywhere

International legal framework KPI 16.1.1: Number of victims Universal Declaration on of intentional homicide per Human Rights (1948) 100,000 population, by sex and age

16.1.2: Conflict-related deaths per 100,000 population, by sex, age and cause

Convention on the Rights of the Child (1989)

16.1.3: Proportion of population subjected to (a) physical violence, (b) psychological violence, and (c) sexual violence in the previous 12 months 16.1.4: Proportion of population that feel safe walking alone around the area they live after dark

International Covenant on Civil and Political Rights (1966)

Related goals

Convention against Torture and Other Cruel, Inhuman or Degrading Treatment, or Punishment (1984) International Convention for the Protection of All Persons from Enforced Disappearances (2006) 16.2: End abuse, exploita- 16.2.1: Proportion of chil- Convention on the Rights dren aged 1–17 years who of the Child (1989) tion, trafficking, and all forms of violence against experienced any physical and torture of children punishment and/or psychological aggression by caregivers in the past month 16.2.2: Number of victims of human trafficking per 100,000 population, by sex, age and form of exploitation

(continued)

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Table 1 (continued) Target

KPI 16.2.3: Proportion of young women and men aged 18–29 years who experienced sexual violence by age 18 16.3: Promote the rule of 16.3.1: Proportion of viclaw at the national and tims of violence in the international levels and previous 12 months who ensure equal access to jus- reported their victimizatice for all tion to competent authorities or other officially recognized conflict resolution mechanisms 16.3.2: Unsentenced detainees as a proportion of overall prison population 16.3.3: Proportion of the population who have experienced a dispute in the past 2 years and who accessed a formal or informal dispute resolution mechanism, by type of mechanism

International legal framework

Related goals

Universal Declaration on Human Rights (1948)

International Convention on the Elimination of All Forms of Discrimination against Women (1979) International Covenant on Civil and Political Rights (1966)

16.4: By 2030, signifi16.4.1: Total value of cantly reduce illicit finan- inward and outward illicit cial and arms flows, financial flows strengthen the recovery and return of stolen assets, and combat all forms of organized crime

(continued)

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Table 1 (continued) International legal framework KPI 16.4.2: Proportion of seized, found or surrendered arms whose illicit origin or context has been traced or established by a competent authority in line with international instruments 16.5: Substantially reduce 16.5.1: Proportion of percorruption and bribery in sons who had at least one contact with a public offiall their forms cial and who paid a bribe to a public official, or were asked for a bribe by those public officials, during the previous 12 months 16.5.2: Proportion of businesses that had at least one contact with a public official and that paid a bribe to a public official, or were asked for a bribe by those public officials during the previous 12 months 16.6.1: Primary govern16.6: Develop effective, accountable, and transpar- ment expenditures as a ent institutions at all levels proportion of original approved budget, by sector 16.6.2: Proportion of population satisfied with their last experience of public services Target

Related goals

(continued)

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Table 1 (continued) Target 16.7: Ensure responsive, inclusive, participatory, and representative decision-making at all levels

International legal framework KPI 16.7.1: Proportions of positions in national and local institutions, including (a) the legislatures; (b) the public service; and (c) the judiciary, compared to national distributions, by sex, age, persons with disabilities, and population groups 16.7.2: Proportion of population who believe decision-making is inclusive and responsive, by sex, age, disability, and population group 16.8.1: Proportion of members and voting rights of developing countries in international organizations

16.8: Broaden and strengthen the participation of developing countries in the institutions of global governance 16.9: By 2030, provide 16.9.1: Proportion of chillegal identity for all, dren under 5 years of age including birth registration whose births have been registered with a civil authority, by age

16.10: Ensure public access to information and protect fundamental freedoms, in accordance with national legislation and international agreements

Related goals

Universal Declaration on Human Rights (1948) Convention on the Rights of Persons with Disabilities (2006) International Covenant on Civil and Political Rights (1966) Universal Declaration on Human Rights (1948)

16.10.1: Number of verified cases of killing, kidnapping, enforced disappearance, arbitrary detention and torture of journalists, associated media personnel, trade unionists, and human rights advocates in the previous 12 months 16.10.2: Number of coun- International Covenant on tries that adopt and imple- Civil and Political Rights ment constitutional, (1966) statutory, and/or policy guarantees for public access to information

(continued)

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Table 1 (continued) Target 16.a: Strengthen relevant national institutions, including through international cooperation, for building capacity at all levels, in particular in developing countries, to prevent violence and combat terrorism and crime 16.b: Promote and enforce nondiscriminatory laws and policies for sustainable development

KPI 16.a.1: Existence of independent national human rights institutions in compliance with the Paris Principles

International legal framework

Related goals

16.b.1: Proportion of population reporting having personally felt discriminated against or harassed in the previous 12 months on the basis of a ground of discrimination prohibited under international human rights law

3 Impact Finance for Social Justice In order to implement investments in favor of social goals, finance plays a crucial role. Nevertheless, traditional finance may result ineffective at the scope. Traditional finance is supply-driven and aims at profit first, while positive effects in terms of social goals may result as an unintended consequence. On the contrary, impact finance—a niche of the broader sustainable finance market—is demand-driven and puts impact first, alongside financial return (Spiess-Knafl & Scheck 2017). This change of paradigm marks a groove between traditional finance and impact finance and poses the need, for the latter, to search for new solutions. That is why, over the last decades, financial architectures have been fine-tuned to pursue a difficult equilibrium between social impact and financial return. What has been developed in the impact finance market, result of great utility in reaching for social justice goals, because it traces the way to divert funds on investments with high social impact, without neglecting the need for a financial return. It is, then, useful to picture the main features of the typical impact finance financial architecture, before analyzing, in the next paragraph, some selected case studies.

3.1

The Main Features of Impact Finance

In the impact finance world, in order to label an investment as “social impact investment,” we have to test the existence of several variables. Firstly, social impact

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investments (SIIs) must generate a social value. Nevertheless, this is not enough: many traditional investments can do so. What makes the difference between traditional finance and social impact finance is the intentionality to generate the impact; that is to say, the investment is planned with the main intention to generate social value (demand-driven approach). Secondly, SIIs also aim at profit: the social value goes alongside the financial return. Again, this is not the whole story; what distinguishes SIIs from traditional investments is that the financial return is strictly connected to the social impact and somehow depends on the achievement of the social goal. In practical terms, investors usually receive higher financial return, if higher impact is achieved; in most cases, if a “minimum level” of social impact is not achieved, investors do not receive any return. This remuneration scheme, known as “pay for success” model, leads to the conclusion that the impact must be measured and converted into financial metrics: the third condition is, therefore, that SIIs need to aim at measurable impacts. In conclusion, it is possible to define social impact investments as those investments which aim at social impact—one which is intentionally pursued and clearly measurable—alongside a financial return dependent on the achievement of the social goal (Social Impact Investment Taskforce 2014). It is worth noting that, along the spectrum of potential investors, we may distinguish between socially responsible investors, aiming at a return around that of the market, and impact investors, open to accept long-term return below the market rate and that, according to this, can be labeled as “patient investors.” That’s why in market practice, a social impact investment, being financed by a pool of different categories of investors, is funded making recourse to sophisticated financial structures who meet the different risk-return-impact profile of the different investors.

3.2

The Typical Financial Structures of Impact Finance

Social impact investments have been financed mainly through Social Impact Bonds (SIBs) and Social Impact Funds (SIFs). Social Impact Bonds SIBs are the most well-known financial structure of the social impact market. A Social Impact Bond is a “pay by result” or “pay for success” financial structure, which does not necessarily provide the issue of any bond and is based on the agreement between a promoter—usually a public authority or a government—and an intermediary aimed at realizing a project with a social goal. When the promoter is a public entity, the project is usually connected with welfare state services traditionally financed through public expenditure (La Torre et al. 2019). The intermediary plays the role of attracting potential investors; rarely it manages the project directly and, more often, uses a social firm specialized in the field of the intervention (“service provider”), which services the flow of funds. Investors provide the capital needed to fund the operational costs of the project and the financial costs related to the fees to be paid to the intermediary and the social firm. They will be repaid with a

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rate of return negotiated upfront with the promoter but only if the social bond is successful, that is to say, only if the program has generated a minimum level of social impact. According to this scheme, the higher the impact, the higher the return. A third-party assessor is usually in charge of estimating the success of the program, which includes measuring the social outcome generated and the correlated return to pay back to investors. As noted above, in market practices, this approach is not applied to all class of investors but typically only to impact-oriented ones. Traditional investors are ensured with a minimum level of return. This “pay by result” mechanism suites very well with the need of governments, both at national and local levels, who are required to pursue social tasks, while experiencing scarcity of public funds. This is also why the SIBs are often promoted by public governments. The premise of the “pay by result” model, indeed, is that achieving social objectives also means obtaining savings in public spending. The first European Social Impact Bond—the Peterborough Social Bond, launched in UK in 2010—aimed at reducing reconviction rates at Peterborough prison, has been inspired by the idea that reducing recidivisms would result in a lower reoffending rate cost. Once obtained the social outcome, the correlated saving in public expenditure can be shared between the promoter, the investors, and the other parties, according to the conditions included in the SIB agreement. From the perspective of the public administration, the recourse to the pay by result model may generate (i) a financial benefit, since the investments is financed by private investors and no public cash is needed; (ii) an economic opportunity, considering the potential net public saving resulting after payback the investors; and (iii) a benefit in terms of social goals achieved. Social Impact Funds The largest funding for social impact investments comes from investment funds set up with an impact-oriented goal. These funds do not differ from traditional ones in terms of financial structure: they are labeled as “impact funds” because of the “impact-oriented approach.” The typical structure of a Social Impact Fund (SIF) requires a vehicle issuing notes to investors and channeling the funds raised on the market to finance a basket of projects identified by the promoter and the Investment Committee. The need to attract investors, and to scale the invested portfolio, led to the consequence that the majority of impact funds issue different classes of notes in order to meet investors with different risk-return appetite; they offer financial return at, or above, the market rate. Besides, in order to meet investors’ preferences, they generally do not link the financial return to the achievement of the social goal— which is measured mostly for communication and funding.

4 A Map of Impact Finance Experiments on Social Justice The financial architecture most suitable to foster social justice is the abovementioned Social Impact Bond. According to the latest report on Social Impact Bonds provided by Social Finance, a not-for-profit organization that partners with

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governments, service providers, the voluntary sector, and the financial community: (i) there are 60 Social Impact Bonds that have been launched in 15 countries, raising more than $200 m in investment to address social challenges and touching approximately 90.000 lives; (ii) 22 SIB projects have posted results, 21 of which have posted positive outcomes for beneficiaries; (iii) 12 programs have made outcomes payments; (iv) 4 Social Impact Bonds have repaid investors in full with a return on their investment. Social Impact Bonds enable governments to partner with highperforming service providers by using private investment to develop, coordinate, or expand effective programs. Of all 60 SIBs mapped by the Social Finance database, only 12 are directly connected to the targets of Sustainable Development Goal 16. The programs and projects are, in all cases, about reducing the percentage of further offense from ex-convicts or potential ones, be it young adults, teenagers, or women. Directly contributing to target 16.4 “significantly reduce illicit financial and arms flows, strengthen the recovery and return of stolen assets and combat all forms of organized crime.” All 12 programs collectively raised almost $ 74 million, touching approximately 16.200 lives. However, only two SIBs resulted as of today into a positive impact performance that repaid investors. Table 2 synthetically represents the SIB projects tackling criminal justice according to: – Geographical allocation; it can be noticed that most projects are located in AngloSaxon countries and just one in Europe. – Type of program; all projects deal with recidivism, most target young adults, while some have a more specific targets as women, children, or homeless. – Payor, which is usually a public entity with an interest in generating an opportunity of public saving. It can be noticed how there are different levels of intervention: national, if conducted by the Ministry of Justice, regional, if conducted by a regional public body, and city-based, if conducted by the municipality. – Service provider, which is generally a nonprofit organization specialized in that specific target of beneficiary providing a combination of services that assists the target beneficiary in his/her re-inclusion in society. – Investors, generally foundations or funds supporting these types of interventions. In the table below, we will generally see more than one player supporting financially a criminal justice project.

5 Conclusion The need for financial resources in favor of social goals, and in particular of social justice, has drawn the attention of policy makers and professionals to new forms of financing. Sustainable finance, and more specifically impact finance, proved to be an effective solution under several perspectives: it put social goals as main driver of any investment; it uses financial architectures that result suitable to public–private partnership schemes, helping public governments in fostering social welfare without

New Zealandc

Australiab

Country The Netherlandsa

Description National rehabilitation program 150 adult prisoners with sentences of 3–12 months. There is no selection based on age, gender, or type of crime. Work-Wise Direct provides participants with an integral work/study program tailored to individual needs, alongside intensive, evidencebased counseling. Each organization in the Consortium has an extensive national network of employers and relevant supply chain partners with which to connect offenders NSW Corrective Services Up to 3900 adult parolees with a medium to high risk of reoffending, released to supervision in selected Sydney metropolitan areas, receive the On TRACC (Transition, Reintegration and Community Connection) intervention. It is an intensive support program that provides individualized support to parolees, particularly in the first 16 weeks of parole Genesis Reducing Youth Offending The objective is to reduce reoffending by under16-year-olds who have already offended. The bond will involve around 1000 youth through an assessment tool YLS/CMI followed by an intensive 20-week program with children and young persons referred by Police Youth Aid, concluding with a monitoring and mentoring program for a further 18 months

Table 2 Synthetic map of SIB projects tackling criminal justice

1. NZ Government 2. Oranga Tamariki

1. New South Wales Department of Corrective Services

Payor 1. Ministry of Security and Justice

Investor 1. ABN AMRO Social Impact Fund 2. Oranjefonds 3. The Start Foundation

1. Nonprofit service provider 1. NZ Super Fund subsidiary of Genesis Youth 2. Caleb No2 Trust 3. Hosanna Charitable Trust Trust 4. Mint Asset Management 5. Wilberforce Foundation

1. Arbias and Australian 1. National Australia Bank Community Support Organi- 2. ACSO sation (ACSO)

Service provider 1. Work-Wise Direct Consortium

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1. The One*Service

1. First Step House

1. Interface Children and Family Services

1. Ministry of Justice Peterborough prison 2. Big Lottery Fund Target population is all offenders leaving Peterborough prison after a sentence of 12 months or less. The objective is to work with 3 cohorts of 1000 offenders through a holistic service including support with housing, training and employment, parenting, substance abuse, and mental health problems

1. Salt Lake County

1. Ventura County 2. California Board of State and Community Corrections

Salt Lake County, UTe Over 225 homeless high-risk, high-need criminal offenders in Salt Lake County. Through the REACH program, participants will provide participants with tailored, evidence-based therapies, short-term housing support, and case management. These services will address criminogenic risks tied to recidivism, substance abuse, and mental health services Venture County, CAf 400 moderate- to high-risk adults on formal probation, not currently served by other funding sources. A customized program, Interface Reentry Services, will provide a suite of services focused on understanding and responding to each client’s individual needs for successful reentry. Clients will receive a combination of moral reconation therapy, trauma therapy, relationship-building classes, and employment support

The UKd

The USA

(continued)

1. Blue Shield of California Foundation 2. Nonprofit Finance Fund 3. Reinvestment Fund 4. The Whitney Museum of American Art

1. Barrow Cadbury Trust 2. Esmee Fairbairn Foundation 3. Friends Provident Foundation 4. The Henry Smith Charity 5. Johansson Family Foundation 6. Lankelly Chase Foundation 7. The Monument Trust 8. Panahpur Charitable Trust 9. Paul Hamlyn Foundation 10. Tudor Trust 11. Rockefeller Foundation 12. Sainsbury’s Charitable Trust 13. J Paul Getty Charitable Trust 1. Northern Trust 2. QBE Insurance Group Limited 3. Ally Bank 4. Reinvestment Fund 5. Sorenson Impact Foundation 6. Living Cities 7. James Lee Sorenson Family Foundation

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Country

Description Los Angeles, CA 300 homeless individuals who are in custody within the county jail and who have a mental health and/or substance-use disorder. The intervention model is permanent supportive housing (PSH) as people struggling with homelessness and mental illness often find themselves going in and out of the criminal justice and emergency healthcare systems Oklahoma 600 women at-risk of incarceration in Tulsa The Women in Recovery program work closely with the criminal justice system and various community partners to ensure program participants receive supervision, substance abuse and mental health treatment, education, workforce readiness training, and family reunification services New York The target population are young men ages 16–21 entering the NYC jail on Rikers Island with a length of stay of more than 4 days (estimated at 3000 per year) and at risk of reoffending. The Young Men’s Initiative, a citywide initiative in New York, developed the Adolescent Behavioral Learning Experience (ABLE) intervention. ABLE provides Moral Recognition Therapy (MRT), an evidence-based intervention that focuses on improving social skills, personal responsibility, and decision-making. It consists of cognitive behavioral therapy (CBT) and counseling, training, and educational services delivered to adolescents before release from Rikers Island.

Table 2 (continued)

1. The Osborne Association 1. Goldman Sachs 2. Friends of Island Academy 2. Bloomberg Philanthropies

1. The City of New York Department of Corrections

1. George Kaiser Family Foundation

1. Women in Recovery

1. State of Oklahoma

Investor 1. The Conrad N. Hilton Foundation 2. UnitedHealthcare

Service provider 1. Amity Foundation 2. The People Concern (formerly LAMP) 3. SSG-HOPICS (Project 180) Volunteers of America Los Angeles and Brilliant Corners

Payor 1. Los Angeles County 2. U.S. Department of Housing & Urban Development 3. California Board of State and Community Corrections

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1. Center for Employment Opportunities

1. Roca

1. La Familia

1. State of New York 2. US Department of Labor

1. The Commonwealth of Massachusetts

1. Alameda County

The project is funded by a mix of federal, state, county, and philanthropic dollars

1. Goldman Sachs 2. The Kresge Foundation 3. Living Cities 4. Laura and John Arnold Foundation 5. New Profit 6. The Boston Foundation

1. Individual investors through Bank of America Merrill Lynch private placement 2. The Rockefeller Foundation 3. The Robin Hood Foundation

b

https://nos.nl/nieuwsuur/artikel/2109648-bedrijfsleven-investeert-in-ex-gedetineerden?title=bedrijfsleven-investeert-in-ex-gedetineerden https://www.osii.nsw.gov.au/news/2016/07/12/new-social-impact-investment-to-reduce-parolee-reoffending-and-re-incarceration/ c https://www.orangatamariki.govt.nz/assets/Uploads/About-us/Research/Latest-research/Reducing-youth-offending-social-bond-pilot/Social-bonds-process-evalua tion_FINAL.pdf d https://www.gov.uk/government/publications/final-results-for-cohort-2-of-the-social-impact-bond-payment-by-results-pilot-at-hmp-peterborough e http://www.thirdsectorcap.org/salt-lake-county/ f http://socialfinance.org/focus-areas/criminal-justice/ventura-county-project-to-support-reentry/

a

New York Two cohorts of 1000 formerly incarcerated individuals at a high risk of returning to prison in New York City and Rochester, NY. The Center for Employment Opportunities (CEO) provides comprehensive employment services through training, transitional jobs, and job placement. Massachusetts Approximately 929 young men aged 17–24 in the probation system or exiting the Massachusetts Department of Youth Services and at risk of reoffending are supported by Roca. The organization helps young men to develop the skills necessary to reduce violence and create positive behavioral changes through intensive case management, educational, prevocational, and employment programming and work opportunities with community partners. Alameda County, CA The program serves 180 young adults, through a service provided 24/7, including access to substance-use disorder treatment, employment training, adult education, mental health services, intensive case management, and housing assistance, delivered as an integrated system of services led by a Relentless Life Coach that has their own lived experience.

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stressing public expenditure. The experience of impact finance targeting social justice mainly refer to the so-called Social Impact Bonds; nevertheless, only 12 out of the 60 impact bonds launched worldwide; according to Social Finance latest report, they address social justice and SDGs 16; furthermore, they all aim at fighting recidivism, while other components of social justice appear to be neglected. This may be due to different reasons, among which, the circumstance that recidivism is relatively easy to measure, with respect to other social goals. Moreover, compared to other experiences of social bonds targeting other areas of welfare, the recourse to a public–private partnership can be observed in just one out of the 12 SIBs analyzed. Future market practices should encourage experiments aimed at enlarging the spectrum of the potential areas of impact, while promoting the intervention of private investors. In order to facilitate this task, a development of more sophisticated impact measurement models is needed, as well as a fine-tuning of the legal and accounting environment in order to eliminate the several constraints that currently hinder the involvement of private investors.

References Ahmed M (2021) Innovative humanitarian financing. Palgrave Macmillan, London, London Inter-Agency and Expert Group on Sustainable Development Goal Indicators (2020) Second Report of the Interlinkages Workstream. https://unstats.un.org/unsd/statcom/51st-session/documents/ BG-Item3a-Interlinkages-Workstream-E.pdf La Torre M, Trotta A, Chiappini H, Rizzello A (2019) Business models for sustainability: the case of study of social impact bonds. Sustainability 11(7):1–23 La Torre M, Zapata JDS, Semplici L (2021) Modelos Financieros para el Desarrollo Sostenible de la Administracion Publica. Revista Diecisiete 5:137–152 Migliorelli M (2021) What do we mean by sustainable finance? Assessing existing frameworks and policy risks. Sustainability 3(2):975 Miola A, Borchardt S, Neher F, Buscaglia D (2019) Interlinkages and policy coherence for the sustainable development goals implementation: an operational method to identify trade-offs and co-benefits in a systemic way. Publications Office of the European Union, Luxembourg Sen A (1987) On ethics & economics. Blackwell Publishing, New York Social Impact Investment Taskforce (2014) Impact investment: the invisible heart of markets Spiess-Knafl W, Scheck B (2017) Impact investing. Palgrave Macmillan, London Tirole J (2017) Economics for the common good. Princeton University Press, Princeton/Oxford United Nations (UN) (2006) Social justice in an open world. The role of the United Nations. United Nations Publication, New York United Nations (UN) (2015) Transforming our world: the 2030 agenda for sustainable development. United Nations publication, New York United Nations (UN) (2020) Second report of the interlinkages workstream, background document prepared for the 51th United Nations Statistical Commission session. United Nations publication, New York

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Links Australian SIB. https://www.osii.nsw.gov.au/news/2016/07/12/new-social-impact-investment-toreduce-parolee-reoffending-and-re-incarceration/ Global Steering Group for Impact Investment (GSG). https://gsgii.org/ Netherland SIB. https://nos.nl/nieuwsuur/artikel/2109648-bedrijfsleven-investeert-in-exgedetineerden?title=bedrijfsleven-investeert-in-ex-gedetineerden New Zealand SIB. https://www.orangatamariki.govt.nz/assets/Uploads/About-us/Research/Latestresearch/Reducing-youth-offending-social-bond-pilot/Social-bonds-process-evaluation_ FINAL.pdf OECD Social Impact Investment Initiative. https://www.oecd.org/dac/financing-sustainabledevelopment/development-finance-topics/social-impact-investment-initiative.htm Salt Lake SIB. http://www.thirdsectorcap.org/salt-lake-county/ Social Finance. https://www.socialfinance.org.uk/ Social Impact Bond Database. https://sibdatabase.socialfinance.org.uk/ Social Impact Investment. http://socialimpactinvestment.org/ Sustainable Development Goals (SDGs). https://sdgs.un.org/ UK SIB. https://www.gov.uk/government/publications/final-results-for-cohort-2-of-the-socialimpact-bond-payment-by-results-pilot-at-hmp-peterborough Ventura County SIB. http://socialfinance.org/focus-areas/criminal-justice/ventura-county-projectto-support-reentry/ Mario La Torre is full professor of “Banking and Finance” and “Sustainable Finance and Impact Banking” at the University of Rome “La Sapienza” (Italy). His main research areas are banking, sustainable finance, and financial innovation. He is the editor of the series “Palgrave Studies in Impact Finance.” He is responsible of the Center for Positive Finance, promoter of the University Alliance for Positive Finance. He is author of several international publications in the field of banking, sustainable finance, and microfinance. Mavie Cardi is Associate Professor in Banking and Finance at the Università Delgi Studi Link (Italy). Her main research deals with banking regulation, risk management, financial markets and intermediaries, sustainable finance, and ESG ratings. She is author of Cassa Depositi e Prestitie Bancoposta. Identità gluridiche in evoluzione (Cacucci Editore, 2012); Ricapitalizzazioni e garanzie nelle crisi bancarie. Profili istituzionali e gestionale del caso italiano (Giapichelli, 2017). Jenny Daniela Salazar Zapata is doctoral candidate in “Banking and Finance,” at the Department of Management—Sapienza University of Rome (Italy). Her main research areas are sustainable finance and impact finance. She is author of few publications in the field of sustainable finance and public expenditure, multidimensional impact measurement, sustainable finance products, and business models. Alessia Palma is doctoral candidate in “Banking and Finance” at the Department of Management—Sapienza University of Rome (Italy). Her principal research areas are related to sustainable finance and impact finance, with focus on social investments and social impact measurement.

The Impact of Financial Institutions on Sustainable Value Creation in Companies’ Business Models Magdalena Ziolo, Iwona Bak, and Anna Spoz

1 Introduction The risk of nonfinancial factors (environmental, social, and governance [ESG]) is one of the critical challenges faced by countries and market entities. ESG risk is the leading risk in terms of its impact and strength of influence on market entities (Global Risks Report 2022). Recently, the scale of phenomena determined by the occurrence of this type of risk has been increasing. Climate change and related extreme weather events, pandemic risk, or the so-called risk of transition determine measures to adapt to new living and business conditions. For example, climate migration and the energy transformation determine business development in the renewable energy sector while limiting the activity of industries using traditional fuel sources, such as mining. Therefore, the ESG risk determines the necessity to undertake adaptation measures and revise business strategies and business models, including the methods of creating sustainable value in enterprises. Adaptation activities have several challenges, including specific costs and benefits. Depending on the type of business and sector, the costs and consequences of the impact of ESG risk may vary, ranging from the company’s bankruptcy and cessation of its activity to opportunities for dynamic development and growth. The transformation of business models is necessary, and companies wanting to operate in the market have to adapt, which results, among others, from the M. Ziolo (✉) Faculty of Economics, University of Szczecin, Szczecin, Poland e-mail: [email protected] I. Bak West Pomerian University of Technology Szczecin, Szczecin, Poland e-mail: [email protected] A. Spoz John Paul II Catholic University of Lublin, Lublin, Poland © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_2

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regulations. For example, the Taxonomy (EU Taxonomy for Sustainable Activities 2022) adopted by the European Union in connection with the European Green Deal strategy requires sustainable adaptation (the European Green Deal). In most enterprises’ cases, adjustment measures’ costs require external financing. Hence, the crucial role, in this case, is the role of financial institutions as capital donors. However, the financial institutions are also subject to adjustment processes and modify their business models toward sustainability. Therefore, they look for entities that have carried out or carried out such activities for cooperation and respect for sustainable business practices. The chapter aims to discuss the role of financial institutions in building companies’ sustainable value. The chapter is organized as follows: the introduction is Sect. 1; in Sects. 2 and 3, the theoretical aspects related to financial institutions’ business models and companies’ business models are presented. Section 4 presents the methodological approach, data collection procedure, and description of the methods. Section 5 discusses the research results, and Sect. 6 is the conclusion.

2 The Link Between Financial Institutions’ Business Models and Companies’ Business Models in the Process of Sustainable Value Creation The financial sector plays a key role in stimulating socio-economic changes; therefore, the inclusion of financial institutions in the process of implementing the concept of sustainable development may be of great importance for the possibility of achieving the Sustainable Development Goals, including the transition to a low-emission and then zero-emission economy and achieving climate neutrality. The key importance of the financial sector in this process results from its role in providing information on investment directions and capital allocation, mobilizing capital to implement sustainable projects (Bielenberg et al. 2016; TaghizadehHesary and Yoshino 2020), and ensuring the efficiency of capital allocation, i.a., by influencing the possibility and cost of obtaining debt on the implementation of investment projects and its cost (Eliwa et al. 2021; Raimo et al. 2021) (Fig. 1). Depending on the banking system model (Anglo-Saxon and German-Japanese model), the role of individual financial institutions varies. Sustainable business models create value for a wide range of stakeholders, including customers, suppliers, employees, financiers, communities, and managers (Freeman et al. 2010). Yip and Bocken (2018) proposed sustainable business model archetypes for sustainability banking industry, which are (1) maximizing material and energy efficiency, (2) digitalization of processes, (3) encourage sufficiency, (4) adopting a stewardship role, (5) inclusive value creation, (6) repurposing for society/environment, (7) resilience in loan granting, and (8) sustainable financial products. Nosratabadi et al. (2020) indicate three directions of banks’ activities in pursuit of sustainable development. The first one is based on incorporating the

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Fig. 1 The role of financial institutions and the concept of sustainable development. Source: Whitney A., Grbusic T., Meisel J., Cid A.B., Sims D., Bodnar P., State of Green Banks 2020, Rocky Mountain Institute, 2020, https://www.nrdc.org/sites/default/files/state-green-banks-2020report.pdf

assumptions of the concept of corporate social responsibility into the business model. Banks, as institutions of public trust, should take into account environmental, social, and ethical aspects in their activities. Environmental and social factors have been included in the sustainable business models and strategies of financial institutions (Abor et al. 2019; Nepomuceno et al. 2020). According to Mendez and Houghton (2020), sustainable bank is a bank that incorporates a system of social, environmental, and governance responsibilities as well as ethical behavior policy in the banking business concept. The literature provides results of numerous studies confirming the positive relationship between the bank’s CSR activity and financial results (Maqbool and Zameer 2018; Wu et al. 2017). The second direction of action focuses on reducing the negative environmental impact of banks’ activities by, for example, reducing energy consumption, increasing use of renewable energy sources, or completely switching to such sources, digitization of processes, or waste management (Weber 2012; Jayabal and Soudarya 2017). The adoption of sustainable practices by banks

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Corporate and investment banking

Asset management

Project finance Partial credit guarantees Securitization Green, social, sustainable, and/or positive impact bonds Indices Private equity and venture capital Carbon finance and emissions trading Weather derivatives Debt-for-nature swaps

Green fiscal funds Funds (e.g., carbon funds, clean energy targeted fund) Impact investing funds

Insurance

Environmental damage insurance. Bank guarantees environmental risks

Consultancy

SME environmental plan

Fig. 2 Examples of sustainable banking products. Source: Carè, R. (2018). Sustainable Banking. Issues and challenges. Cham: Palgrave Pivot

also contributes to the reduction of costs (Wu and Shen 2013). Striving for sustainable development, banks expand their existing offers with sustainable products and services (Fig. 2). Expanding the offer with products and services compliant with the sustainability concept may provide opportunities for banks for improved reputation and brand image (Bowers 2010; Kumar and Christodoulopoulou 2014). Other benefits are customer attraction, new market opportunities, increased market participation and penetration, competitive advantage, and innovator advantage (Carè 2018). Banks’ decisions in this regard are, on the one hand, dictated by the expectations of customers (individual and corporate) who are more and more aware of and sensitive to environmental and social issues (Mishra and Sharma 2014), and on the other hand, they are one of the main ways of influencing business decisions of economic entities. The product offer of banks affects the access of enterprises to debt financing and its cost and thus also the nature, scope, and pace of implementation of projects (especially investments) by enterprises. An example of a financial banking instrument is a green credit. Lemmon and Roberts (2010) showed that a green credit policy can limit bank lending to highly polluting enterprises, reducing the scale of financing for such enterprises and increased its cost (Li et al. 2022). To ensure access to financing, enterprises are interested in investments that fit into the concept of sustainable development. This is confirmed by the research by Yang and Fang (2010), who showed that the green credit policy may result in increased interest in investments in environmental protection by enterprises whose activities have a negative impact on the environment, e.g. investment in renewable energy (Zhang et al. 2019). Hong et al. (2021) pointed out that the impact of green loans on the implementation of green technology innovations depends on the size of the enterprise. In the case of state-owned large

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companies, the impact is large, while in the case of small, private companies, the impact of green loans on innovation in the field of green technologies has not been demonstrated. This situation may result from the fact that small enterprises mostly finance their investments from their own resources, while large enterprises use banking services. The impact of the green credit policy on the activities of enterprises is greater in the case of entities operating in countries with the GermanJapanese banking system than in countries with the Anglo-Saxon system. Another example of a financial instrument is green bond. For issuers, it is an additional source of obtaining financing, which facilitates obtaining funds for the implementation of sustainable projects (reducing the risk related to the availability of capital) and reduces the cost of capital. For investors, green bonds are additional investment options with lower risk and higher rates of return (Maltais and Nykvist 2020). The ways of functioning of financial institutions and enterprises and their sustainable value creation are also influenced by regulations in the field of sustainable financing. Potential channels of the impact of sustainable finance regulations on enterprises and financial institutions are presented in Fig. 3. Financial institutions are actively searching their role in supporting enterprises in the field of circular economy. This is due to the fact that financial institutions are aware that this economy is still developing and stimulating it by technological innovations can increase resource productivity, which is extremely important nowadays. Banks also notice that enterprises implementing the concept of sustainable development generally achieve better financial results and have a better credit rating (ING 2015). Equity investors are also aware that companies not taking into account ESG factors expose themselves to higher linear risk (market, operational, business, and legal) (Goovaerts and Verbeek 2018). The impact of sustainable banking practices on the activities of enterprises is determined, among others, by the enterprises’ awareness of the existence of sustainable financial instruments and banking services, their availability, and ease of use (Dhamija and Sahni 2018). Iqbal and Molyneux (2016) emphasized that increasing the level of customer satisfaction would increase the pace of growth in the use of green banking financial instruments. Therefore, it is extremely important that banks monitor the changing needs and expectations of customers and constantly analyze what features of green banking determine their acceptance by customers and affect their satisfaction of using green financial instruments (Herath and Herath 2019).

3 Companies’ Motives and Attitudes Toward Cooperation with Financial Institutions The transformation of enterprises toward sustainable business models is determined by the growing awareness of the importance of environmental and social factors among stakeholders, increasing customer demand for sustainable products and the requirements for companies in the entire sustainable supply chain. Other factors are

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Financial institutions Public incentives (special investment fund, grants and consulting)

Involvement of capital donors as investors (e.g., co-financing of renewable energy projects) Involvement of banks as executive partners in the distribution of EU funds

Enterprises Technical support and EU grants (e.g., project development support) Facilitating the financing of projects aimed at SDG

Channels of impact of regulations on sustainable finance on enterprises and financial institutions

Financial institutions Financial regulations (inclusion of sustainability in financial services; taking into account climate risks in prudential regulation)

Changing the way investment products are offered Impact on the structure of investment fund portfolios Impact on the structure of assets owned by banks and insurance companies

Enterprises Impact on management and strategy (e.g. investing in low-carbon technologies to obtain financing) Impact on the possibility/cost of raising capital (e.g. easier obtaining of financing thanks to business activities consistent with the sustainable development goals)

Financial institutions

Standardization (Taxonomy, certificates, low-carbon indicators, standardization and dissemination of assessments of ESG risks made by rating agencies)

Impact on risk assessment and optimization of investment and credit decisions Reduction of the asymmetry of non-financial information (in particular regarding ESG)

Enterprises Diversification of investors (gaining interest of stable long-term investors) Impact on the profitability of issuing shares and corporate bonds, as well as on obtaining financing. Potential increase in the availability of capital for SMEs meeting the taxonomy criteria Impact on management and strategy (considering ESG factors in the decision-making process) Impact on company image (image improvement of companies meeting the requirements of Taxonomy)

Financial institutions Corporate governance and strategic management (developing a sustainable development strategy)

Making more aware investment and credit decisions Obligation to develop a sustainable development strategy for financial institutions, the same as for capital recipients

Enterprises Developing new business models supporting technological development and improving efficiency Impact on obtaining financing (e.g., easier capital obtaining by companies with solid, based on reliable calculations, long-term strategy)

Financial institutions Disclosure (obligatory disclosure of climate related risks and opportunities)

Impact on more aware credit, insurance, and investment decisions Obligation of trainings and organization of internal processes in a way that allows to effective use information disclosed by other entities, as well as appropriate preparation of own disclosures

Enterprises Impact on obtaining financing and cost of insurance Impact on image, management and strategy of company (e.g., greater attention to ESG factors because of disclosure obligation)

Fig. 3 Potential channels of impact of regulations on sustainable finance on enterprises and financial institutions. Source: own elaboration based on: Perspektywy rozwoju zrównoważonego finansowania—implikacje dla sektora przedsiębiorstw finansowych i niefinansowych w Polsce (Prospects for the development of sustainable finance—implications for the financial and nonfinancial enterprise sector in Polan), Deloitte, Warsaw 2019

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legal regulations concerning the rules of conducting business activity, disclosures, and applied standards (International Training Center of the International Labor Organization 2016). Due to the increasing dependence of corporate value creation on sustainable practices, financial management is gaining importance as it plays a key role in initiating such practices (AlShamsi and Nobanee 2020). In the process of company finance management, an extremely important issue is the selection of financing sources (capital structure) and optimization of the cost of capital. The studies by Xu et al. (2020) show that enterprises aiming at sustainable development in the long term try to reduce the costs of debt financing. Environmental investment is a way to reduce financing costs. There are many research in the literature which results confirm the positive relationship between the impact of taking ESG factors into account and the company’s financial results (Ahmad et al. 2021; Zhao et al. 2018). Looking for answers to the question about the factors determining the selection of banking institutions, Yip and Bocken (2018) distinguished eight archetypes of a sustainable business model and then tested the sensitivity of customers to these archetypes. According to the results, customers are more likely to adopt the archetype of “substitute with digital processes,” which is the archetype that refers to the use of digital channels to reduce environmental impact. The second most-chosen archetype was “adopt a stewardship role,” emphasizing the importance of active interaction with all stakeholders. Third was the archetype of “encouraging sufficiency,” that is, the archetype indicating solutions that reduce the need for banking services. Mary (2015) drew attention to the importance of knowing sustainable banking offer by consumers. In this context, the disclosure of nonfinancial information, which is mandatory for selected entities, becomes significant. Customer loyalty becomes a key factor in gaining a competitive advantage and market share; therefore, the literature on the subject includes research aimed at identifying factors influencing loyalty to a bank. The study by van Esterik-Plasmeijer and van Raaij (2017) shows that one of the determinants is brand loyalty and the bank’s image (Makanyeza and Chikazhe 2017). Including ESG factors in the company’s strategy contributes to strengthening the company’s image as a socially responsible. Research show that clients prefer banks adopting more ethical or sustainable approach, taking into account ESG factors in the decision-making process and including ESG risks in the risk management model (Nosratabadi et al. 2020).

4 Research Material and Method Statistical data for the survey were taken from surveys on business models carried out among 120 enterprises located in Poland in Zachodniopomorskie and Lubuskie voivodships. Due to the purpose of the article, the following variables and their categories were adopted for the study:

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1. 2. 3. 4. 5.

6. 7. 8.

9. 10. 11.

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Manufacturing sector: S_M1 (yes) or S_M2 (no). The service sector: S_S1 (yes) or S_M2 (no). Commercial sector: S_C1 (yes) or S_M2 (no). Enterprise size: micro (B1), small (B2), medium (B3), and large (B4). Reasons for cooperation with the bank: ethical bank (M1), environmentally friendly bank (M2), socially engaged bank (M3), a bank offering cheap products and services (M4), and others (M5). Is the bank important for the company’s business: yes (R1) or no (R2). Whether the financial institution has an impact on the business model of enterprises: yes (BM1), or no (BM2). Whether, in exchange for a “cheaper” loan, the company would make changes in its business so that the business would be more socially responsible: yes, if it would benefit the company and the company would have the means to make such changes (CH1); no, the company cannot afford such changes (CH2); no, the company would look for another financing option (CH3); the company is not interested in a socially responsible business (CH4). Whether the cooperation with the financial institution has reduced the environmental risk in the enterprise: yes (ER1) or no (ER2). Whether cooperation with a financial institution has reduced social risk in the enterprise: yes (SR1) or no (SR2). Whether the cooperation with the financial institution has reduced other risks in the enterprise: yes (OR1) or no (OR2).

Further issues relate to the opinion of the respondents on the benefits of a company resulting from cooperation with a financial institution: 12. The business risk reduction, the bank monitors the company’s risk and reacts: low (O1_1), average (O1_2), and high (O1_3). 13. The transfer of knowledge and good practices, the bank advises on solutions that are beneficial to the company, thereby influencing the way the company is organized and managed: low (O2_1), average (O2_2), and high (O2_3). 14. An impact on investment efficiency, the bank analyses and evaluates the company’s investments and influences the terms of their implementation and the cost of financing: low (O3_1), average (O3_2), and high (O3_3). 15. An increase in the company’s credibility for cooperators: low (O4_1), average (O4_2), and high (O4_3). 16. An impact on environmentally friendly business solutions through accessibility to innovation financing for companies: low (O5_1), average (O5_2), and high (O5_3). 17. An impact on company sustainability and growth by reducing the financing of “dirty” businesses and financing “clean” companies: low (O6_1), average (O6_2), and high (O6_3). 18. Other benefits: low (O7_1), average (O7_2), and high (O7_3). Multidimensional correspondence analysis was used to detect the relationship between the categories of variables adopted for the study. The choice of this research

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tool was subordinate to the purpose of the work, and on the other hand, it resulted from the nature of the variables, which were measured on a nominal scale. With this method, it is possible to analyze the co-occurrence of companies (of different sizes, operating in three sectors) and categories of characteristics related to the determination of the reasons of companies for sustainable adaptation and the creation of sustainable business models with a particular focus on the impulses coming from the financial market. Correspondence analysis is an exploratory technique for examining contingency tables. It aims to transform the points representing the rows and columns of this table into a space with a smaller dimension in which it is easier for the researcher to observe certain regularities. This analysis aims to graphically present the relationship between the categories of studied variables, which leads to inference about the relationships between these categories. The algorithm for using multidimensional correspondence analysis consists of the following stages (Lebart et al. 1984; Greenacre 1984, 1993, 1994; Goodman 1986; Stanimir 2005; Bąk 2009; Batóg and Batóg 2016; Zioło et al. 2020): 1. The determination of the Burt matrix, which consists of several blocks. On the main diagonal, there are diagonal matrices containing the occurrence counts of feature categories. The contingency tables for each pair of features are placed off the diagonal. 2. The determination of the dimension of the real space of co-occurrence of the categories of variables K based on the formula: K=

Q q=1

Jq - 1 ,

ð1Þ

where Jq is the number of feature categories q (q = 1, 2, . . ., Q) and Q is the number of variables. 3. The verification to what extent the eigenvalues of lower dimension spaces explain total inertia with the use of the Greenacre criterion according to which, the major inertia are considered important for the study if they are greater than 1/Q. 4. The implementation of the modification of eigenvalues according to Greenacre’s suggestions in order to increase the quality of mapping in n-dimensional space in the following way: ~λk =

Q Q-1

2

.

λB,k -

1 Q

2

,

ð2Þ

where Q is the number of analyzed variables, λB, k is the kth eigenvalue of matrix B (k = 1, 2, . . ., K ), λB,k = γ B,k , and γ B, k is the kth singular value of matrix B.

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5. The graphic presentation of the results of correspondence analysis in the ndimensional space, including the modification of eigenvalues. The new coordinate values are equal: ~ ~ = F * . Γ - 1 . Λ, F

ð3Þ

where F is the matrix of new coordinate values for variable categories, F* is the matrix of original coordinate values for variable categories, Γ -1 is the inverse diagonal matrix of singular values, and Λ is the diagonal matrix of modified eigenvalues. 6. The use of cluster analysis when the best form of presentation of co-occurrence of variables is a space of dimension greater than three. The categories of all analyzed variables should then be defined as objects, while the variables are the values of the projection coordinates of each category. The article will use the Ward method, which is one of the agglomeration clustering methods. It is used in empirical research in relation to classifying objects and features. In this method, the distance between groups is defined as the module of the difference between the sums of squares of the distance of points from the centers of the groups to which these points belong.

5 Results Correspondence analysis was carried out based on a 50 × 50 Burt matrix (the number of response categories assigned to selected questions of the questionnaire). For the 18 variables studied, the dimension of the true co-occurrence space of question responses is 32. Next, it was checked to what extent the eigenvalues of the smaller dimensions explain the total inertia (λ = 1.7778). For this purpose, the Greenacre 1 = 0, 0556 criterion was used, according to which major inertia greater than Q1 = 18 are considered significant for the study. Table 1 shows that these are inertias for K with values up to 12. For these dimensions, the values of the τk measure were analyzed, which determines the share of the inertia of the selected dimension (λk) in the total inertia (λ). An eigenvalue chart was also drawn (Fig. 4), and it was decided that the space of presentation of co-occurrence of categories of variables should be four-dimensional based on the “elbow” criterion. The degree of explanation of inertia in this space is 32.25%, and after modifying, the eigenvalues according to Greenacre’s proposal is 51.12% (Table 1). The Ward method with Euclidean distance was used to determine the relationship between the categories of variables in four-dimensional space. The optimal number of clusters was determined based on the first clear increase in the agglomeration distance for the subsequent bonding steps. In Fig. 5, showing the merging of categories into classes, a horizontal line marks the stage at which the merging of classes was discontinued. On the basis of this criterion, the dendrogram was trimmed

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Table 1 Singular values and eigenvalues together with the degree of explanation of the total inertia in the original and modified versions K 1 2 3 4 5 6 7 8 9 10 11 12 13

Singular values γ k 0.4816 0.3587 0.3458 0.3051 0.3026 0.2881 0.2816 0.2766 0.2632 0.2518 0.2489 0.2428 0.2355

Eigenvalues λk 0.2320 0.1286 0.1195 0.0931 0.0916 0.0830 0.0793 0.0765 0.0693 0.0634 0.0620 0.0590 0.0555

λk/λ 13.0485 7.2364 6.7244 5.2363 5.1503 4.6693 4.4601 4.3031 3.8964 3.5663 3.4861 3.3168 3.1201

τk 13.0485 20.2850 27.0093 32.2456 37.3959 42.0652 46.5253 50.8284 54.7248 58.2912 61.7772 65.0940 68.2141

~λk 0.2035 0.1030 0.0944 0.0698 0.0684 0.0606 0.0573 0.0548 0.0483 0.0432 0.0419 0.0393 ~λk = 0:9209

~λk =~λ 0.2210 0.1119 0.1025 0.0758 0.0743 0.0658 0.0622 0.0595 0.0525 0.0469 0.0455 0.0427

~τk 0.2210 0.3329 0.4354 0.5112 0.5855 0.6513 0.7135 0.7730 0.8255 0.8724 0.9179 0.9606

0.25 0.2 0.15

"elbow"

0.1 0.05 0 1

2

3

4

5

6

7

8

9

10

11

12

Fig. 4 Eigenvalue: Elbow criterion

at the binding height of 1.52, obtaining five homogeneous clusters. When analyzing their composition, the following conclusions can be drawn: Class one (O5_1, O6_1, O2_1, O4_1, O3_1, O1_1, CH2) concerns companies of different sizes and operating in different sectors. They believe companies cannot afford to change even in exchange for “a cheaper loan.” The benefits to companies of cooperating with a financial institution are low, especially for the reduction of business risk, the transfer of knowledge and good practices, the impact on investment efficiency, the increase of credibility of the company for cooperators, the impact on environmentally friendly business solutions through the availability of financing innovations for companies, and impact on sustainable development and

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L i n k ag e d i s t an ce

2,5 2,0 1,5 1,0

0,0

O5 _ 1 O6 _ 1 O2 _ 1 O4 _ 1 O3 _ 1 O1 _ 1 CH2 O5 _ 3 O6 _ 3 O3 _ 3 O2 _ 3 O4 _ 3 O1 _ 3 B4 O7 _ 2 M1 B1 O7 _ 3 CH1 R1 O7 _ 1 B3 S_ C 1 BM2 R2 SR2 M4 ER2 B2 O3_2 OR2 S_C2 S_S1 S_M2 O6_2 O4_2 O2_2 O1_2 O5_2 SR1 CH4 M5 M3 M2 ER1 OR1 BM1 CH3 S_S2 S_M1

0,5

Fig. 5 The diagram of a hierarchical classification of variable categories performed with the use of the Ward method. Source: own elaboration

growth of the company through a reduction of financing of “dirty” business and financing “clean” companies. Class two (O5_3, O6_3, O3_3, O2_3, O4_3, O1_3, B4) includes large companies that consider the benefits of cooperation with a financial institution to be high, specifically: the reduction of business risk, the transfer of knowledge and good practices, the impact on investment efficiency, the increase of the company’s credibility for cooperators, the increase of the company’s credibility for cooperators, the impact on environmentally friendly business solutions through the availability of financing innovations for companies, and the impact on sustainable development and the growth of the company through the reduction of financing “dirty” business and financing “clean” companies. Class three (O7_2, M1, B1) includes microenterprises engaged in production, which claim that the enterprise benefits of cooperation with a financial institution on knowledge transfer and good practices are average. Class four (O7_3, CH1, R1, O7_1, B3, S_C1, BM2, R2, SR2, M4, ER2, B2, O3_2, OR2, S_C2, S_S1, S_M2) includes small- and medium-sized enterprises, operating in the manufacturing and often commercial sectors. They do not have a clear opinion on whether the bank is important for the company’s operations. They believe that cooperation with a financial institution has not reduced any risks in the enterprise and that the financial institution has no influence on the enterprise’s business model. The reason for their cooperation with the bank is the fact that it offers low-cost products and services. According to the surveyed companies, the impact of cooperation with a financial institution on the effectiveness of the company’s investment is average. On the other hand, their opinion on reducing business risk thanks to this cooperation is extreme; some enterprises believe it is low,

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and some define it as high. In exchange for a “cheaper” loan, the company would make changes in its business so that this business would be more socially responsible if it would benefit the company, and the company would have the means to make such changes. Class five (O6_2, O4_2, O2_2, O1_2, O5_2, SR1, CH4, M5, M3, M2, ER1, OR1, BM1, CH3, S_S2, S_M1) consists mainly of companies from the manufacturing sector. Their reasons for cooperation with the bank are an environmentally friendly bank and a socially engaged bank. The respondents believe that the financial institution influences the business model of enterprises. However, in exchange for a “cheaper” loan, the company would not make changes in its business so that this business is more socially responsible because it is not interested in such a business and would therefore look for another financing option. In addition, they believe that cooperation with a financial institution would reduce environmental, social, and other risks to the company. In their opinion, the company’s benefits of cooperating with a financial institution are average, mainly concerning: the reduction of business risks, the transfer of knowledge and good practices, the increase of the company’s credibility for cooperators, the influence on environmentally friendly business solutions through the availability of financing innovations for companies, and the influence on sustainable development and growth of the company through the reduction of financing of “dirty” business and financing “clean” companies.

6 Conclusion In the context of the risk of nonfinancial factors, all market entities undertake adjustments toward sustainability. It finds expression in sustainable business models through which sustainable value is created. Actions transforming business models toward sustainability are conditioned, among other things, by a series of mandatory or optional regulations. The leader of solutions in this area remains the European Union, which has adopted several solutions aimed at, among other things, ensuring climate neutrality by 2050 (including Fit for 55, Taxonomy). Both financial institutions and enterprises have made an effort to change the existing business models and ensure sustainable business models. A question arises about how and whether the cooperation of enterprises with financial institutions affects the motivations of entrepreneurs to create sustainable value and sustainable business models. Financial institutions include ESG risk in their credit assessment and internal ratings. Hence, ESG risk is an essential factor affecting banks’ cost of servicing and raising capital and customer segmentation. The chapter examines the role of financial institutions in creating sustainable value and business models for enterprises. In particular, the analysis of correspondence was used to study 120 Polish enterprises and diagnose their motives and attitudes toward cooperation with financial institutions and the perception of the benefits of collaboration with financial institutions in the context of ensuring sustainability. In particular, it was examined whether cooperation with a financial institution in the case of sustainable business impacts the

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level of risk, the cost of acquiring capital, transfer of knowledge and good practices, and increase in credibility among cooperators. As a research result, five typological groups of enterprises were obtained. The companies represent the SME (Small and Medium Enterprise) sector and large enterprises operating in various industries, from production to services. Particular enterprises differed regarding the motives of cooperation with a financial institution. Based on the conducted research, it can be concluded that the size of the company and the industry in which it operates impact the assessment and benefits that a given company records from cooperation with a financial institution in the context of sustainability. The most significant influence of financial institutions on sustainable value and the sustainable business model was noted in the case of companies from the manufacturing sector and large companies, the lowest in the case of microenterprises. Such results are justified; the exposure of large companies to the ESG risk means that the probability and effects of this impact in the case of these companies are disproportionately more significant than for microcompanies. In addition, the scope of cooperation with financial institutions is broader in large companies compared to microcompanies. Similarly, the complexity of financial products and the demand for financial innovations, including sustainability, are more significant in large companies than in microentrepreneurs. Also, manufacturing is more exposed to ESG risk than the service sector, hence the greater need to finance adaptation activities by financial institutions in this company group. Acknowledgments Research results presented in this paper are an integral element of research project implemented by the National Science Centre Poland under the grant OPUS16 no 2018/31/B/ HS4/00570.

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Magdalena Ziolo is Associate Professor, Prof. at the University of Szczecin (Faculty of Economics, Finance and Management, Institute of Economics and Finance, Department of Sustainable Finance and Capital Markets, Poland). Her research and teaching scope focus on finance, banking, and sustainability. She has received scholarships from the Dekaban-Liddle Foundation (University of Glasgow, Scotland) and Impakt Asia Erasmus + (Ulan Bator, Mongolia). She is a Member of Polish Accreditation Commission, Member of the Financial Sciences Committee of PAS (the Polish Academy of Sciences), Member of the Advisory Scientific Committee of the Financial Ombudsman, Expert of the National Centre for Research and Development, Expert of the National Science Centre and the National Agency for Academic Exchange, Expert of the Accreditation Agency of Curacao. She was a member of State Quality Council, Kosovo Accreditation Agency and visiting professor at the University of Prishtina (Kosovo). She is the author and editor of numerous books, mostly about financing sustainable development. She has co-authored (with Beata Zofia Filipiak and Blanka Tundys) Sustainability in Bank and Corporate Business Models: The Link Between ESG Risk Assessment and Corporate Sustainability (Palgrave Macmillan, 2021). Iwona Bak is an Associate Professor, PhD at West Pomeranian University of Technology Szczecin (Faculty of Economics, Department of Mathematical Applications in Economy, Poland). She is an expert in the field of quantitative methods, specializing in analyses regarding the use of quantitative methods in economic research, with particular emphasis on international comparisons, in the area of sustainable development, competitiveness of the national economy and regional development, with experience in working with advanced statistical packages: STATISTICA, R program, etc. Author and co-author of scientific articles published in scientific journals from the JCR list, also having practical experience in the implementation of projects carried out on behalf of public institutions. Anna Spoz Assistant Professor, PhD at the John Paul II Catholic University of Lublin (Institute of Economics and Finance, Department of Finance and Accountancy, Poland). Her research and teaching scope focus on finance, particularly corporate finance, accounting and tax and sustainable finance. Author and co-author of numerous publications on finance, accounting, reporting, and management. She is reviewer of international publications. She combines teaching and scholarly activities with work in the business.

Sustainable Finance: Banks, Sustainability, and Corporate Financial Performance Rosella Carè and Olaf Weber

1 Introduction The role of finance in for being a supporter or a barrier for sustainable development is discussed increasingly. Since the 2008 financial crisis, it became clear to most people that the influence of the financial industry on our life and the planet is significant. Economic development, housing prices, pension, the job market, food prices, and more are increasingly dependent on the financial industry. Therefore, some speak about the financialization of our world (Dore 2008; van Loon and Aalbers 2017; Clapp and Isakson 2018). However, there are also positive impacts of finance on sustainable development. The value of green bonds issued, for instance, is more than $400 billion, and the amount of environmental, social, and governance (ESG)-related and socially responsible investing is estimated as more than $40 trillion globally. Also, the financial industry can play a significant role in financing the UN Sustainable Development Goals (SDG) (Weber 2019, 2021). Furthermore, sustainability issues can be a risk or an opportunity for banks as well. Physical impacts of climate change, such as extreme weather events, can harm banks’ assets and create business interruptions. Extreme weather can also harm different industries that are borrowers or investees. For instance, clients in agriculture, forestry, tourism, and other industries can be significantly affected by climate change depending on the climate risk exposure (Monasterolo et al. 2017; Bardoscia et al. 2021). In addition, the transition to a low-carbon economy can create risks for banks and investors that are exposed to high emitting industries through the

R. Carè · O. Weber (✉) University of Waterloo, Waterloo, ON, Canada e-mail: [email protected]; [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_3

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risk of stranded assets (Weber and Oyegunle 2019; Weber et al. 2020). This chapter provides an overview of the history of sustainable banking and finance, provides a description of the main sustainability-related banking policies and products, and explores the connection between corporate sustainability and financial performance.

2 The History of Sustainable Banking This section describes the history and the development of sustainable banking over time. However, it can also be interpreted as different views and development stages of sustainable banking since we find past approaches still applied currently. We will cover then development between the first “modern” banks founded in the sixteenth century in Italy to modern approaches of sustainable and climate finance supervision and regulations.

2.1

Early Developments Including Credit Unions and Cooperatives

In Italy the sixteenth-century banks were founded to guarantee financial flows between those who owned financial capital and those who were in need of finances mainly to start and to run a business. These businesses were traditional businesses such as bakeries or carpenter shops that were needed in the community. However, these trades did not have the financial capital they needed. Hence, banks stepped in as an intermediate to assess the risk of these commercial borrowers. One of the ethical principles these banks used was the prevention of usury, which was quite common in these times (Milano 2011). These banks also included some basic assessment criteria, such as the work ethics of the borrower, their responsibility and efficiency, and their risk-taking (Weber and Feltmate 2016). Many of these banks, for instance, Monte di Pieta had strong ties with the Catholic church. As a special variety of these banks credit unions and cooperatives were founded. They addressed the new middle class as well as entrepreneurs and farmers. Credit unions were founded in cities, while cooperative banks were mainly founded in the countryside. A difference to the early banks founded in Italy was that their clients were also their members and owners. This guaranteed a democratic governance structure and financial benefits for the members. Credit unions are still strong in many countries, such as Canada (Desjardins) and Germany. Also, agricultural cooperatives such as Raiffeisen are still very popular in rural regions in Europe.

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Ethical Banks and Impact Investment

Ethical banks arose in the 1960s. Reasons were the political changes in the 1960s and the beginning of the discussions around business and the environment caused, among others, by Rachel Carson’s book Silent Spring (Carson 2002). The banks implemented ethical approaches at the core of their business and wanted to contribute to environmental and societal change. One example was financing and divesting from the South African Apartheid regime. Ethical banks and investors argued that the financial industry should not contribute to financing such an unjust political system (Hunt et al. 2017). The Global Alliance for Banking on Values, an association of 72 ethical banks ion 2022, put it as “We put finance at the service of people and the planet” (www.gabv.org). The number and assets under management of ethical banks are still increasing. However, these banks are still a niche in the financial industry. Impact investment follows a similar goal as ethical banking. However, their main players are institutional investors and foundations. Their goal is to invest in ventures to generate positive social and/or environmental impact and a financial return (Lehner et al. 2022). Their main association is the Global Impact Investment Network (www.thegiin.org) with about 360 members in 2022.

2.3

Assessment of Sustainability Risks in Lending

During the 1980s changes in environmental regulations in Europe and North America implemented stronger responsibility for the originators of environmental damage. Furthermore, sites that have been used for industrial purposes needed to be assessed with regard to contaminations before they could be sold. These changes in regulations also increased the risk of commercial loans. Consequently, lenders might suffer under a decrease in the value of sites used as collateral if a commercial loans defaults. Furthermore, commercial lenders might suffer under environmental regulations because they need to implement technologies that are more environmentally friendly or were not able to find markets for their products if they did not meet the environmental expectations of clients. These risks led to development of environmental and later sustainability risk assessment tools that analyzed potential financial risks because of environmental or sustainability risks (Weber et al. 2008, 2010).

2.4

(Socially) Responsible Investment

In addition to addressing risks in lending, investors used non-financial criteria to select green or sustainable investments as well as investments with low environmental and sustainability risks. Also, green or sustainable indexes, such as the Dow Jones Sustainability Indexes, have been founded. These investments and indexes

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used non-financial environmental, social, and governance (ESG) criteria to select investments (Weber and Feltmate 2016). According to Bloomberg, in 2021 responsible investment had a market share of about $41 trillion (Kishan 2022). Hence, it increased its share since its inception in the mid-1990s significantly. Also, ESG-related investments changed from being a niche activity by specialized investors and asset managers to a general financial risk and opportunity assessment tool applied by conventional institutional investors, such as pensions funds, and big asset managers like Black Rock.

2.5

Banks and Climate Risks, Including Fossil Fuel Financing and Divestment

A newer development that is driven by risks and opportunities of climate change is climate finance. On the one hand, it includes financial products and services that actively address climate change mitigation and adaptation. On the other hand, it addresses divestment from and engagement with investees with high greenhouse gas (GHG) emissions. Historically, the first wave of climate finance came with the Kyoto Protocol signed in 1997. The so-called Clean Development Mechanism (CDM) allowed countries to fund projects that reduce GHGs in other countries in order to achieve carbon credits (Pfaff et al. 2000). These projects, however, usually needed financing in the form of investments and loans. Hence, also private lenders and investors engaged in these projects. However, in 2012 the CDM mechanism has been outphased. Since then, there is no UN-based official climate finance mechanism existent. However, climate finance is still a big part of green finance, including climate bonds. Divestment became a major topic with regard to divestment from the South African Apartheid Regime (Hunt et al. 2017). It started in the late 1970 and ended with the political change in the early 1990a. The purpose was to destabilize the South African economy to weaken by depriving the economy of financial capital. Later, divestment has been used to address climate change. Since 2012, the divestment movement tries to limit the fossil fuel sector from financial capital. The strategy is to deprive the industry of the financial means to exploit fossil fuel resources and to create political awareness. The final goal is to transition the industry to a low-carbon energy industry. Motivations of divestments can be financially and ethically (Dordi et al. 2022; Zhang and Weber 2022). Some investors try to reduce financial risks of stranded assets through divestment. Others divest because of ethical reasons because they do not want to invest in investments that increase climate change.

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Sustainability-Related Banking Supervision and Regulation

The integration of ESG criteria into banking supervision and regulations started with the Task Force on Climate-Related Financial Disclosure (TCFD) of the Financial Stability Board in 2015 (Financial Stability Board 2015). Though the proposal started as voluntary initiative, a number of central banks and other financial supervisors are considering the make the guideline (Task Force on Climate-related Financial Disclosures 2018) mandatory. In addition, the US SEC published a draft of rules to enhance and standardized climate-related disclosures for investors. SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors (SEC 2022) based on the TCFD guidelines.

3 Sustainable Banking, Green Credit Policies, and Environmental Credit Risk Management Practices: An Overview During the last years, academics, policymakers, and regulators increasingly recognized climate change’s implications for the financial sector by wondering how climate change affects financial stability and how banks can better prepare for climate-related risks. The current landscape of initiatives and regulatory interventions is characterized by a great heterogeneity in scope and areas of applications. Under this perspective, sustainable banking practices and green credit guidelines have been developed in several countries but with different approaches. The 2030 Agenda for Sustainable Development indicate environmental challenges, including climate change, as a major concern for the stability of the global economy (Alexander 2019). The entire banking industry is moving toward a growing awareness of the importance of sustainable practices. Many central bank initiatives emerged worldwide to integrate sustainability issues into the financial sector (McDaniels and Robins 2018; Dikau et al. 2019). As summarized in Table 1, in many countries, regulatory authorities have launched national policies, guidelines, principles, or roadmaps on sustainable banking and climate risks. As highlighted by the Sustainable Banking Network (SBN 2018, 5), three general approaches to sustainable finance emerge among countries: (a) Regulatory approach, led by banking or financial regulators, such as in Bangladesh, China, Peru, and Vietnam (b) Industry-led voluntary approach, led by banking associations such as in Colombia, Turkey, and South Africa (c) Collaborative approach combining industry-led initiatives and policy leadership: starting with voluntary principles led by the banking association and then

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Table 1 Sustainable banking and/or green policies Country Action South America Brazil Voluntary Protocolo Verde

Colombia

Peru

Industry-specific and thematic green banking regulations Resolution on Social and Environmental Responsibility for Financial Institutions Green Protocol General Guidelines for the Implementation of Environmental and Social Risk Analysis Regulation for E and S Risk Management

Sustainable Banking Protocola Sustainable Finance Protocol Guide for Environmental and Social Risk Management North America Mexico Sustainability Protocolb Asia China Green Credit Guidelines Ecuador Panama Paraguay

Vietnam

Mongolia Turkey Nepal

Pakistan Indonesia

Bangladesh

Year

Proposing authority

2008

Five Brazilian state-owned banks in 2008 and then by commercial banks in 2009 Central Bank of Brazil

2008– 2014 2014

Central Bank of Brazil

2012 2016

Colombian Banking Association Colombian Banking Association

2015

2016 2018 2018

Superintendency of Banking, Insurance and Private Pension Fund Administration of Peru Banking Association of Ecuador Panama Banking Association Paraguay’s Central Bank

2015

Mexican Banking Association

2012

China Banking Regulatory Commission China Banking Regulatory Commission China’s Central Bank State Bank of Vietnam

Green Credit Key Performance Indicators Green Bond Guidelines Directive on promoting Green Credit and E and S Risk Management Mongolia Sustainable Finance Principles and Sector Guidelines Sustainability Guidelinesc Guideline on Environmental and Social Risk Management (ESRM) for Banks and Financial Institutions Green Banking Guidelines Sustainable Finance Roadmap

2015

Sustainable Finance Umbrella Policy Technical Guidelines for Banks on the Implementation of Sustainable Finance in Indonesia

2018

2015 2015/ 2016 2014

Mongolian Bankers Association

2014 2018

Bank Association of Turkey Central Bank of Nepal

2017 2014

State Bank of Pakistan Indonesia Financial Services Authority Indonesia Financial Services Authority Indonesia Financial Services Authority

2018

2011

Bangladesh Bank (continued)

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Table 1 (continued) Country

Hong Kong Sri Lanka Georgia Africa South Africa Morocco

Kenya Nigeria Ghana

Action Environmental Risk Management Guidelines Policy Guidelines for Green Banking Mandatory Environmental Risk Management Guidelines Guidelines on ESRM for Banks and FIs (upgrade) Measures on Sustainable Banking and Green Finance Sustainable Finance Roadmap Sustainable Finance Roadmap

Year

Proposing authority

2011

Bangladesh Bank

2012

Bangladesh Bank

2017

Bangladesh Bank

2019

Hong Kong Monetary Authority

2019 2019

Central Bank of Sri Lanka National Bank of Georgia

Principles for Managing Environmental and Social Risks Roadmap for Aligning the Financial Sector with Sustainable Development Sustainable Finance Principles Sustainable Banking Principles Sustainable Banking Principles

2014 2016

South Africa Banking Association Central Bank of Morocco

2015 2012 2019

Kenya Bankers Association Central Bank of Nigeria Bank of Ghana

a

The protocol was signed with ten signatory banks representing more than 80% of the market share and with the participation and support of IFC/SBN b 19 FIs have signed the protocol c In 2014, the Banks Association of Turkey (BAT) issued voluntary Sustainability Guidelines for the banking sector. The Guidelines were prepared by a BAT working group on the Role of the Financial Sector in Sustainable Growth, with the participation of 18 banks. The basic principles that have been formulated under these guidelines refer to (1) Survey and Management of Environmental and Social Risks Arising From Banking Activities, (2) Manage the Impact of Banks’ Internal Activities, (3) Human Rights and Employee Rights, (4) Stakeholder Engagement and Communication, (5) Corporate Governance, (6) Capacity Improvement, and (7) Monitoring and Reporting. For further details, please see Banks Association of Turkey (BAT). (2014). Sustainability Guidelines for the banking sector. Available at https://www.tbb.org.tr/en/Content/Upload/Dokuman/137/Sustain ability-Guidelines-for-The-Banking-Sector.pdf; Sustainable Banking Network (SBN). (2018). Global progress report. February 2018. Available at http://documents.worldbank.org/curated/en/ 563041520939488095/pdf/WP-SBN-GlobalProgressReport-PUBLIC.pdf

reinforced through regulatory actions led by regulators such as Brazil and Nigeria At the same time, the necessity to address climate change has led central banks and supervisors to establish networks and joint initiatives to coordinate their responses. In this sense, among the most important initiatives, the Network for Greening the Financial System (NGFS)—a global network of central banks and supervisory authorities focused on integrating climate change into regulatory frameworks—aims to facilitate the work of central banks and supervisors on climate

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and environmental risk and scale up green finance by help strengthening the global response required to meet the goals of the Paris Agreement by enhancing the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments (Després and Bourgey 2020). Other examples are represented by the Sustainable Banking Network (SBN)—a voluntary community of financial sector regulatory agencies and banking associations from emerging markets committed to advancing sustainable finance in line with international good practice—and the Global Alliance for Banking on Values (GABV)—a network of banks, banking cooperatives and credit unions, microfinance institutions, and community development banks—that emphasize the positive role that the financial industry could play in fostering sustainable development.

4 Examples of Sustainable Financial Products and Services As stated before, the banking industry can contribute to sustainable development both by collaborating toward clients’ sustainable transitions and by transforming its own offer of products (Working Group Finance 2016). The issues related to sustainable development also have an important strategic and commercial dimension for banks (Carè 2018a, b). In this perspective, Yip and Bocken (2018, 150) define sustainable banking as the delivery of “financial products and services, which are developed to meet the needs of people and safeguard the environment while generating profit.” So, in addition to risk management tools, traditional commercial banks have started to develop new products to encourage improved environmental performance on the customers side and provide environmental businesses with easier access to capital (Labatt and White 2011; Bouma et al. 2017; Carè 2018a, b). The shift in banks’ strategies toward sustainability is already underway. An increasing number of financial institutions have started to direct their resources and lending power with an eye on sustainability. In this sense, two main strategies can be observed: developing niche products or developing a fully integrated portfolio of products and services. This section provides an overview of some currently available sustainable financial products and services.

4.1

Green Mortgages

Considering that mortgages constitute the main component of the assets of banks, in recent years, the banking sector has been starting to unlock the benefits and opportunities offered by energy efficiency to strengthen the quality of loan portfolios. An Energy Efficient Mortgage (EEM) aims to incentivize borrowers to improve their buildings’ energy efficiency and/or acquire highly energy-efficient properties. The incentives for borrowers could be favorable mortgage financing conditions and/or an increased loan amount at origination to financing the energy efficiency improvement

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of the property (EEMI 2018). In general, green mortgages offer retail customers lower interest rates than those on the market for clients that purchase new energyefficient homes and/or invest in retrofits, energy-efficient appliances, or green power (Noh 2019). Table 1 provides some examples of green mortgages currently offered by banks. Home mortgage Bank Barclays Danske Bank Unicredit Intesa Sanpaolo

Product name Green Home Mortgages Danske Carbon Neutral Mortgage Green Mortgage (loan) Green Mortgage (loan)

Region/ market The UK The UK

Eligibility Eligible with an energy efficiency rating of 81 or above, or an energy efficiency bands A or B Eligible with an energy efficiency rating of A–C

Italy

Eligible with an energy efficiency rating > B

Italy

Eligible with an energy efficiency rating > B

Source: Authors’ elaboration

4.2

Credit Cards

Green credit and debit cards are becoming popular, serving a sustainable development purpose. Linked to environmental activities, “green” credit cards typically offer donations equal to approximately half a percentage point on every purchase made by the card owner (UNEP 2007). Several models exist, like the WWF credit cards in partnership with the Bank of America, the Bank of Montreal (Canada), and Citibank in India (FAO 2015). Another example is the BarclayBreathe Card, which includes discounts and low borrowing rates to users when buying “green” products and services. A percentage of card profits are devoted to emissions reduction projects (UNEP 2007).

4.3

Green Securitization

Green securitization has significantly expanded in the last years as structured finance investors increasingly consider sustainability in their investment decisions. The term refers to the transformation of illiquid green assets into tradable securities (Petit and Schlosser 2020). Green securitization can also refer to any asset-backed security with proceeds raised to finance loans for green infrastructure (CBI 2017). The green securitization market includes various transaction types that vary broadly across regions and collateral types (Fitch Ratings 2021). More in detail, the underlying collateral pool typically comprises financial assets such as (i) mortgages on certified

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buildings, (ii) mortgage financing for energy efficiency upgrades, (iii) loans/leases on electric vehicles and hybrids, (iv) loans/leases on solar and wind assets, (v) loans/ leases on equipment, (vi) loans for energy efficiency improvements, and (vii) loans to green (pure-play) SMEs (CBI 2017). The OECD estimates that the annual issuance of green ABS could reach between USD 280 and 380 billion by 2035 (CBI 2017). Regarding the US market, the government agencies Fannie Mae and Freddie Mac purchase a significant volume of mortgage pools from originating lenders and refinance them in the MBS market, while the Dutch mortgage originator Obvion N.V., fully owned by Cooperatieve Rabobank U.A., has sponsored several green RMBS (residential mortgage-backed securities) issuances under its Green STORM program (Fitch Ratings 2021).

4.4

Green Bonds

Green bonds are financial instruments that tap the capital markets to support investments addressing environmental challenges (IBRD 2018). The growth of the green bond market has sparked interest from decision-makers and banks in many countries. Issuance in 2022 (Q1) reached USD83.5bn, with Deutsche Bank among the top 5 issuers in 2022 (Q1) (CBI 2022). Financial institutions are the most active players in the green bond market (Fatica et al. 2021). Different regulators worldwide elaborated their specific criteria for binding financing to green bonds (Schumacher 2020), like the Green Bond Principles that have been developed and endorsed by financial actors through the International Capital Markets Association (ICMA) (Torvanger et al. 2021). The Green Bond Principles identify four types of Green Bonds: (1) Standard Green Use of Proceeds Bond; (2) Green Revenue Bond; (3) Green Project Bond; and (4) Green Securitized Bond. Differently, according to the classification of the Climate Bond Initiative—an international organization working to mobilize global capital for climate action—there are at least seven different types of green bonds: (1) Use of Proceeds Bonds, (2) Use of Proceeds Revenue Bond or ABS, (3) Project Bond, (4) Securitization (ABS) Bond, (5) Covered Bond, (6) Loan, and (7) Other debt instruments. In the framework of its company’s Environmental Business Initiative, Bank of America has issued five green bonds raising a total of $6.35 billion for renewable energy projects since 2013 (Bank of America 2022).

4.5

Sustainability Bonds

Sustainability bonds are bonds where the proceeds will be exclusively applied to finance or refinance a combination of both green and social projects (ICMA 2021). According to the latest market data, the USA, France, and the UK are the three biggest issuing countries in the sustainability bond market in 2021 (Environmental

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Finance 2022). In 2020 and 2021, Bank of America launched two Equality Progress Sustainability Bonds in which proceeds from the bond offering are designed to advance racial and gender equality, economic opportunity, and environmental sustainability (Bank of America 2021). The list of banks that have already launched sustainability bonds comprises the following: Agricultural Development Bank of China (China), Australia and New Zealand Banking Group Limited (ANZ) (Australia), AXA (France), Banco BPM (Italy), Banco Santander SA (Spain), Bank of America (USA), Bank of China (China), Bank of Montreal (BMO) (Canada), CaixaBank (Spain), Goldman Sachs Group (USA), National Bank of Canada (Canada), Royal Bank of Canada (Canada), Toronto-Dominion Bank Group (Canada), and Intesa Sanpaolo (Italy) (ICMA 2022).

4.6

Sustainability-Linked Bonds

Unlike sustainability bonds, Sustainability-Linked Bonds (SLBs) do not bind the collected money to be used for specific investments only, but the funds raised can be used for all sorts of expenses (Berrada et al. 2022). The International Capital Market Association (ICMA) defines SLBs as “[. . .] any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined Sustainability/ ESG objectives.” So, instead of prescribing what the proceeds can be used for, SLBs follow the logic of linking coupon payments to the achievement of specific sustainability targets: indeed, coupon penalty payments are due if the issuing firm does not reach a specific key performance indicator (KPI) at a predetermined date (Berrada et al. 2022, 1). More in details, SLBs can be used to finance investments in projects that are not considered green under the condition that issuers improve their overall sustainability performance (Vulturius et al. 2022). In September 2020, the European Central Bank (ECB) decided that bonds with coupons linked to sustainability performance targets will become eligible as collateral for Eurosystem credit operations and Eurosystem outright purchases for monetary policy purposes. The identified performance target refers to one or more of the environmental objectives set out in the EU Taxonomy Regulation and/or to one or more of the United Nations SDGs relating to climate change or environmental degradation (ECB 2020).

4.7

Catastrophe Bonds

Catastrophe (CAT) bonds are natural disaster risk-linked securities born to transfer natural disaster risk from an issuer (or insurance company) to bond market investors (Morana and Sbrana 2019). The marker for insurance-linked securities (ILS) emerged following the devastating damage of Hurricane Andrew, which hit Florida in 1992 (Scism and Das 2016). CAT bonds are a fully collateralized instrument that

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pays off on a defined catastrophic event (Cummins 2008) and can be considered the most well-known type of ILS to transfer catastrophe risk to capital markets. By purchasing a cat bond, investors take on the risk of the occurrence of a specified natural disaster in return for payment: if the event occurs, investors will lose part or all of the capital invested, and the issuer will use that money to cover the damage (Morana and Sbrana 2019, 274). The first CAT bond was issued in 1997, giving insurers access to broader financial markets and offering institutional investors the opportunity to obtain an attractive return on investment uncorrelated with the returns of other financial market instruments in exchange for assuming catastrophe insurance risks (Polacek 2018). In a cat bond contract, the primary insurer enters a reinsurance agreement with a special purpose vehicle (SPV) created ad hoc for the transaction (Polacek 2018). The SPV issues cat bonds to capital market investors. The proceeds from the sales of the bonds are used to compensate the primary insurer should a “loss event” occur, deposited in a trust company, and invested in securities with a high credit rating. The associated credit risk is close to zero because cat bonds are fully collateralized (ECB 2005; Cummins 2008; Edesess 2014). During the life of the cat bond, the SPV pays coupons at a floating rate (usually LIBOR plus a risk premium), and if the disaster occurs, the coupon payment is suspended, and, depending on the severity of the damage, the investor may lose the principal amount (Carayannopoulos and Perez 2015; Demers-Bélanger and Lai 2020). If no triggering event occurs during this period, investors receive their principal back at maturity and benefit from a higher coupon than what is offered by similarly rated corporate bonds (ECB 2005, 95). According to the Artemis database of cat bonds and other insurance-linked securities, recent examples of CAT bonds mention risks ranging from windstorms in France to wildfires in California, or tropical cyclones in a bond sponsored by the Philippine government via the World Bank (Artemis 2022). Among the biggest corporate and investment banks, Goldman Sachs is the leader in structuring and underwriting CAT bonds, with over $14 billion of weather-related catastrophe bonds structured since 2006 (Goldman Sachs 2019).

5 The Connection Between ESG Performance and Financial Performance in the Banking Industry Research on the relationship between financial performance and corporate environmental performance (CEP) has been the focus of several literature review and of a plethora of empirical studies (Dixon-Fowler et al. 2013; Nizam et al. 2019). The majority of the existing studies support a generally positive relationship exists between corporate environmental performance (CEP) and corporate financial performance (CFP) (e.g., Albertini 2013; Dixon-Fowler et al. 2013). Some of them provide a focus on the relationship between positive environmental performance and innovation and operational efficiency (Porter and van der Linde 1995; Starik and Marcus 2000) by explaining how being eco-efficient and reducing pollution can

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reduce costs for the firm (Porter and van der Linde 1995). At the same time, a strong environmental performance might be viewed as a source of reputational benefits (Hart 1995; Turban and Greening 1997; Russo and Fouts 1997). Although academic research has focused for many years on the relationship between financial performance and environmental and social performance, the increased availability of corporate ESG information also captivates academic interests in expanding ESG research (Lee and Suh 2022). ESG performance is an increasingly important topic for the banking industry and academia (Galletta et al. 2022). The attention on ESG issues in the banking industry is driven by the increasing pressure from shareholders and stakeholders (Houston and Shan 2022; La Torre et al. 2021). Following the stakeholder approach, a company aims to create value for stakeholders (Ullmann 1985; Clarkson 1995; Freeman 2010; Signori et al. 2021). As stated by Azmi et al. (2021), the stakeholder view of ESG explains that the firm has an ethical obligation to maximize the value of all shareholders. Under this perspective, ESG activities should be a source of opportunity, competitive advantage, and corporate innovation rather than a cost or constraint (Porter and Kramer 2006). Moreover, in the light of instrumental stakeholder theory (Donaldson and Preston 1995), a responsible bank must meet the needs of diverse stakeholder groups, including environmental, employee, and societal groups (Dixon-Fowler et al. 2013). ESG-associated opportunities and risks are becoming more and more relevant for banking supervisors. Generally, banks and regulators are also increasingly concerned with ESG risks and opportunities connected to lending activities. Climate change and the associated need to transition toward a more sustainable economy will lead to changes in the real economy that will in turn impact the financial sector through new risks and opportunities (EBA 2021).

6 ESG Risks: Open Issues and Future Challenges ESG risks can be considered as the main challenges banks are facing because of their scale, breadth, and complexity, as a whole, with potentially systemic consequences (EBA 2021). The environmental one is undoubtedly the most urgent among the three core dimensions of ESG risks. Banks are beginning to assess their overall exposure to climate risks across their investment and lending activities moving from the realization that climate risk is a financial risk (Rudebusch 2021). The faster acceleration of ESG risk management is being driven by a combination of regulatory and market drivers. Regulatory initiatives requiring banks to manage climate risks have gathered pace over the recent period, and several initiatives have been launched. In these veins, for example, the UK’s Prudential Regulation Authority was among the first to publish detailed expectations for governance, processes, and risk management, requiring banks to identify, measure, quantify, and monitor exposure to climate risk. Similarly, the European Banking Authority (EBA) is establishing regulatory and supervisory standards for ESG risks and has published a multiyear sustainable finance action plan (Eceiza et al. 2020). However, while banks recognize

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ESG risks (and especially environmental risks), previous research find that they encounter difficulties with regard to data availability, to pricing and hedging of environmental risks, and appropriate assessment within their risk management process and procedures (Basel Committee on Banking Supervision 2020; Krueger et al. 2020). In this veins, for example, it should be noted that the use of standard financial risk metrics like the value-at-risk, which are backward-looking and computed from historical time series, while climate risk cannot be assessed based on past events (Battiston et al. 2017; Battiston 2019; Roncoroni et al. 2021). During the last years, some ESG providers have started to provide ESG risk scores that can be considered as measures of the firms’ exposure to ESG-related risks. However, as stated by Ferriani and Natoli (2021), these new scores have substituted the old ones with a radical change in perspective: from indicators of sustainability virtue to measures of internal vulnerability. The quality of ESG data represents an important issue for banks, investors, and policymakers, and several works have already tried to understand how ESG data accurately capture a firm’s—and especially a bank’s— performance (Kotsantonis and Serafeim 2019; Chen et al. 2021; Gyönyörová et al. 2021; Jacobs and Levy 2022; Jonsdottir et al. 2022). Regarding the quality of ESG data, Berg et al. (2019) investigated the divergence of ESG ratings based on data from six prominent ESG rating agencies by documenting divergence arising from measurement (56%), scope (38%), and weight (6%). In this sense, for example, Kotsantonis and Serafeim (2019) suggest that data providers should include a list of material issues and a detailed description of their scoring methodology and clearly distinguish between real and imputed data.

7 Conclusions This chapter provides an overview of the historical development of the concept of sustainable finance from the origins to the current challenges and opportunities. The historical overview of sustainable banking leads to the following conclusions. First, traditionally sustainability has been a part of good banking since lending is mainly based on the sustainability of the borrower. If a borrower cannot create additional value from the loans and investments, they become a financial risk for the lender. Second, sustainable banking includes both risks and opportunities for the financial industry. It started with managing sustainability risks, such as environmental credit risks. Later sustainable banking also addressed the creation of positive impacts on sustainable development. Third, recently sustainability aspects are considered as core aspects of prudent financial decision-making by both the financial industry and financial supervisors. This step out of the niche is one of the major changes in sustainable finance. As discussed in the sections before, the concept of sustainable banking and finance is rapidly evolving. In particular, the debate about the role of financial regulations in addressing climate-related financial risks is rapidly changing the scenario. The UN Sustainable Development Goals (SDGs) place environmental

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sustainability issues and challenges as a matter of major importance for the economic and financial stability (Alexander 2014; Weber and Feltmate 2016). The increased frequency of severe weather events poses severe implications for asset prices, macroeconomic outcomes, credit risks, and insurance contracts’ cost and coverage (Central Bank of Ireland 2019). At the same time, transition to a carbon-free economy might increase the risks of economic dislocation and “stranded” assets (Campiglio et al. 2018). The growth of climate issues has encouraged research in many directions. The discussion around the role of the entire banking industry toward the climate change questions can be approached from three different perspectives: the first that reflects the role of banks in terms of capital provision, the second that reflects the need for banks to be “accountable” and “responsible” to their stakeholders, and the third that reflects concerns about the potential impact of climate change on banks and thus on financial stability. Regarding this latter perspective, academic literature reveals that climate change can increase the rate of default of corporate loans with effects on the banking system’s stability (Dafermos et al. 2018). In a recent work, Nieto (2019) emphasized the relevance of exploring prudential policy responses and statistical and reporting frameworks that could contribute to reducing negative externalities of climate risks. The issue has been recently addressed by central banks (e.g., BoE, ECB), financial supervisors, key international standard setters, and organizations (e.g., BIS, ESRB, EBA) that are focusing on two main directions: the development of scenario analysis and of new disclosure frameworks, reflective of how climaterelated financial risks are integrated into governance and risk management processes (BoE 2018). Traditionally banks have approached climate issues—and, consequently, climate risks—through the lens of corporate social pesponsibility (CSR), and, by extension, under a reputational perspective (Carè 2018a, b; Marqués Sevillano and Romo González 2018). However, in recent times, banks are increasingly approaching climate change as a core financial/strategic risk and an opportunity (TFCFD 2017; BoE 2018; Carè 2018a, b). Under the lens of the financial/strategic risks, the chapter highlighted how, in recent times, banks are growingly posing attention to the concept of ESG risks and ESG performance. The current state of research in this field is still a “work in progress,” and results about the relationship between ESG scores/performance and financial performance are in the spotlight. The fashionable world of ESG data offers a myriad of information not always clear in methodology and source. At several latitudes, regulators are trying to understand what kind of ESG data can be relevant for banks and especially what ESG-related risks can be relevant in terms of bank performance and potential effects on financial stability. Under the lens of the business opportunities, several sustainable banking products and services have been developed and are growingly used by banks not only to manage the risks they are exposed to—like in the case of securitization—but also to increase their reputation as banks that care about the environment and the society.

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Labatt S, White RR (2011) Carbon finance: the financial implications of Climate change. Wiley Lee MT, Suh I (2022) Understanding the effects of environment, social, and governance conduct on financial performance: arguments for a process and integrated modelling approach. Sustain Technol Entrep 1(1):100004. https://doi.org/10.1016/j.stae.2022.100004 Lehner OM, Nicholls A, Kapplmüller SB (2022) Arenas of contestation: a Senian social justice perspective on the nature of materiality in impact measurement. J Bus Ethics 179:971. https:// doi.org/10.1007/s10551-022-05158-2 Marqués Sevillano JM, Romo González L (2018) The risk of climate change in financial markets and institutions: international challenges, measures and initiatives. Financ Stab Rev 34:111–134 McDaniels J, Robins N (2018) Greening the rules of the game. How sustainability factors are being incorporated into financial policy and regulation. UNEP Inquiry into the Design of a Sustainable Financial System, Geneva. https://wedocs.unep.org/bitstream/handle/20.500.11822/25525/ Greening_sustainabilty.pdf Milano R (2011) Social banking: a brief history. In: Weber O, Remer S (eds) Social banks and the future of sustainable finance, vol 64. Routledge, New York, pp 15–47 Monasterolo I, Battiston S, Janetos AC, Zheng Z (2017) Vulnerable yet relevant: the two dimensions of climate-related financial disclosure. Clim Chang 145(3):495–507. https://doi.org/10. 1007/s10584-017-2095-9 Morana C, Sbrana G (2019) Climate change implications for the catastrophe bonds market: an empirical analysis. Econ Model 81:274–294. https://doi.org/10.1016/j.econmod.2019.04.020 Nieto MJ (2019) Banks, climate risk and financial stability. J Financ Regul Compliance 27(2): 243–262. https://doi.org/10.1108/JFRC-03-2018-0043 Nizam E, Ng A, Dewandaru G, Nagayev R, Nkoba MA (2019) The impact of social and environmental sustainability on financial performance: a global analysis of the banking sector. J Multinatl Finance Manag 49:35–53. https://doi.org/10.1016/j.mulfin.2019.01.002 Noh HJ (2019) Financial strategies to accelerate green growth. In: Sachs JD, Woo WT, Yoshino N, Taghizadeh-Hesary F (eds) Handbook of green Finance: energy security and sustainable development. Springer, pp 37–61 Petit CA, Schlosser P (2020) Rationale, potential and pitfalls of green securitization. Robert Schuman Centre for Advanced Studies Research Paper No. RSCAS, 35. https://doi.org/10. 2139/ssrn.3688362 Pfaff ASP, Kerr S, Hughes RF, Liu S, Sanchez-Azofeifa GA, Schimel D, Tosi J, Watson V (2000) The Kyoto protocol and payments for tropical forest: an interdisciplinary method for estimating carbon-offset supply and increasing the feasibility of a carbon market under the CDM. Ecol Econ 35(2):203–221. https://doi.org/10.1016/S0921-8009(00)00199-3 Polacek A (2018) Catastrophe bonds: a primer and retrospective. Chicago Fed Lett 405:1–7. https:// doi.org/10.21033/cfl-2018-405 Porter ME, Kramer MR (2006) The link between competitive advantage and corporate social responsibility. Harv Bus Rev 84(12):78–92 Porter M, Van der Linde C (1995) Toward a new conception of the environmental-competitiveness relationship. J Econ Perspect 9(4):97–118. https://doi.org/10.1257/jep.9.4.97 Roncoroni A, Battiston S, Escobar-Farfán LO, Martinez-Jaramillo S (2021) Climate risk and financial stability in the network of banks and investment funds. J Financ Stab 54:100870. https://doi.org/10.1016/j.jfs.2021.100870 Rudebusch GD (2021) Climate change is a source of financial risk. FRBSF Econ Lett 03:01–06 Russo MV, Fouts PA (1997) A resource-based perspective on corporate environmental performance and profitability. Acad Manag J 40:534–559. https://doi.org/10.5465/257052 Schumacher K (2020) Green bonds: the shape of green fixed-income investing to come. J Environ Invest 10(1):5–29 Scism L, Das A (2016) The insurance industry has been turned upside down by catastrophe bonds. Wall Street J. https://doi.org/10.21033/cfl-2018-405

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Signori S, San-Jose L, Retolaza JL, Rusconi G (2021) Stakeholder value creation: comparing ESG and value added in European companies. Sustainability 13(3):1392. https://doi.org/10.3390/ su13031392 Starik M, Marcus AA (2000) Introduction to the special research forum on the management of organizations in the natural environmental. Acad Manag J 43(4):539–546. https://doi.org/10. 5465/1556354 Sustainable Banking Network (SBN) (2018) Global progress report. http://documents.worldbank. org/curated/en/563041520939488095/pdf/WP-SBN-GlobaProgressReport-PUBLIC.pdf Task Force on Climate-related Financial Disclosures (2017) The use of scenario analysis in disclosure of climate-related risks and opportunities. https://assets.bbhub.io/company/sites/ 60/2021/03/FINAL-TCFD-Technical-Supplement-062917.pdf Task Force on Climate-related Financial Disclosures (2018) Task force on climate-related financial disclosures: status report. Basel, Switzerland. https://apo.org.au/node/240501 Torvanger A, Maltais A, Marginean I (2021) Green bonds in Sweden and Norway: what are the success factors? J Clean Prod 324:129177. https://doi.org/10.1016/j.jclepro.2021.129177 Turban D, Greening D (1997) Corporate social performance and organizational attractiveness to prospective employees. Acad Manag J 40(3):658–672. https://doi.org/10.5465/257057 Ullmann AA (1985) Data in search of a theory: a critical examination of the relationships among social performance, social disclosure, and economic performance of U.S. firms. Acad Manag Rev 10(3):540–557. https://doi.org/10.5465/amr.1985.4278989 UNEP Finance Initiative (2007) Green financial products and services – current trends and future opportunities in North America. https://www.unepfi.org/fileadmin/documents/ greenprods_01.pdf van Loon J, Aalbers MB (2017) How real estate became ‘just another asset class’: the financialization of the investment strategies of Dutch institutional investors. Eur Plan Stud 25(2):221–240. https://doi.org/10.1080/09654313.2016.1277693 Vulturius G, Maltais A, Forsbacka K (2022) Sustainability-linked bonds–their potential to promote issuers’ transition to net-zero emissions and future research directions. J Sustain Finance Invest 2022:1–12. https://doi.org/10.1080/20430795.2022.2040943 Weber O (2019) Sustainable Finance and the SDGs: the role of the banking sector. In: Dalby S, Horton S, Mahon R, Thomaz D (eds) Achieving the sustainable development goals. Routledge, Milton Park, UK, pp 226–239 Weber O (2021) The banking sector and the SDGs: interconnections and future directions. In: Lehner OM (ed) A research agenda for social Finance. Edward Elgar, Cheltenham, UK, pp 175–198 Weber O, Feltmate B (2016) Sustainable banking: managing the social and environmental impact of financial institutions. University of Toronto Press, Toronto, ON Weber O, Oyegunle A (2019) Climate scenarios for the Canadian lending and investment industry. Centre for International Governance Innovation, Waterloo, ON Weber O, Fenchel M, Scholz RW (2008) Empirical analysis of the integration of environmental risks into the credit risk management process of European banks. Bus Strateg Environ 17:149– 159. https://doi.org/10.1002/bse.507 Weber O, Scholz RW, Michalik G (2010) Incorporating sustainability criteria into credit risk management. Bus Strateg Environ 19(1):39–50. https://doi.org/10.1002/bse.636 Weber O, Dordi T, Oyegunle A (2020) Stranded assets and the transition to low-carbon economy. In: Migliorelli M, Dessertine P (eds) Sustainability and financial risks. Palgrave Macmillan, Cham, Switzerland, pp 63–92 Working Group Finance (2016) Money makes the world go round (and will it help to make the economy circular as well?). https://usfl-new.wp.hum.uu.nl/wp-content/uploads/sites/232/201 6/04/FinanCE-Digital.pdf Yip AW, Bocken NM (2018) Sustainable business model archetypes for the banking industry. J Clean Prod 174:150–169. https://doi.org/10.1016/j.jclepro.2017.10.190 Zhang Y, Weber O (2022) Investors’ moral and financial concerns - ethical and financial divestment in the fossil fuel industry. Sustainability 14(4):1952. https://doi.org/10.3390/su14041952

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Rosella Carè is Assistant Professor of Banking and Finance at the University of Cagliari (Italy) and Marie Curie Research Fellow at the University of Waterloo (Canada). She is the Principal Investigator of the research project “COPERNICUS—Social Finance for Social Enterprises: Theory and Practice to build a more inclusive society” funded by the European Commission under the Marie Skłodowska-Curie Global Fellowship. Her major research areas include social and sustainable finance, alternative finance, impact investing, sustainable banking, climate risks, and financial stability. Her most recent book is Sustainable Banking: Issues and Challenges (Palgrave Macmillan, 2018). Olaf Weber is a Professor at the School of Environment, Enterprise, and Development, University of Waterloo (Canada). In addition, he holds the position as the University of Waterloo's Research Chair in Sustainable Finance and is Senior Fellow of CIGI. His research and teaching interests address the connection between financial sector players, such as banks and sustainable development and the link between sustainability and financial performance of enterprises. His research focus is on the impacts of the financial industry on sustainable development, the role of voluntary and regulatory mechanisms for the financial sector to become more sustainable, social banking and impact investing, the materiality of sustainability risks and opportunities for investors and artificial intelligence as a tool to analyze environmental, social, and governance (ESG) performance. He was co-editor (with Sven Remer) of Social Banks and the Future of Sustainable Finance (Routledge, 2014). He has co-written (with Blair Feltmate) Sustainable Banking and Finance: Managing the Social and Environmental Impact of Financial Institutions (University of Toronto Press, 2016).

International Informal Capital Flows and Sustainable Finance: China’s Regulatory Approach David Chaikin

1 Introduction There is a rich academic discourse on informal international capital flows, originally conceived in terms of capital flight from developing countries but now viewed as illicit financial flows. The capital flight literature focused on unrecorded funds based on capital account statistics and the need to improve the attractiveness of developing countries to combat capital outflows (Cobham and Janský 2020). The mindset of academics, economists and policymakers has changed, with the widespread acceptance that capital flows are frequently illegitimate (i.e. illicit) and consequently should be regulated. The elimination of exchange control laws spearheaded the globalisation of finance, with illicit financial flows representing ‘globalization’s dark side’ (Kahler 2018). It was the 1996 World Bank anticorruption campaign, coupled with the adoption of the United Nations (UN) Convention Against Transnational Organised Crime in 2000, that contributed to illicit financial flows becoming a major item on the international development agenda (Forstater 2018). The illicit financial flow agenda has expanded beyond issues of transnational laundering of corrupt monies from developing countries; it now includes ‘some behaviours related to tax and trade practices’ (United Nations Office of Drugs and Crime [UNODC] and United Nations Conference on Trade and Development [UNCTAD] 2020), such as aggressive tax avoidance. Illicit financial flows (IFFs) are linked to nearly all varieties of international financial crime, including drug money laundering, transnational bribery and corruption, international fraud, cybercrimes and tax offences. Without IFFs, the perpetuators of these financial crimes would not be able to enjoy their illicit gains. Illicit financial flows have a ‘devastating effect on developing countries’, dwarfing official D. Chaikin (✉) University of Sydney, Sydney, NSW, Australia e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_4

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development assistance and investment from Organisation for Economic Co-operation and Development (OECD) countries (OECD 2015; Kar and Spaniers 2014). Their negative consequences include a loss of public resources, a widening of inequality of wealth and the undermining of social and political stability (Herkenrath 2014). Illicit financial flows also undermine the ‘fundamental social contract’ in developed countries through tax evasion by the wealthy elite (Zucman 2015). Several studies conclude that IFFs facilitate massive offshore tax evasion and tax avoidance by individuals and multinational corporations (Palan et al. 2010), which is of direct concern to all countries. This should mean that there is a potential mutuality of interest in combating IFFs. In 2015, the United Nations (UN) Member States agreed on a series of extremely ambitious goals—the 17 Sustainable Development Goals (SDGs)—to be achieved as part of the UN’s 2030 Agenda. Those goals included the end of poverty and hunger, reduction of inequality, access to good health and quality education, and the creation of a peaceful, just and inclusive society. Illicit financial flows, particularly those which are sourced from bribery, corruption and stolen monies, affect nearly all the SDGs (Rubio and Andvig 2019). The UNODC and the OECD (2016) described IFFs as a ‘“major disabler” of sustainable development’. The target of SDG 16.4 is that by 2030 jurisdictions should ‘significantly reduce illicit financial and arms flows’, ‘strengthen the recovery and return of stolen asset’ and ‘combat organized crime’. Curbing illicit financial flows has the potential to mobilise domestic resources for development and to finance the implementation of the SDGs (African Union Commission and UN Economic Commission for Africa 2015). There is some doubt whether this goal can be achieved without a dramatic change of national policy and international co-operation, given the modest record of actual recovery and return of illicit assets to victim countries. The World Bank has noted that only $5 billion in illicit assets was recovered over a 15-year period, yet each year $40 to $50 billion has been stolen from developing countries (Stephenson et al. 2011). The starting point for an analysis of IFFs is to formulate a common definition and approach. This is a work in progress. There is no satisfactory definition of the term ‘illicit financial flows’, with the definition being influenced by the perspectives and agenda of national jurisdictions, regulators and academic commentators. A proposed definition might focus on the motivation of the export, transfer, or import of capital or the impact of capital flows on the national welfare of a country. The notion of illegitimacy of informal capital flows is encapsulated by the term ‘illicit financial flows’, but there is ongoing disagreement about what is to be included in IFFs and how IFFs are to be measured. For example, to what extent should questionable tax avoidance practices be included in the definition of IFFs? (Forstater 2018). The definition of IFFs will influence how IFFs are calculated. Measurement is important because it provides objective evidence of the nature and size of the problem of IFFs and provides a base of comparison in determining whether there is progress in meeting the SDG16.4 target. In addition to discussing issues of definition and measurement of IFFs, this chapter will focus on China’s regulatory approach to IFFs. China is an interesting case study because it has experienced high levels of IFFs and massive corruption but has achieved major positive successes in

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sustainable development (Ang 2020; Nolan 2019; World Bank and the People’s Republic of China 2022). This chapter will provide a critique of how money laundering facilitates IFFs from China, estimated to amount to $1.39 trillion over the past decade. It will argue that China is different from other developing countries because of the significant capital inflows into China, which includes a process of ‘round-tripping’. It will assess how China’s foreign exchange regulations and antimoney laundering (AML) system are utilised to regulate IFFs.

2 Illicit Financial Flows 2.1

Definition of Illicit Financial Flows

In this part, I discuss various terminology—international informal capital flows, capital flight and illicit financial flows. What are the different meanings of the phrase ‘international informal capital flows’ and why is it important to understand its implications for regulatory policy? The broadest definition of international informal capital flows is the flow of money in and out of a country, which is not approved by national government policy, not subject to regulation, or is contrary to domestic law. International informal capital outflows from developing countries which are economically disadvantageous from a national perspective may be encapsulated by the term ‘capital flight’ (Lessard and Williamson 1987). International informal capital outflows include illegal capital flight and legal capital flight which causes a loss of national welfare. The purpose of including legal and illegal capital flight in a definition would be to evaluate the effectiveness of national regulatory policy to prevent or limit capital flight, irrespective of its legality (Kindleberger 1987). This definition of capital flight would cover the entire range of motivation of capital flight, such as capital seeking refuge from currency restrictions, depreciation of currency, expropriation of assets as well as capital flight motivated by political, religious or racial persecution. Another perspective is to restrict the term informal capital flows to ‘illicit capital flight’ defined as an ‘unauthorised transfer of capital in the form of foreign exchange, banknotes or securities from a country which forbids or restricts such transfer abroad by its residents’ (Chaikin 2005a). The cue for this definition is article VIII section 2b of the International Monetary Fund (IMF) Agreement which renders unenforceable any contract which violates an IMF-approved exchange control law. With the dismantling of exchange controls in developed countries in the 1980s and the expansion of international financial crime, illicit capital flight has been rebranded as ‘illicit financial flows’. The definition of illicit financial flows which has received widespread academic and official attention is the one popularised by Global Financial Integrity (2015). Illicit financial flows are defined as ‘illegal movements of money or capital from one country to another. . . (in circumstances where such flows) are illegally earned, transferred and/or utilised’. This definition captures money flows which violate a domestic law at any point of time (Kar and Spaniers 2015). Illicit financial flows

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would thus include tax evasion activity, such as sending money overseas without paying taxes, and complex money laundering schemes where multiple jurisdictions are used to conceal criminal proceeds (OECD 2015). This definition gives rise to the view that the principal driver of IFFs is the underground economy (Kar and Spaniers 2015). By linking IFFs to international money laundering, it is easier to argue that all countries, including the country where the illicit flows are exported and the country where the illicit flows are imported, have a responsibility to prevent and interdict such flows. One of the widest interpretations of IFFs is that of Campbell and Lord (2018) who argue that the term should not only include criminal and unlawful behaviour but also ‘ostensibly legal but harmful assets, acts and actors’. Under this interpretation, the proceeds of lawful but unethical tax avoidance schemes should be treated as IFFs. This view is consistent with UNODC and UNCTAD’s proposed conceptual framework for IFFs (2020). These intergovernmental organisations—which are the joint custodians of the indicator framework of SDG16.4 target—recommend a statistical definition of IFFs that includes illicitly generated flows (e.g. from crimes such as bribery or corruption or tax evasion); illicitly transferred flows (e.g. breach of exchange control laws); and illicitly used flows (e.g. financing of crime and terrorism). Thus, UNODC and UNCTAD (2020) suggest that IFFs would include ‘crossborder tax avoidance schemes, which erodes the tax base of a country where that income was generated’.

2.2

Measurement of Illicit Financial Flows

There is an extant and growing academic and official literature on measuring illicit financial flows. Illicit financial flows are by their very nature secretive and are subject to significant measurement problems. There are several methods to measure IFFs, such as measures which capture the ‘clandestine use of the international banking system to send money out of a country’, and trade misinvoicing which ‘generates illicit funds that are shifted abroad’ (Kar and Cartwright-Smith 2008). Other methods, which are not discussed here, include the ‘offshore capital and wealth model’—estimating undeclared offshore assets—which is used by economists, such as James Henry and Gabriel Zucman (Cobham and Janský 2020). The offshore model has produced few, if any, valuable insights in relation to countries, such as China, which is the main subject of this chapter. The Gross Excluding Reversals (GER) method measures trade misinvoicing as a proxy for illicit financial flows. The justification for focusing on GER is the claim that ‘the vast majority of illicit financial outflows’ (from developing countries)— approximately 77.8% are due to trade misinvoicing (Kar and Spaniers 2014). The Gross Excluding Reversals method compares a developing country’s reported exports and imports with an industrialised country’s reported imports and exports to that country (Cardamone and Kar 2014). The idea is that by comparing the statistics of two trading countries, say China and the United States, differences in

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the statistics reported to the Chinese and US Customs authorities respectively may be attributable to trade misinvoicing (Beja 2008). Global Financial Integrity (GFI), a highly influential US-based think tank, produces annual reports on IFFs from nearly 150 developing countries, using a methodology applying GER. Applying GER or what is sometimes described as ‘mirror trade statistics’, GFI has estimated that the losses for developing countries arising from IFFs was $7.8 trillion for the period 2004–2013 (Kar and Spaniers 2014). The GFI study found that China topped the illicit financial flows for every year except 2011, when the Russian Federation was the leading source of illicit capital exports. IFFs from China (in nominal US dollars) were $81.5 billion in 2004, rising to $258.6 billion in 2013, and with a cumulative outflow over the 10-year period of $1.39 trillion. GFC made the further claim that corrupt government officials, tax evaders and criminals based in China were the major users of trade misinvoicing to move illicit monies out of China (Kar and Spaniers 2014). In an earlier 2012 report, GFI claimed that China lost a much larger sum, i.e. $3.79 trillion in illicit financial flows, estimating that 86.2% of IFFs from China were attributable to misinvoicing of foreign trade transactions (Kar and Freitas 2012). Kessler and Borst (2013) disputed this statistic, arguing that GFI had ignored the role of Hong Kong (SAR) as a transhipment intermediary in China’s international trade. According to Kessler and Borst, the major factor influencing the discrepancy between the trade statistics of China and the United States is that China treats its exports to Hong Kong as just that, while the United States treats imports from Hong Kong originating from China, as imports from mainland China. The criticism by Kessler and Borst led GFI to revise its methodology in 2013 (Cobham and Janský 2020). The more recent GFI reports explicitly consider the transit trade to Hong Kong in estimating IFFs from China to the United States, by disaggregating the bilateral trade data between China and Hong Kong (Kar and Spaniers 2015). There are other limitations in using trade mirror statistics in that they ignore capital outflows which have a positive effect and capital inflows which are disguised as ‘round-tripping’ (Cobham and Janský 2020). Nor does the statistical analysis of trade misinvoicing include misinvoicing through services. Another limitation is that while reported import statistics will include transportation and insurance charges, reported export statistics will commonly not include such charges (Cheung et al. 2016). National policy interests may also result in a distortion of estimates of IFFs. There is an asymmetry of interests between the governmental authorities in importing countries which are concerned about the price, quantity and origin of goods because of the importance of applying the correct tariff, while exporting countries do not have the same incentive to vet the reported price and quantity of exported goods (Kessler and Borst 2013). A more fundamental objection is that mirror trade statistics are too simplistic as a proxy for IFFs and there are often more plausible explanations for mismatched values of exports and imports (Forstater 2018). Further, trade misinvoicing captures only part of the illicit financial flows, for example, it does not consider the bulk movement of cash or negotiable instruments which may have no recorded paper trail, or the usage of the underground

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banking system which is an alternative to the regulated banking system (Kar and Spaniers 2014). In the case of China, illicit financial flows from underground banking are likely to be more significant than trade misinvoicing as a mechanism for IFFs (Financial Action Task Force 2019). This may mean that the estimated IFFs from China are greater than those calculated by Global Financial Integrity. The complexity of transferring and recording value in calculating IFFs is an area which requires further study. Much could be learned from the experiences of customs and tax authorities. For instance, the misuse of international trade for tax reasons may involve additional layers of complexity. An example cited by one author is a popular tax evasion scam which netted RMB 1 trillion and involved selling goods between different parts of China via Hong Kong and then claiming VAT rebates where no such rebate was available (Chang 2012).

3 Theory and Practice of Money Laundering Involving China 3.1

International Money Laundering

Under the auspices of a group of experts, in 1990 the Financial Action Task Force (FATF) developed a theory on how money laundering was carried out. This theory was developed in the context of drug money laundering, which was the most significant law enforcement issue facing Western developed countries in the 1980s (Gilmore 2004). Subsequently the theory was applied to all crimes, including fraud, corruption and tax evasion. The theory has been endorsed by international organisations, law enforcement agencies and national governments, including China (Chaikin 2017). Under the theory money laundering will typically involve three stages: placement of funds, layering of funds and integration of funds (FATF and OECD’s Centre for Tax Policy Administration 2009). At the first or placement stage, money launderers introduce illicit monies, usually cash, into the financial system. The idea is that if illicit cash is turned into a bank deposit, there will be a lower risk of the cash being connected with the underlying/predicate crime, such as drug trafficking. In the second stage, denoted as the layering stage, the money launderer creates a series of transactions involving movements of monies which make it extremely difficult to connect the launderer and laundered funds with the original illicit source. The final or third stage of money laundering is denoted as the integration phase whereby illicit money forms part of the legitimate economy so that the launderers have achieved their goal of money laundering. The criminals will have a strong justification for owning or controlling what appears to be a legal or licit asset. In the following section, I will apply the theory of money laundering by focusing on offshore money laundering schemes involving China. Offshore money laundering schemes are part and parcel of the significant internationalisation of currency,

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capital and corporate securities markets. Since opening to the international community in 1978, the Chinese economy has become deeply integrated with the rest of the world, with China becoming the world’s largest exporter and its foreign trade representing 35% of its gross domestic product in 2020 (World Bank 2022). The massive developments in communications and information technology and the ease of international travel which has become available to Chinese businesses, tourists and students have meant that an increasing proportion of financial crime involving China is likely to be transnational, in conception, execution or realisation. Applying money laundering theory to China entails a consideration of China’s complex and evolving foreign exchange control regime. For example, at the placement stage, illicit money that is moved out of China is likely to breach China’s foreign exchange control law. Moreover, at the final stage of money laundering, a legitimate source will be formed in a foreign country, through which the now clean money may be safely repatriated to China, or the laundered monies may be maintained offshore for investment or other purposes.

3.1.1

Placement of Money Offshore

There are many ways of placing funds offshore, but the most efficient method is to use a financial institution which has access to international money transfer facilities. Money transfer facilities are a vital component of international trade in goods and services, and placement may simply entail crediting electronically an account. In the case of China, this laundering method will frequently involve deceiving the foreign exchange control authorities. Another method of placement is to physically transport cash or negotiable monetary instruments offshore. A popular technique for moving cash out of China is smurfing or structuring, whereby individuals circumvent the $50,000 annual threshold foreign exchange limit through supplying a larger pool of cash to family, relatives and friends who move amounts under the threshold limit to a foreign country. The pooling of $50,000 individual quotas has become so commonplace that Chinese nationals openly discuss smurfing with news reporters (Panckhurst 2015), even though such conduct is illegal and sometimes criminal. Other vehicles for smuggling funds offshore include the use of false or fraudulent customs documentation and the manipulation of securities, commodities and foreign exchange transactions. The various smuggling vehicles that have been used in evading exchange control are likely to have been adapted by professional money launderers to assist corrupt government officials and financial criminals to transfer criminal capital out of China.

3.1.2

Layering of Funds Through Offshore Jurisdictions

The first stage of the laundering cycle is completed when the illicit funds reach an offshore jurisdiction, such as a tax haven. Additional secrecy protection is obtained by layering the funds through one or more laundering cycles. The funds may travel

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across many countries and pass through multiple financial institutions, bank accounts and businesses. Corporate service providers and the legal and accounting professions may supply complex secrecy vehicles which will cause obstacles to unravelling offshore laundering schemes (Chaikin 2013). It is likely that offshore shell companies which are extensively used by Chinese business groups to raise capital and deal with China’s cross-border flow regulations (Tan and Ammal 2021) are also used to facilitate illicit financial flows. Evidence to support this view can be found on the website of the International Consortium of Investigative Journalists (2022). For example, a corrupt Chinese government official hires a money launderer who organises several Chinese tourists to transport illicit cash to Hong Kong. The cash is deposited in a bank account in Hong Kong in the name of a British Virgin Islands company. The funds are then moved electronically through a series of bank accounts held under corporate forms in various countries and cities, such as Zurich, London, or New York. The maze of financial transactions may mean that where the illicit monies reach a major international financial centre such as New York, the governmental authorities will not know whether the money entering their country is derived from an illegal source (Chaikin and Geary 2009). Nor will the receiving bank in New York necessarily have any grounds for believing that the funds are suspicious in that it is not a requirement that the bank knows its customer’s customers (Wolf 2012). Further, the funds which are held in the name of offshore shell companies have been channelled through respectable banks which are assumed to have carried out appropriate due diligence checks.

3.1.3

Integration of Funds into China or Offshore

After the illicit funds have passed through the layering stage, the secret owner of those funds has the choice of either leaving them in the offshore jurisdiction or arranging to repatriate them to China. If the laundering scheme is to be successful, the funds must be repatriated to China in such a way that it appears that they were legitimately acquired from abroad. A common scheme for repatriating laundered money is a loan back arrangement, but in the case of China, round-tripping seems to be a popular mechanism for integrating funds back into China. Round-tripping and its relationship to misinvoicing in trade are discussed below.

3.2

Misinvoicing or False Trade Invoicing

It is well recognised that misinvoicing in international trade transactions is a common method of capital flight, tax evasion and money laundering (FATF 2006). Although trade misinvoicing affects the current account in a country’s balance sheet, its impact is also reflected in the capital account. Through trade misinvoicing, criminals may move money or value from one country to another by manipulating the price, quantity or quality of goods and services in trade

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documentation; they may also manipulate ancillary expenses, such as transport and insurance charges. There are two types of trade misinvoicing: over-invoicing and under-invoicing. If the aim of the scheme is to move money or value offshore, then this will entail over-invoicing by importers or under-invoicing by exporters (FATF/ Egmont 2020). Importers which engage in over-invoicing will transfer money out of a country by arranging for the invoice to be priced above the normal market price and collecting the difference between the two prices outside the country. That is, an importer sends value offshore, so where there is over-invoicing, the importer will have to pay a higher price, thereby justifying the movement of additional value offshore. In the case of under-invoicing by exporters, the invoiced price will be below the normal market price, so that the exporter will receive less monies onshore than it is entitled to, with the difference in value being deposited offshore. Typically, exporters in China will engage in under-invoicing, so as to move money out of China in breach of its exchange control laws. A Chinese manufacturer/exporter agrees to export goods to a US importer at a price that is lower than the market price. This means that the exporter will receive less monies in China than it would otherwise be entitled to. There is a secret agreement that the difference between the invoiced price and the market price will be deposited offshore and shared between the exporter and the importer or an intermediary. The money may be deposited in an offshore bank account which the Chinese exporter secretly controls, frequently through a shell company. In this way the Chinese exporter has evaded China’s foreign exchange control laws and business tax laws. Trade misinvoicing— which has been rebranded as trade-based money laundering (TBML)—is considered by the FATF (2021) and national law enforcement authorities as a significant problem. TBML schemes are sometimes carried out by using alternative remittance system (ARS)/underground banking, so that differences in the declared value of goods and the actual value are ‘filled up’ by ARS (Asia/Pacific Group on Money Laundering 2012). The Commission of Inquiry into money laundering in British Columbia (2022) provides several case studies showing how organised crime groups are using the informal value system in China and elsewhere to transfer illicit proceeds of crime to legitimate Chinese businessmen in exchange for legal sourced RMB.

3.3

Round-Tripping

China is different from most developing countries because trade misinvoicing is used not only for illicit capital flight but also for repatriating capital to China after the funds have been laundered. This is achieved through under-invoicing by importers or over-invoicing by exporters. Under-invoicing by an importer will result in the movement of money onshore in that the importer will pay a lower price, thereby justifying the movement of additional value onshore. Similarly, over-invoicing by an exporter will result in the transfer of value onshore, in that the exporter receives a higher price than it is entitled to. Since the 1990s foreign direct investments (FDI)

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inflows into China have sharply risen, largely due to market reforms and the Chinese government’s incentives for FDI (World Bank 2002). Recent government reforms have resulted in FDI inflows into China reaching record levels despite COVID-19, amounting to nearly $181 billion for the year 2021 (Statista 2022). For over a decade, economists have suggested that part of the FDI is ‘round tripping’ (Fung et al. 2011; Geng 2004). This is the situation where Chinese residents who have moved money offshore in breach of exchange control laws repatriate a portion of the secret capital under the guise of foreign investment. It is not only Chinese individual residents who engage in ‘round-tripping’, but also Chinese enterprises which circumvent domestic restrictions and take advantage of a host of preferential advantages which arise from the status of a foreign investor. The motivation of round-tripping includes FDI fiscal and other incentives, property rights protection under international agreements and investors’ expectations on exchange controls and exchange rates (Gallagher and Shan 2009). For example, a Chinese resident who has a concealed interest in a foreign investment in China may take advantage of China’s bilateral investment treaties (BITs). Under China’s 128 BITs, foreign investors in China are accorded ‘fair and equitable treatment’ and nondiscriminatory treatment and are protected against expropriation without adequate compensation (UNCTAD 2014). Any dispute concerning expropriation is subject to an investor-state dispute settlement provision in the BIT, whereby a ‘foreign investor’ may rely on international arbitration (not Chinese courts) to make claims against alleged unlawful expropriation by China (Gallagher and Shan 2009). China is aware of this problem, and its more recent BITs have sought to ‘avoid misusing or misinterpretation in the event of arbitral tribunals’ (Wang and Wang 2020). The size of ‘round-tripping’ FDI into China is a contested issue, with the World Bank estimate of 25% of China’s FDI in 2002 being considered low by some economists who suggest that 40% is a more accurate estimate (Geng 2004). While Hong Kong has played a major role in FDI flows into China in the 1990s, offshore financial centres such as the British Virgin Islands have become increasingly important since the early 2000s as channels for FDI and round-tripping into China (World Bank 2002). Economists have studied round-tripping in the context of ‘hot money flows’ into China, which have been defined as ‘capital flows which are not related to the trade surplus or foreign direct investment’ (Zhao et al. 2013). It is argued by Zhao that China’s persistent trade surpluses may conceal sizeable ‘hot money inflows’. The adverse impact of ‘round-tripping’ through trade misinvoicing include lower tax revenue collection by the Chinese authorities, currency instability and currency speculation resulting in upward pressure on the Chinese RMB and a reduced capacity to implement monetary and fiscal policy (Girardin and Fall 2013; Zhao et al. 2013). Given that the overall aim of national investment policy is sustainable development, the misuse of BITs, such as in the case of China, through roundtripping undermines SDG 16. Round-tripping should be combated since it undermines the purpose of a BIT which is to provide benefits to genuinely foreign investors. This is recognised by UNCTAD (2016) which has sought to reform BITs to deny their benefits to investors who are ultimately owned and controlled

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by nationals of the country which hosts the investment. Among UNCTAD’s suggestions is that new BITs should redefine who is entitled to protection and impose obligations on so-called foreign investors to disclose their corporate structure. UNCTAD’s arguments are even more compelling where the misuse of BITs involves illicit activities.

4 Regulation of Illicit Flows by China 4.1

Foreign Exchange Control Regulation in China

The foreign exchange controls of China constitute a series of laws and regulations with the most important being the Foreign Exchange Administration Regulations issued by the State Council in 2008 (hereinafter the General Regulations) (People’s Republic of China 2008). The aim of the foreign exchange laws is to improve China’s foreign exchange reserves, maintain an equilibrium in its balance of payments position and facilitate positive economic development. The administration of foreign exchange is carried out by the State Administration of Foreign Exchange (SAFE) and its local offices throughout China. There is a broad definition of foreign exchange which captures several mechanisms for utilising foreign exchange. Under article 3 of the General Regulations, foreign exchange is defined to include the ‘means of payment and assets denominated in foreign currency for international settlement’, namely, foreign exchange cash, foreign exchange negotiable instruments, foreign bank deposits and foreign bank cards, equity and debt securities denominated in foreign currency, special drawing rights and any other assets denominated in foreign currency (People’s Republic of China 2008). The exchange control laws are applied to payments and receipts of foreign exchange by domestic individuals or entities, such as companies, partnerships and trusts. The laws are also applied to foreign exchange operations or payments and receipts of foreign exchange by foreign persons in China. Upon joining the World Trade Organisation in 2001, China agreed to liberalise its foreign exchange controls, particularly in relation to its current account which involves exports and imports of goods and services. This is reflected in article 5 of the General Regulations which states that ‘international payment and transfer in foreign exchange for current account transactions shall not be subject to government restriction’. Although there is no prohibition on foreign exchange current account transactions, there is a system of disclosure and administration under Chapter 2 of the General Regulations to ensure that only ‘bona fide and legitimate (current account) transactions’ take place. Under article 12 of the General Regulations, financial institutions which are authorised foreign exchange operators in China are obliged to carry out due diligence checks of customs documentation against receipts and payments in foreign exchange. Foreign exchange controls have been liberalised in China on the current account, they continue to be strictly applied on the capital account which deals with capital

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imports. Under chapter 3 of the General Regulations, a governmental system of registration and approval applies to direct and indirect investments in China by foreign entities and foreign individuals and to overseas investments by domestic entities and domestic individuals. This does not mean that the capital account is entirely closed. According to People’s Bank of China Deputy Governor Yi Gang, ‘about 80% of capital-account items listed by the IMF are convertible or partially convertible in China’ (Bloomberg 2013). Chinese companies are permitted to exchange RMB for foreign currencies only for approved business transactions. Chinese investors are permitted to use their foreign exchange to invest in B-shares, while qualified foreign institutional investors are permitted to invest in China’s capital market (People’s Bank of China 2008). But as the IMF has pointed out, inward portfolio investment into China is subject to a quota in that it must be carried out through Qualified Foreign Institutional Investors, while foreign short-term borrowing by Chinese businesses is subject to a ceiling (International Monetary Fund 2013). Foreign invested enterprises (FIEs) must not only be registered with SAFE but also with the State Administration for Industry and Commerce (SAIC), which is the corporate regulator, and the State Administration of Taxation (SAT), which is the tax regulator. The system of controls applying to FIEs is somewhat complex, albeit that there has been a trend since 2013 whereby SAFE has been relaxing some of its disclosure and regulatory requirements to facilitate direct foreign investment in China (People’s Republic of China 2013). One key concern of SAFE is to ensure that FIEs are not secretly controlled by Chinese interests, which might occur through the ‘round-tripping’ phenomena and might explain in part the significant capital flows into China. The main regulatory method of uncovering domestic entities and domestic individuals concealing their interests in FIEs is through disclosure. FIEs are obliged to disclose to SAFE the name and nationality of its ultimate beneficial shareholder (Organization for Economic Cooperation and Development 2012). However, it is very difficult for the Chinese authorities to verify beneficial ownership information because overseas countries do not generally require the disclosure of beneficial ownership of private companies to regulatory authorities (Chaikin 2005a, b). This is changing in that in the European Union and the United Kingdom there are requirements for public disclosure of beneficial ownership of private companies. The trend towards automatic exchange of information for tax purposes and the expansion of the network of bilateral tax information exchange agreements, which China is an active participant, may in the future improve the level of administrative co-operation available to the Chinese authorities. There are specific foreign exchange controls applying to domestic individuals. For instance, individuals in China have a $50,000 annual limit in settling foreign exchange or purchasing foreign exchange (SAFE 2007, article 2; People’s Republic of China 2008). There is a prohibition on the transfer of an annual quota for individual foreign exchange purchases and sales. However, the foreign exchange purchased by individuals may be sent by that individual to a foreign bank account or carried overseas provided it is within the annual aggregate limit of $50,000 (SAFE 2007, article 3). A breach of China’s foreign exchange control laws may result in

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administrative sanctions, and in some cases, there will be criminal liability which will be investigated by both the Public Security Bureau (PSB) and SAFE. There are a variety of circumstances giving rise to criminal liability, such as breaches of articles 39, 40, 45, 46 and 49 of the General Regulations. A criminal violation of China’s foreign exchange control law may also occur where the annual illegal foreign exchange trading exceeds $200,000 (SAFE and PSB 2010), where there is a fraud or deception of the Chinese foreign exchange authorities, or where the offence of money laundering is committed. In terms of enforcement of foreign exchange controls, there is scarce empirical literature in China, apart from general statistics issued by SAFE. SAFE carries out on and off-site monitoring of financial institutions and conducts foreign exchange control investigations, with 15,000 cases arising during the period 2007 to 2011 (SAFE 2012). In the first half of 2011, SAFE increased its enforcement efforts by investigating 1865 cases of suspected violations of foreign exchange laws and regulations and imposing RMB 260 million in administrative penalties and confiscation (SAFE 2012). SAFE has also worked with the PSB focusing on ‘irregular border capital flows’ resulting in the ‘investigation of 10 cases of illegal banks and on-line foreign exchange speculation in an amount exceeding RMB10 billion and the destruction of 16 illegal trade markets’ (SAFE 2012). There are many ways of avoiding and evading exchange control laws. The enforcement record of exchange control countries is generally poor, especially where there is a high degree of dependence on voluntary compliance. A former IMF economist Professor Eswar Prasad has expressed the view that the ‘wealthy in China have always had an open capital account’ and that the middle classes are increasingly evading exchange control laws (Frangos et al. 2012). A recent report by the Commission of Inquiry into Money Laundering in British Columbia (2022) provides support for this view. The Canadian study detailed how wealthy individual in China received vast sums of illicit cash from ‘cash facilitators’ which allowed them to gamble in British Columbia’s casinos while evading China’s export control restrictions.

4.2

Anti-money Laundering Regulation in China

China has had laws relating to money laundering since the 1990s, but it was only after China decided to participate fully in the international anti-money laundering (AML) discourse that there was a complete overhaul of China’s AML system and enforcement. China’s AML laws are based on the global AML standards issued by the FATF, which China joined as a full member in 2007. China is also a member of the Asia/Pacific Group on Money Laundering and the Eurasian Group on Combatting Money Laundering and Financing of Terrorism. The regulation of AML in China is based on a series of laws, regulations and normative and policy documents which apply to over 2000 legal persons and 300,000 branches of financial institutions and nonfinancial institutions (People’s Republic of China 2015). The AML

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regulations apply to institutions, such as commercial banks, policy banks, credit cooperatives, post savings institutions, securities and futures brokerage companies, insurance companies, asset management companies, trust and investment companies, finance companies and money brokerage companies (People’s Republic of China 2006, article 2). The AML obligations of these institutions include customer identification and risk rating of customers after carrying out Know Your Customer and Enhanced Due Diligence for higher risk customers such as Politically Exposed Persons; the reporting of suspicious transactions (STRs) and large-value transactions (LVTs) to the People’s Bank of China (PBOC); the establishment of internal AML compliance programmes; and the appointment of specialist AML units. The main challenges to the institutions have been the vetting of the identification of customers using naming conventions, obtaining sufficient information to build customer risk profiles, the determination of the beneficial ownership of corporate customers and applying an effective risk-based approach to money laundering. Although some of these deficiencies have been addressed by amended Customer Due Diligence rules in China (FATF 2012), there is some question as to whether this has been reflected in increased compliance by institutions. It has been recognised since 2012 that China’s AML regulatory system complies with the core international AML standards (FATF 2012) and on paper is equal to the AML systems in Europe and the United States (FATF and APG 2012). There are nevertheless deficiencies in China’s compliance with the FATF Standards, for example the failure to apply AML laws to Designated Non- Financial Businesses or Professions. (FATF 2019). There is also an issue of the effectiveness of the AML laws which is a major issue for nearly all countries, not just China (Chaikin 2018). The principal AML enforcement agency which operates as a financial intelligence unit (FIU) and as a regulator is the China Anti-Money Laundering Monitoring and Analysis Centre (CAMLMAC) which is part of the PBOC. The PBOC works with other regulatory agencies in combatting money laundering, as well as with the PSB. The enforcement statistics provide a clue as to the use and enforcement of AML in financial investigations and criminal prosecutions. The PBOC processed over 24½ million suspicious transaction reports (STRs) in 2013, although it is not clear how these were utilised in practice (US Government 2015). According to the latest FATF report on China (2019), the number of filed STRs has dramatically fallen to 5.44 million in 2016 as part of a strategy to reduce the volume of defensive reporting and increase the quality of STRs. At the same time, the number of Large Value Transaction Reports (LVTRs) has dramatically increased to 4.94 billion in 2016 (FATF 2019), which may reflect a massive increase in licit banking system payments rather than illicit economic activity. The PBOC carried out 2113 regular inspections of financial institutions for AML compliance in 2010 (FATF 2012), but this figure is small given the huge numbers of legal entities and branches that fall within its jurisdiction. China’s AML regulatory system is utilised to combat informal money transfers/ underground banking which involve a criminal offence. There are several money laundering offences under Chinese law which are based on a list of predicate offences, including drug-related offences, crimes committed in the form of

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syndicates, smuggling, corruption and bribery, terrorist crime, disrupting financial management order and financial fraud. Money laundering is committed where the individual has knowledge of an obvious predicate offence and commits one of the following acts for the purpose of disguising or concealing its origin or nature—‘providing any capital account, assisting transfer of property into cash, . . . .assisting transfer of capital by any means of settlement, assisting remittal of funds to a foreign country or disguising or concealing the origin or nature of any crime-related income or proceeds generated by any other means’ (Lishan 2012). In terms of money laundering prosecutions, there were 11,645 prosecutions in China in 2013, but no available statistics on convictions (United States Government 2015). The failure to utilise the money laundering offence might be explicable in that money laundering prosecutions have had a narrow focus on third parties and selfmoney laundering was not criminalised (FATF 2019). This has been remedied with new proposed measures in China, including higher penalties for money laundering and the criminalisation of self-money laundering (FATF 2021). The AML system is linked to the foreign exchange regulatory system. The PBOC is given specific responsibility to monitor funds flows not only in relation to RMB but also in relation to foreign currencies (People’s Republic of China 2006, article 5(1)). A financial institution is obliged to report to PBOC and SAFE suspicious transactions or large value transactions which concerns foreign exchange. The AML laws empower the PBOC to freeze assets held in an institution for up to 48 hours in circumstances where there is a money laundering suspicion and there is risk that the assets may be transferred abroad (People’s Republic of China 2006, article 23). International co-operation in combatting money laundering is possible through several avenues. The CAMLMAC has signed AML information sharing agreements with 24 foreign financial intelligence units, which has enabled CAMLMAC to obtain access to and share information collected through the AML process in foreign countries and China. China has also entered mutual assistance in criminal matters treaties with a large number of countries, including the United States and Australia, which have enabled the obtaining of evidence, including information held by private sector institutions and domestic government agencies. One limitation of current Chinese law is that it does not permit the enforcement of foreign court judgements obtained through a non-criminal confiscation procedure against assets in China (United States Government 2015). On the other hand, China has faced numerous obstacles in recovering the billions of dollars stolen by corrupt government officials who have fled to developed countries and laundered their monies in offshore and international financial centres. It is noticeable that while Chinese authorities have lauded the success of Operation Foxtrot in repatriating corrupt officials to China, there was until relatively recently little information concerning the recovery of stolen monies. According to the Chinese government, in 2014–2016 illicit proceeds totalling RMB 8.64 billion (approximately $1.4 billion) were recovered (FATF 2019). Although this may seem to be a large number, it relates to monies illegally exported over more than 20 years; with a People’s Bank of China report (2008a, b) asserting that as many as 18,000 officials have fled China with US $120 billion during the period 1993 to 2008.

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5 Conclusion China has enacted comprehensive AML laws and foreign exchange regulations which have the potential to limit the growth of international informal capital flows into and out of China. But the enforcement record of the Chinese authorities in both AML and exchange control is modest, which suggests that China’s regulatory system is not very effective in combating illicit financial flows. In the next decade, China is likely to widen its AML coverage of nonfinancial institutions and increase the intensity of enforcement of both AML and foreign exchange control regulations. This will be consistent with the FATF’s renewed focus on measuring the AML enforcement record of countries. Although China has not been a major offshore money laundering centre, it is likely that China will become a more attractive destination for illicit foreign capital even if China takes proactive steps to combat money laundering.

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Herkenrath M (2014) Illicit financial flows and their developmental impacts: an overview. International Development Policy (Revue Internationale de Politique de Developpement) (Online) 5(3) http://journals.openedition.org/poldev/1863. https://doi.org/10.4000/poldev.1863 International Consortium of Investigative Journalists (2022). https://www.icij.org/ International Monetary Fund (2013, July) Article IV consultation with the People’s Republic of China. IMF country report no 13/211, pp 31–32 Kahler M (2018) Countering illicit financial flows: expanding agenda, fragmented governance. In: Kahler M, Forstater M, Findley MG, Vittori J, Westenberg E, Fanusie YJ (eds) Global governance to combat illicit financial flows: measurement, evaluation, innovation. Council of Foreign Relations, Washington, DC Kar D, Cartwright-Smith D (2008, December) Illicit financial flows from developing countries: 2002-2006. Global Financial Integrity, Washington, DC Kar D, Freitas S (2012, October) Illicit financial flows from China and the role of trade misinvoicing. Global Financial Integrity, Washington, DC Kar D, Spaniers J (2014, December 16) Illicit financial flows from developing countries: 20032012. Global Financial Integrity, Washington, DC Kar D, Spaniers J (2015, December 8) Illicit financial flows from developing countries: 2004-2013. Global Financial Integrity, Washington, DC Kessler M, Borst N (2013, January 10) Did China really lose $3.75 trillion in illicit financial flows? Web log post. China Economic Watch. Peterson Institute for International Economics, Washington, DC Kindleberger CP (1987) A historical perspective, Chapter 2. In: Lessard DR, Williamson J (eds) Capital flight and third world debt. Institute of International Economics, Washington, DC Lessard DR, Williamson J (1987) Introduction, Chapter 1. In: Lessard DR, Williamson J (eds) Capital flight and third world debt. Institute of International Economics, Washington, DC Lishan A (2012) Anti-money laundering (AML) regulation and implementation in Chinese financial sectors: moneylaundering vulnerabilities and the ‘rule-based but risk-oriented’ AML approach, Doctor of Philosophy thesis. University of Wollongong. https://ro.uow.edu.au/ theses/3641 Nolan P (2019) China and the west: crossroads of civilisation. Routledge, London Organisation for Economic Co-operation and Development (2012, June 20) Global forum on transparency and exchange of information for tax purposes. Peer reviews on the People’s Republic of China: Combined Phase 1 and Phase 2. OECD, Paris Organisation for Economic Co-operation and Development (2015) Illicit financial flows from developing countries: measuring OECD responses. OECD, Paris Palan R, Murphy R, Chavagneux C (2010) Tax havens: how globalization really works. Cornell University Press, Ithaca Panckhurst P (2015, November 2) China’s ‘Smurfs’ beat cash controls, Sending Real Estate Soaring. Bloomberg News People’s Bank of China (2008a) China: the evolution of foreign exchange controls and the consequences of capital flows. In: Paper No 44, Bank of International Settlements. Basel, Switzerland, pp 143–151 People’s Bank of China (2008b) A study on methods of transferring assets outside China by Chinese corruptors and monitoring methods for this problem. Available as exhibit 961 in Cullen Commission. https://cullen-commission-prod.apps.silver.devops.gov.bc.ca/exhibits/?page=10 People’s Republic of China (2006) Rules for anti-money laundering by Financial Institutions. Decree No 1 of 2006. In: Adopted at the 25th Meeting of the Governor of the People’s Bank of China on 6 November 2006, effective from 1 January 2007 People’s Republic of China (2008) Foreign Exchange Administration Regulations. Issued by the State Council No 532 People’s Republic of China (2013) Provisions for administration of Foreign Exchange relating to inbound direct investment by Foreign Investors. Circular 21 issued by SAFE, effective 13 May 2013

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People’s Republic of China (2015) Administration of Public Finance in China. In: Paper submitted to the Open-ended Intergovernmental Working Group on Prevention of Corruption, UNCAC, Sixth Inter-Sessional Meeting, Vienna, 31 August to 2 September Rubio DF, Andvig E (2019) Serious about sustainability? Get serious about corruption. World Economic Forum State Administration of Foreign Exchange and Public Security Bureau, China (2010, November 1) Risk alerts for individual foreign exchange transactions. Issued by the Shanghai Branch of SAFE and Economic Crime Investigation Department of Shanghai PSB State Administration of Foreign Exchange, China (2007, January 2) Implementing rules of the administrative measures for personal foreign exchange State Administration of Foreign Exchange, China (2012, January 18) An interview with the Deputy Administrator of the State Administration of Foreign Exchange, Deng Xianhong, on issues concerning dealing with and cracking down on illegal and irregular capital flows such as hot money. SAFE News Bulletin Statista (2022) Annual inflow of foreign direct investment (FDI) to China from 2011 to 2021. https://www.statista.com/statistics/1016973/china-foreign-direct-investment-inflows/ Stephenson KM, Gray L, Power R, Brun J-P, Dunker G, Panjer M (2011) Barriers to asset recovery: an analysis of the key barriers and recommendations for action. World Bank, Washington, DC Tan W, Ammal B (2021, October 6) Chinese shell companies’ assets skyrocket to more than $4 trillion, Bloomberg United Nations Conference on Trade and Development (2014) Recent developments in investor state dispute settlement. UNCTAD, Geneva, Switzerland United Nations Conference on Trade and Development (2016, September) World Investment Report 2016, Investor Nationality: policy changes United Nations Office on Drugs and Crime and the Organisation for Economic Co-operation and Development (2016) Coherent Policies for Combatting Illicit Financial Flows, Vienna United Nations Office on Drugs and Crime and United Nations Conference on Trade and Development (2020) Conceptual framework for the statistical measurement of illicit financial flows, Vienna United States Government (2015, March) International Narcotics Control Strategy Report Volume 11: money laundering and financial crimes, Annual Report issued by the US Department of State’s Bureau of International Narcotics and Law Enforcement Wang H, Wang L (2020) China’s bilateral investment treaties, Chapter 1. In: Chaisse J, Choukroune L, Jusoh S (eds) Handbook of international investment law and policy. Springer, Singapore. https://doi.org/10.1007/978-981-13-5744-2_37-1 Wolf B (2012, December) US banks not in position to spot reported flow of dirty Money from China, sources say. Thomson Reuters Anti-Money Laundering Magazine World Bank (2002) Private capital flows to emerging markets, Chapter 2. In: Global development finance 2002: financing the poorest countries. World Bank, Washington, DC World Bank (2022, June 10) China: economic update. World Bank, Washington, DC World Bank and the People’s Republic of China (2022, April 1) Four decades of poverty reduction in China: drivers, insights for the world, and the way ahead, World Bank and development research Center of the State Council, PRC. https://www.worldbank.org/en/news/pressrelease/2022/04/01/lifting-800-million-people-out-of-poverty-new-report-looks-at-lessonsfrom-china-s-experience Zhao Y, de Haan, J, Scholtens B, Yang H (2013, May 9) The dynamics of hot money in China. Working Paper, City University of Hong Kong Zucman G (2015) The hidden wealth of nations. University of Chicago Press, Chicago, IL

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David Chaikin is the Chair of the Business School’s discipline of Business Law, at the University of Sydney Business School, where he teaches and researches international financial crime and banking and finance law. Prior to his academic career, David was a practicing lawyer specializing in transnational asset recovery litigation and extradition. David has worked as a consultant with the Financial Action Task Force, the Asia/Pacific Group on Money Laundering, and the Australian Financial Services Council. He has held the positions of Senior Assistant Secretary and the International Criminal Law Enforcement and Security Branch Head in the Australian federal Attorney-General’s Department, and Senior Fraud Officer of the London-based diplomatic body, the Commonwealth Secretariat. He has published books and articles on corruption, money laundering, international cooperation in criminal matters, financial services law, and trusts and wealth management. He was co-editor of the following books: (with Gordon Hook) Corporate Trust Structures: Legal and Illegal Dimensions (Australian Scholarly Publishing, 2018); (with Derwent Coshott) Markets, Misconduct, and the Technological Age (Australian Scholarly Publishing, 2019).

The Environmental Performance of Firms and the Probability of Environmental Events Claudia Champagne, Samuel Chrétien, Frank Coggins, and Hajer Tebini

1 Introduction The financial scandals and environmental catastrophes that marked the last two decades have brought social and environmental concerns back to the heart of financial decision-making. The numerous summits and conferences (Kyoto in 1997, Johannesburg in 2002, Copenhagen in 2009, Lima in 2014, COP21 to COP27 between 2015 and 2022, etc.) also testify to their importance. Issues related to global warming, greenhouse gas emissions, pollution, or biodiversity and natural resources degradation force us to appreciate the magnitude of environmentally related global risks. These environmental issues, which were once the prerogative of activists and scientists, have become central to policy decisions and media debates. The integration of environmental issues in financial analysis is becoming imperative, not only from the firm’s point of view but also from its stakeholders’. For instance, analysts and investors, particularly institutional investors, now consider the management of environmental issues as essential risk management to optimize their portfolios. Extra-financial indicators on environmental or social issues can therefore play a major role.

C. Champagne · F. Coggins (✉) Department of Finance, School of Business, Université de Sherbrooke, Sherbrooke, QC, Canada e-mail: [email protected] S. Chrétien Treasury & Performance and Financial Planning, National Bank of Canada Chrétien, Montréal, QC, Canada H. Tebini HÉC-Montréal, Montréal, QC, Canada © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_5

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Extra-financial ratings have become an important tool for investors and are primarily intended for those whose primary concern is risk management and longterm income stability.1 Preference for, or aversion to, environmental, social, or governance (ESG) attributes of securities can influence investors’ choices and thus affect security prices and risk (Fama and French 2007; Mackey et al. 2007). In this respect, extra-financial ratings are key inputs in the estimation of extra-financial risk as well as an important decision-making indicator. In recent years, the financial sector has forced the improvement of extra-financial information. Moody’s integration of ESG risks into its credit rating system and its acquisition of Vigeo Eiris, one of the first extra-financial rating agency, in 2019, as well as Standard & Poor’s inclusion of ESG criteria in its credit reports highlight the growing consideration of extra-financial data by the financial sector. The reporting of ESG ratings can have a direct effect on financial markets and stakeholder behavior (Scalet and Kelly 2010), which can influence the value of the underlying firms. This influence justifies the need to study the validity, accuracy, and suitability of the ratings. The now infamous Volkswagen emissions scandal is a prime example of the shortcoming of extra-financial analysis and ratings.2 Although even the most rigorous ESG analysis is not meant to predict a specific corporate event, we can argue that ESG ratings can be related to the probability of occurrence of the event. In other words, are ESG ratings related to firm risk? The impact of extra-financial ratings on financial risk is commonly examined in the financial literature. This research generally concludes to a negative relationship between extra-financial ratings and financial risks (see, e.g., Spicer 1978; McGuire et al. 1988; Feldman et al. 1997; Orlitzky and Benjamin 2001; Boutin-Dufresne and Savaria 2004; Goss 2007; Sharfman and Fernando 2008; Semenova and Hassel 2008; Lee et al. 2009; Godfrey et al. 2009; Luo and Bhattacharya 2009; Bauer and Hann 2010; Chava 2010; Oikonomou et al. 2012; Salama et al. 2011; El Ghoul et al. 2011; Friede et al. 2015; Engle et al. 2020; Pastor et al. 2021; Pedersen et al. 2021; Zerbib 2022) and validates the use of corporate social responsibility (CSR) activities as a strategy for reducing financial risks (Orlitzky and Benjamin 2001; Goss 2007; Sharfman and Fernando 2008; El Ghoul et al. 2011; Revelli and Viviani 2013). Investors can, from a risk management perspective, integrate the risks associated with environmental performance (EP) in their strategy (Lee et al. 2009). In this sense, investments in CSR, especially for environmental purposes, can generate moral capital and credibility to mitigate the impact on a company’s cash flow in the event of a crisis or negative events (Godfrey et al. 2009). In this study, we wish to further explore the relationship between the financial risk perceived by investors and corporate EP measures. Like for credit ratings, which provide creditors and investors

1

European SRI Study 2021 and European Sustainable Investment Forum (Eurosif). Up until the scandal began on September 18, 2015, Volkswagen was ranked number one among the world’s car companies by the Dow Jones Sustainability Index released in early September, with full marks awarded for codes of conduct, compliance, and anti-corruption as well as innovation management and climate strategy. Many ESG-guided portfolios held full positions in Volkswagen. 2

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with important information to assess the likelihood of a default event, we examine the ability of extra-financial ratings, which represent one of the main sources of extra-financial information for investors, to predict ESG-related events. Specifically, we focus on the environmental (E) dimension and ask the following question: Are EP ratings related to the probability of occurrence of corporate environmental events? Such a relationship could help explain empirical findings that firms with low (high) EP have higher (lower) financial risk. Explaining the link between EP and environmental events is important not only on a scientific level but also on a practical level. Institutional investors and other users of extra-financial ratings need to know what type of risk are measured and captured by the ratings. Our results indicate that EP ratings are related to the likelihood of environmental events, but the link depends on the firm’s environmental strengths and concerns. Specifically, environmental strengths (based on positive corporate activities) are related to positive corporate environmental events, while environmental concerns (based on negative environmental activities) are related to negative events. This result provides evidence that extra-financial ratings are a good indicator of ESG risk and supports and explains the previous observations of an inverse relationship between EP and financial risk. It also suggests that investors and financial analysts are right to integrate environmental ratings into their investment strategy. In addition, we find that environmental strengths (concerns) are positively related to negative (positive) corporate environmental events, which suggests a compensation effect whereby firms compensate CSR concerns with positive activities. Furthermore, firms that have both positive and negative environmental activities are associated with a higher probability of negative events. This result suggests that while some firms may adopt strategic positioning to offset their negative environmental activities, the compensating strengths do not reduce the probability of negative events. The rest of the article is organized as follows. In Sect. 2, we formulate our main research hypotheses based on a broad theoretical and empirical literature review. In Sect. 3, we describe our data sources and the empirical model that we use to test our hypotheses. In Sect. 4, we present and discuss our empirical results. Finally, in Sect. 5, we provide a synthesis of our results.

2 Literature Review and Research Hypotheses 2.1

ESG Performance and Risk

Several perspectives have been put forward to explain the economic impact of social and environmental corporate involvement. An important stream of research examines the impact of ESG performance on financial risk (see, e.g., Spicer, 1978; McGuire et al. 1988; Feldman et al. 1997; Orlitzky and Benjamin 2001; BoutinDufresne and Savaria 2004; Goss 2007; Sharfman and Fernando 2008; Semenova and Hassel 2008; Lee et al. 2009; Godfrey et al. 2009; Luo and Bhattacharya 2009;

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Bauer and Hann 2010; Chava 2010; Oikonomou et al. 2012; Salama et al. 2011; El Ghoul et al. 2011; Blitz and Fabozzi 2017; Engle et al. 2020; Pastor et al. 2021; Pedersen et al. 2021; Zerbib 2022). Results generally support a negative relationship between ESG performance and financial risk. The finance and CSR literature brings three arguments to clarify the nature of the relationship between ESG performance and risk: (i) risk management, (ii) investor preferences, and (iii) management opportunism. The risk management argument, which is based on stakeholder theory, predicts a negative relationship between ESG performance and risk. Specifically, the argument states that meeting the expectations of stakeholders strengthens the image and reputation of the firm (e.g., through increased employee morale, retained customers, development of relationships with banks, investors, and government) which, consequently, improves its long-term ESG performance while reducing financial and operational risk (Freeman 1984; McGuire et al. 1988; Waddock and Graves 1997) or ESG-related risks (Feldman et al. 1997; Sharfman and Fernando 2008; El Ghoul et al. 2011). Engaging in welldeveloped CSR activities therefore generates moral capital and greater credibility with stakeholders to offer insurance-like protection to reduce the firm’s exposure to risk (Godfrey 2005; Godfrey et al. 2009). In addition, this moral capital created by firms with high ESG activities can result in a more favorable assessment by their stakeholders which can preserve the firm value, particularly in the event of a crisis or adverse events (Bansal and Clelland 2004), and can generate surplus economic value (Godfrey et al. 2009). For instance, better management of environmental risks (e.g., reducing toxic emissions and pollution) reduces the likelihood of an environmental crisis that could negatively affect the firm’s future cash flows through lawsuits, cleanup costs, fines, or reputational damages (Sharfman and Fernando 2008). This mechanism can also offer a type of insurance against the financial consequences of negative externalities caused by scandals or environmental crises. In this sense, welldeveloped CSR activities can mitigate negative ESG shocks (Bansal and Clelland 2004). The investor preferences argument, based on theoretical models of the relationship between CSR and expected returns, also suggests a negative relationship between ESG performance and risk (Heinkel et al. 2001; Barnea et al. 2005; Mackey et al. 2007; Pedersen et al. 2021; Zerbib 2022). These models, derived from Merton’s (1987) investor recognition theory, suppose that investment decisions are not only based on financial criteria but also on nonfinancial criteria such as CSR. By taking into account differences in investor preferences and in investor exclusions, as suggested by Merton (1987), it follows that the risk of the firm is a decreasing function of the number of potential shareholders. Thus, excess demand for shares from high-ESG firms will allow for greater risk sharing, which reduces risk. Conversely, investors will require additional premiums to compensate for the lack of risk sharing opportunities when there is weak demand or portfolio exclusion for shares from low-ESG firms, which increases risk. The third argument, based on managerial opportunism and entrenchment, states that managers can overinvest in CSR activities to improve their reputation as good citizens, to the detriment of shareholders (Barnea and Rubin 2010). This

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opportunistic behavior by managers can also be motivated by the wish to gain the support of stakeholders, including social and environmental activists, in order for managers to keep their position in case of a takeover (Cespa and Cestone 2007). This third argument, derived from agency theory, implies a prioritization of managers’ interests over that of shareholders (and other stakeholders) and thus a positive relationship between EP and risk.

2.2

Environmental Performance and Risk

The importance of climate change issues and environmental risks for investors have encouraged the multitude of empirical work that examine the relationship between the environmental dimension of ESG and the risk of the firm (see, e.g., Li et al. 1997; Heinkel et al. 2001; Saghroun and Eglem 2008; El Ghoul et al. 2011; Girerd-Potin et al. 2014; Krüger 2015). Despite the diversity of risk measures (e.g., leverage, book-to-market value ratio, beta, standard deviation of returns, cost of capital, or bankruptcy risk) and the complexity of evaluating extra-financial performance, there is a consensus on the usefulness of CSR activities as a risk management strategy (McGuire et al. 1988; Feldman et al. 1997; Orlitzky and Benjamin 2001; Godfrey et al. 2009; Salama et al. 2011; Lee et al. 2009; Oikonomou et al. 2012). Results obtained in the U.S. (Spicer 1978; McGuire et al. 1988; Feldman et al. 1997; Orlitzky and Benjamin 2001; Goss 2007; Sharfman and Fernando 2008; Lee et al. 2009; Luo and Bhattacharya 2009; Oikonomou et al. 2012), Canada (BoutinDufresne and Savaria 2004) and the UK (Salama et al. 2011) support a negative relationship between ESG performance and various risk measures. Orlitzky and Benjamin’s (2001)’s meta-analysis confirm that CSR investments reduce the level of risk for firms, while Revelli and Viviani’s meta-analysis (2013) concludes to a lower risk for the most socially responsible companies. Empirical studies that focus on the impact of corporate environmental policies on financial risk also find a negative relationship between the two. Results show that investors are willing to sacrifice some of their portfolio return in exchange for a stronger environmental firm commitment that can reduce their long-term financial risk (see, e.g., Spicer 1978; Feldman et al. 1997 or Jo and Na 2012 for total risk; see Salama et al. 2011; Oikonomou et al. 2012 or Jo and Na 2012 for systematic risk; see Bouslah et al. 2013; Mishra and Modi 2013 or Champagne et al. 2015 for specific risk; and see Heinkel et al. 2001; Sharfman and Fernando 2008; El Ghoul et al. 2011 or Girerd-Potin et al. 2014 for cost of capital). Spicer (1978) shows that less polluting companies have a lower total risk and a lower systematic risk compared to more polluting companies. Feldman et al. (1997) observe that improved environmental activities and EP lead to a significant reduction in the firm’ systematic risk. These results support that environmentally conscious firms create value for shareholders through reduced risk which, in turn, leads to a lower cost of capital. Bouslah et al. (2013) examine the relationship between individual ESG performance dimensions and total or idiosyncratic risk for nonfinancial firms and find that sustainable

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environmental activities reduce the risk for companies that are not included in the S&P500 index. Champagne et al. (2015) examine the impact of extra-financial rating changes on firm risk and observe that a deterioration of a firm’s EP increases its systematic risk, which suggests that changes in EP influence the risk of companies as perceived by investors. Other studies highlight a negative relationship between EP and the cost of capital (see Heinkel et al. 2001; Sharfman and Fernando 2008; El Ghoul et al. 2011; GirerdPotin et al. 2014). Heinkel et al. (2001) show that nonpolluting firms have a lower cost of capital than polluting firms, which implies that environmental policies can help firms reduce their financial risk. This result is validated by Sharfman and Fernando (2008) with S&P500 companies and El Ghoul et al. (2011).

2.3

ESG Performance and Adverse Events

Good environmental policies not only reduce the risk of the firm but also protect it in times of crisis through their promotion of a better reputation (Godfrey et al. 2009). Specifically, CSR encourages firms to be more proactive in improving their EP and ESG performance by strengthening their relations with stakeholders and thus building and maintaining a good ESG reputation. The importance of maintaining good stakeholder relations is all the more important with the evolution of communication technologies as media plays a decisive role in society’s perception of the firm’s image and reputation. In this context, negative media attention toward irresponsible corporate behavior can lead to the loss of stakeholder confidence and significant costs. Several studies explore the impact of CSR activities on risk via the building of a better reputation, which allows the firm to protect itself in times of crisis (Godfrey et al. 2009; Philippe and Durand 2011; Melo and Garrido-Morgado 2012). Media, both social and traditional, play a significant role in the dissemination of information and affect investors’ perceptions of the firm’s image. Einwiller et al. (2010) observe that stakeholders are more dependent on news media to get information about reputational dimensions that are difficult to observe. Other studies measure the extent of reputational damage associated with adverse corporate environmental events. Philippe and Durand (2011) examine the causal link between reputation and EP and show that for the 11 sectors considered, environmental violations negatively affect the reputation of the firm, as measured by Fortune magazine. Melo and Garrido-Morgado (2012) argue that CSR, which includes environmental activities, is an integral component of a company’s reputation.

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2.4 2.4.1

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Research Hypotheses Environmental Performance and Corporate Environmental Events

As discussed above, empirical studies generally find a negative relationship between EP and corporate financial risk. This relationship, supported among other things by stakeholder theory, suggests that firms with a positive EP enjoy a good ESG-related reputation which, in turn, allows for better management of risk (Waddock and Graves 1997; Heinkel et al. 2001; Sharfman and Fernando 2008; El Ghoul et al. 2011). In addition, the reporting of EP ratings, which is of interest for investors, can reduce market information asymmetry if it’s perceived as a signal of the firm’s quality of management (McGuire et al. 1988; Waddock and Graves 1997). Firms can thus benefit from investors’ confidence and will, through their environmental policies and activities, and send a positive signal to investors who will perceive them as less risky. Moreover, a higher EP can lead investors to perceive the firm as being less prone to environmental crises and to be better positioned to comply with increasingly stringent environmental regulations. Following these arguments, we propose the following research hypothesis: H1: A firm’s EP is positively (negatively) related to the probability of occurrence of positive (negative) environmental events.

2.4.2

Environmental Strengths and Concerns

The simple method of measuring EP by subtracting environmental concerns from strengths can mask the individual effect of positive and negative corporate activities, regardless of the firm’s level of environmental commitment. For instance, the aggregate EP for firms with both high environmental strengths and high concerns is comparable to the aggregate EP for firms with both low strengths and concerns. An aggregate measure also implicitly considers that ESG strengths and concerns have equal importance, a hypothesis challenged by Mattingly and Berman (2006) who argue that positive (strengths) and negative (concerns) CSR activities are empirically and conceptually distinct and should not be combined. Their respective financial impacts can also differ. The asymmetry in terms of financial risks of positive and negative activities has been shown many times in the literature on ESG performance (see, e.g., Strike et al. 2006; Bouquet and Deutsch 2008) and for EP (Bird et al. 2007; Bouslah et al. 2013; Mishra and Modi 2013; Cai et al. 2016). Studies that examine the market’s reaction to ESG-related news show that irresponsible (responsible) behavior will result in a significant drop (increase) in the firm’s market value (see, e.g., Lanoie and Laplante 1994; Hamilton 1995; Klassen and McLaughlin 1996; Konar and Cohen 1997; Dasgupta et al. 2001; Gupta and Goldar 2005; Lundgren and Olsson 2009). Mishra and Modi (2013) highlight an asymmetric effect of positive versus negative CSR activities on risk.

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They show that positive engagement (i.e., strengths) in CSR allows for a reduction in the firm’s specific risk, unlike negative CSR activities (i.e., concerns) that lead to an increase. Oikonomou et al. (2012) validate a weak negative relationship between positive ESG activities and the firm’s systematic risk but a strong link between negative ESG activities and the firm’s total risk. This result suggests that the negative impact of ESG performance on risk stems mainly from the reduction of negative CSR activities since the market seems more sensitive to negative ESG activities (i.e., concerns). Jo and Na (2012) argue that these conclusions depend on the firm’s industry and that the risk reducing impact of CSR activities should be more pronounced for firms that operate in controversial industries. Regarding the environmental dimension specifically, literature results validate the asymmetrical effects of positive and negative CSR activities on risk. For example, Klassen and McLaughlin (1996) observe a positive stock market reaction for firms with rigorous environmental management activities. Dasgupta et al. (2001) show that, despite weak enforcement of environmental regulations, capital markets in Argentina, Chile, Mexico, and the Philippines react to environmental events. Their results show that 51% (39%) of positive (negative) environmental events have a significant positive (negative) impact on the firm’s market value. In the European context, Lundgren and Olsson (2010) also highlight the negative effects of environmental incidents on firm value. A higher frequency of environmental incidents, which translates into more severe regulatory actions (Konar and Cohen 2001), can negatively affect firms’ financial performance. Market reaction to media news can also create incentives for pollution control in both developed and developing economies (Dasgupta et al. 2001; Gupta and Goldar 2005). By examining the impact of firms’ environmental rankings on financial performance for the automotive and pulp and paper industries, Gupta and Goldar (2005) show that the market penalizes firms with the lowest EP with negative abnormal returns that can reach -30%. Bouslah et al. (2013) look at nonfinancial firms and explore the impact of EP on risk and validate the asymmetrical effects of positive and negative environmental activities. Specifically, their results show that positive environmental activities reduce the risk for firms, while negative environmental activities have no significant impact on various risk measures. Cai et al. (2016) find that the firm can reduce its risk by increasing its environmental strengths and by decreasing its environmental concerns. These results corroborate those by Lankoski (2009) who shows that the economic impacts of ESG performance are stronger when negative externalities are decreased than when positive externalities are increased. In fact, Chatterji et al. (2009) test the effectiveness of KLD-MSCI ratings in evaluating environmental activities and find a significant difference between the scores for positive and negative activities. These results suggest that an aggregated EP measure does not take into account the particularity of positive and negative activities nor avoids the compensatory effect of positive and negative scores. Some studies also find that firms with high scores for strengths also have high scores for concerns (Mattingly and Berman 2006; Delmas and Blass 2010).

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Overall, we expect environmental concerns to predict negative environmental events and environmental strengths to predict positive environmental events, as highlighted in the second research hypothesis below: H2: A firm’s environmental concerns (strengths) are positively related to the probability of negative (positive) corporate environmental events.

2.4.3

Compensation Effect

The few studies that examine responsible and irresponsible corporate behaviors suggest different motivations to explain the two behaviors. Moreover, although positive and negative ESG activities are conceptually different, the two types can be positively correlated (Mattingly and Berman 2006; Oikonomou et al. 2012). This result calls into question the fungibility hypothesis and has been validated by several authors such as Mattingly and Berman (2006), Strike et al. (2006), Delmas and Blass (2010), and Kotchen and Moon (2012). Their results show that firms with high ESG strengths also tend to have high ESG concerns. The same firm can therefore be respectful of the environment and, at the same time, behave irresponsibly. For example, Mattingly and Berman (2006) show that firms that adopt good environmental activities are often those that are most likely to harm the environment. According to Kotchen and Moon (2012), this implies a deliberate intention by firms who engage in CSR activities to mitigate, or even hide, some of their negative activities. According to Chatterji and Toffel (2010), firms with low EP scores are more likely to subsequently improve their environmental activities and benefit from a higher EP afterward. This behavior allows firms that are most likely to cause environmental damage to remedy their negative environmental impacts by adopting good environmental activities (Mattingly and Berman 2006). Stakeholder theory provides an explanation for the coexistence of responsible and irresponsible behaviors. Specifically, a good perception by stakeholders about the firm’s CSR activities can contribute to the building of good social capital or a goodwill reservoir from which the firm can draw in times of crisis (Fombrun 2001). This stakeholder perception can directly influence CSR activities. For example, some firms can be tempted to strengthen their social capital by promoting and overinvesting in positive environmental activities when they expect an adverse event in order to reduce the media coverage of bad news (Bouslah et al., 2013). Firms can also use this social capital and positive stakeholder perception to “insure” against CSR activities. This perceptual strategic CSR concept highlights a “protective halo” effect during a crisis (Coombs and Holladay 2006; Seeger and Ulmer 2001). This halo can translate into stakeholders who would more easily give the benefit of the doubt to the firm in the case of adverse events or bad news (Caponigro 2000). In times of crisis, stakeholders may also be more inclined to overlook the criticism (and only retain the positive) about the firms they like (Coombs and Holladay 2006; Seeger and Ulmer 2001). A positive perception by stakeholders can therefore act as a shield against losses in the case of adverse events.

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Other explanations can help explain the link between responsible and irresponsible behaviors. Kang et al. (2016) argue that CSR can be used as a penance mechanism to undo the negative effects caused by their irresponsible behavior. In other words, responsible behaviors can help “wash away the sins” of irresponsible behaviors. Firms engage in CSR activities to correct, compensate, or even mask their ESG-related irresponsibility (Heal 2005; Kotchen and Moon 2012; Kang et al. 2016). Kotchen and Moon (2012) argue that when companies do “more harm,” they also do “more good.” Given the nature of the firm’s operations, which may expose it to a greater risk of adverse environmental events, managers may decide to invest in projects that have a positive environmental impact. This will be all the more valuable for firms that are active in industries that receive more public attention (Kotchen and Moon 2012). This mechanism of compensating for weaknesses with strengths does not necessarily imply opportunisms and may reflect a good ethical sense on the part of the firm. Firms may very well want to build on their CSR strengths while still managing their concerns. Compensating investments can be real and have true benefits for the environment or society. However, it can also be used as window dressing or other greenwashing activities which would reflect a camouflage strategy on the part of the manager who tries to cover up the firm’s bad EP. For example, the firm can exaggeratingly publicize the little it does in terms of its environmental commitment (Kotchen and Moon 2012; Kang et al. 2016). The firm’s CSR commitment would then imply a communication or risk anticipation strategy aimed at getting and/or preserving a positive image. CSR activities can also be used as window dressing, while business as usual remains in the background. Given that the effects of positive versus negative CSR activities are manifested in the case of firms that combine both strengths and concerns scores (Strike et al. 2006), we propose the following research hypothesis based on the compensation effect: H3: Firms with both environmental strengths and concerns are associated with a higher probability of corporate environmental events.

3 Methodology 3.1

Data

To test our research hypotheses, we need data on EP and on corporate environmental events. We measure EP with extra-financial ratings by MSCI ESG KLD STATS, which are widely analyzed in the economic and financial literature (see, e.g., Oikonomou et al. 2012; Bouslah et al. 2013; Krüger 2015). Because of its extensive coverage (Waddock 2003; Carroll and Shabana 2010), the database is also widely used by investors (Chen and Delmas 2011; Jo and Na 2012). The rating agency assesses the positive and negative activities on seven dimensions of CSR, including the environment. For each dimension, the agency evaluates the firm’s strengths and

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concerns by assigning the value 1 if the strength or concern indicator is present and 0 otherwise.3 To collect corporate environmental events, we construct a unique database of environmental events, based on news articles in the Wall Street Journal (WSJ), for companies in the S&P500. These media-reported environmental events, which can include corporate-caused environmental catastrophes such as oil spills, are linked not only to potential financial losses but, more importantly, to the image or reputation of the firm. We collect events from the ProQuest ABI/INFORM electronic database which archives all the articles published in the WSJ. Our methodology for constructing this database is explained in Appendix I. Our final sample consists of 90 positive environmental events and 280 negative events between 2000 and 2014.4 These events involve 819 distinct firms and 8092 firm-year.

3.2

Model Specification

We wish to examine the impact of a firm’s EP on the probability of occurrence of corporate environmental events. To do so, we use the following logit model: F ð ωÞ = eβ0 þβ1 EPi,t - 1 þ 1 - F ðωÞ

βk X i,t - 1 þ εi,t

,

ð1Þ

PðY i = 1Þ of event where 1 -FðFωðÞωÞ = 1 -probability probability of event = 1 - PðY i = 1Þ and where the dependent variable, Yi, takes the value of 1 if firm i experiences a corporate environmental event and 0 otherwise. The main variable of interest, EPi,t-1, represents firm i’s aggregate environmental performance at t - 1. We follow the common method in the literature (see, e.g., Harjoto and Jo 2008; Jiraporn et al. 2014 or Bouslah et al. 2013, 2018) and measure it by subtracting firm i’s score for environmental concerns from its score for strengths at t - 1, both taken from the MSCI-KLD database:

EPi,t - 1 = EP‐strengthsi,t - 1 - EP‐concernsi,t - 1 ,

ð2Þ

where the scores for environmental strengths and concerns are standardized as follows to overcome the non-constancy of the different indicators in the MSCIKLD database:

Since the acquisition of KLD by MSCI in 2010, all firms in the coverage universe have been evaluated with a continuously decreasing number of ESG indicators. Thus, for the sake of consistency, we focus on ESG ratings from 2001 to 2013. 4 As explained in Appendix I, an adverse ESG-related event can be composed of more than one newspaper article if it relates to the same event and the same firm. 3

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EP - strengthsi = EP - concernsi =

ns i = 1 str i

ns nc i = 1 coni

nc

where ns = number of strengths indicators: where nc = number of concerns indicators:

To account for the contingency nature of the relationship, we add commonly used firm-specific control variables: size, financial performance, risk, and industry (see, e.g., Waddock and Graves 1997; Andersen and Dejoy 2011). Specifically, SIZEi is measured by the natural logarithm of the firm’s market capitalization. Financial performance, ROAi, is measured by the return on assets ratio. Firm risk, RISKi, is captured by the firm’s financial leverage measured by the ratio of total assets to total equity. Significant differences may also exist between different industries in terms of dissemination of ESG activities (Waddock and Graves 1997). Moreover, since the nature of each industry’s activities entails different levels of risk, notwithstanding risk management, we control for industry effects with a series of ten binary variables for the following sectors (taken from the Industry Classification Benchmark classification): oil and gas, materials, industry, retail goods, health, retail services, telecommunications, utilities, finance, and technology. Finally, we add a binary variable that equals 1 if firm i is not in the S&P500 index when the environmental event occurs and zero otherwise. We also consider the potential impact of macroeconomic variables. Theories that link CSR to financial performance and business risk often refer explicitly or implicitly to the health of the economy. Champagne et al. (2015) argue that the conditioning of firm performance and beta to macroeconomic variables distinguishes between the portion of performance and risk evolution attributable to the economic context and that related to changes in extra-financial performance. To avoid multicollinearity issues and reduce the number of variables, we use a principal component analysis (PCA) technique on a set of ten macroeconomic variables: gross domestic product, monetary mass M2, consumer price index, production price index, consumer sentiment index, current employment situation, retail and food services sales, housing starts, manufacturing and trade inventories and sales, and S&P500 market index return. From these variables, we identify three factors that are added to model (1): FACT1, FACT2, and FACT3. Finally, to capture the effect of the economic risk that can affect the level of CSR investment, we add three financial market variables: the level of risk-free rate (Rf), the credit spread (SPREAD), and the slope of the structure term (TERM).5

5

Descriptive statistics for all variables is available upon request.

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4 Impact of Environmental Performance on the Probability of Corporate Environmental Events 4.1

Aggregate Environmental Performance

Results presented in Table 1 show a negative relationship between aggregate EP and the probability of corporate environmental events. In Panel A, we observe a significant negative relationship between aggregate EP and the probability of positive environmental events for two out of four model specifications. The relationship is not significant when firm-specific control variables are added. In Panel B, we observe that an increase in aggregate EP is associated with a decrease in the probability of a negative environmental in all four cases. These results show that an aggregate measure of EP is a good predictor of negative corporate environmental events reported by the media but a bit less so for positive events.

Table 1 Impact of environmental performance on the probability of environmental event Panel A: Positive environmental events [1] [2] [3] [4]

Panel B: Negative environmental events [5] [6] [7] [8]

Environmental performance (EP) EP t-1

-0.2396** (-2.5154)

-0.0768 (-0.8703)

-0.2334** (-2.3802)

-0.0319 (-0.3328)

-0.4059*** -0.2936*** -0.4390*** -0.3325*** (-6.7752) (-4.822) (-7.4439) (-5.5926)

Company-specific control variables 0.4556*** (10.1421) 0.1171 (0.7993) -0.1380 (-0.5463)

SIZE t-1 ROA t-1 RISK t-1

-0.4449*** (9.4928) 0.1042 (0.6956) -0.2061 (-0.6961) -1.7770** (-2.4497) Yes

SP500 t

0.3702*** (10.0530) 0.2690*** (2.8220) 0.0233 (0.3018

0.3428*** (9.0599) 0.2736*** (2.7769) 0.0234 (0.2975) -1.1027*** (-3.1535) Yes

Industry dummies No Yes No No Yes No Macroeconomic and financial control variables Macroeconomic factors No No Yes Yes No No Yes Yes Financial variables No No Yes Yes No No Yes Yes -4.7690*** -5.0331*** -4.8195*** -4.8263*** -3.9966*** -4.1171*** -4.2133*** -4.1971*** Constant (-38.4982) (-35.0057) (-28.5910) (-25.7373) (-46.0488) (-43.948) (-35.6354) (-32.146) # of observations Adj. R-squared

8092 0.0075

7810 0.1227

8092 0.022

7810 0.1548

8092 0.0263

7810 0.0938

8092 0.0374

7810 0.1145

This table presents the results of the estimation of model (1) where EP is the aggregate EP measured with Eq. (2). All variables are defined in Sect. 3.2. For each variable, the table presents the odds ratios which are the exponentials of the logit regression coefficients estimated by the maximum likelihood method as well as the z statistic values calculated with the Wald test. The sample includes 8092 firm-year observations from 2000 to 2014. The R2 is the McFadden adjusted pseudo Rsquared. *, **, and *** indicate level of significance at the 10%, 5%, and 1%, respectively

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Environmental Strengths and Concerns

In this section, we decompose our aggregate EP measure into strengths and concerns. Table 2 presents the results for the regression of environmental strengths (concerns) on the probability of positive (negative) corporate environmental events. From Panel A, we see that, while aggregate EP was a relatively weak indicator of positive environmental events, the environmental strengths score of a firm is a much better determinant of positive events, with a significant coefficient in all cases (specifications 1 to 4). Specifically, based on model specification (4), a 1% increase in the standardized strength score increases the odds of experiencing a positive corporate environmental event by 16. In Panel B, we observe that higher environmental concerns increase the probability of experiencing a negative event. Specifically, based on model specification (8), a 1% increase in the standardized concerns score multiplies the odds of experiencing a negative corporate environmental event by 22. In sum, consistent with our second research hypothesis and stakeholder theory, we observe that higher environmental strengths increase the probability of positive events and higher concerns increase the probability of negative events. In Panels C and D, we present the results for the regression of environmental strengths (concerns) on the probability of negative (positive) corporate environmental events. Panel C shows that higher concerns increase the probability of positive events, and Panel D shows that high strengths increase the probability of negative events. These results, consistent with our third research hypothesis, imply a compensating effect whereby firms that have environmental concerns compensate with environmental strengths. In other words, firms appear to compensate their exposure to environmental risks (i.e., concerns) through positive environmental activities (i.e., strengths).

4.3

Environmental Performance Levels and Categories

In order to better understand and interpret our previous results, especially those related to the compensating effect, we analyze the probability of environmental events according to the environmental performance category of the firm-year. We start by dividing our sample into three strengths and three concerns levels: zero, low, and high. In Table 3, we examine the probability of environmental events conditional on the firm’s EP level. Results in Panel A show the probability of events according to the level of environmental strengths of the firm-years in our sample. For firms with no environmental strengths (ZERO-STRENGTHS), the probability of a positive (negative) environmental event is 0.92% (0.87%) lower than for all other firms in our sample. For firms with the highest positive strengths, the probability of a positive (negative) event is 2.09% (1.02%) higher than for all other firms.

0.4425*** (10.0661) 0.1029 (0.7004) -0.1316 (-0.5200)

0.4124*** (8.9798) 0.1001 (0.6655) -0.1672 (-0.5697) -1.5051*** (-2.0624) Yes

Panel C: Positive environmental events [9] [10] [11] [12]

0.2962*** (7.4476) 0.3219 (3.2774) 0.03832 (0.5210)

0.2793*** (6.9600) 0.3327*** (3.2580) 0.0331 (0.4367) -0.9158*** (-2.6056) Yes

0.3732*** (7.5606) 0.1823 (1.1791) -0.0912 (-0.3967) 0.3665*** (7.2485) 0.1674 (1.0602) -0.1358 (-0.4970) -1.6619** (-2.2868) Yes

4.0055*** 3.2311*** 4.0233*** 3.1333*** 4.2038*** 2.5612*** 4.2390*** 2.3929*** (11.9473) (8.6105) (11.7257) (8.17306) (8.7699) (4.4506) (8.5192) (4.0545)

Panel B: Negative environmental events [5] [6] [7] [8]

0.3849*** (10.7865) 0.2277** (2.4267) 0.0243 (0.3057)

0.3639*** (9.9939) 0.2319** (2.3801) 0.0224) (0.2704) -0.9803*** (-2.7864) Yes

1.5557*** 0.9959*** 2.0201*** 1.0378** (5.2287) (3.1448) (5.3444) (2.5542)

Panel D: Negative environmental events [13] [14] [15] [16]

0.0398

0.1357

0.0798

0.1824

0.0714

0.1197

0.0768

0.1329

0.0734

0.1439

0.0871

0.1737

0.0143

0.0847

0.0225

0.0992

This table presents the results of the estimation of model (1) where EP is either the measure of environmental strengths or the measure of environmental concerns defined in Sect. 3. All variables are defined in Sect. 3.2. For each variable, the table presents the odds ratios which are the exponentials of the logit regression coefficients estimated by the maximum likelihood method as well as the z statistic values calculated with the Wald test. The sample includes 8092 firm-year observations from 2000 to 2014. The R2 is the McFadden adjusted pseudo R-squared. *, **, and *** indicate level of significance at the 10%, 5% and 1%, respectively

Adj. R-squared

Industry dummies No Yes No No Yes No No Yes No No Yes No Macroeconomic and financial control variables M acroeconomic factors No No Yes Yes No No Yes Yes No No Yes Yes No No Yes Yes Financial variables No No Yes Yes No No Yes Yes No No Yes Yes No No Yes Yes -5.1593*** -5.2772*** -5.2423*** -5.1772*** -4.4093*** -4.4435*** -4.5277*** -4.4548*** -5.3204*** -5.3060*** -5.3130*** -5.0700*** -4.1007*** -4.1989*** -4.2111*** -4.1807*** Constant (-32.8659) (-30.9208) (-26.9872) (-23.9583) (-41.3361) (-39.5868) (-34.8468) (-31.0676) (-32.2572) (-31.4680) (-27.0175) (-24.6437) (-42.5148) (-40.2972) (-35.0734) (-31.1063) # of observations

SP500 t

RISK t-1

ROA t-1

SIZE t-1

Company-specific control variables

EP-concerns t-1

Panel A: Positive environmental events [1] [2] [3] [4] Environmental performance (EP) 2.4784*** 1.5354*** 3.9698*** 2.7832*** EP-strengths t-1 (-6.4184) (3.5533) (7.9226) (4.9391)

Table 2 Impact of environmental strengths and concerns on the probability of environmental event

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Table 3 Probability of environmental event conditional on environmental performance level and category

EP Levels/Category Zero-Strenghts Panel A Low-Strengths ]0;2σ[ High-Strengths [2;4+σ[ Zero-Concerns Panel B Low-Concerns ]0;2σ[ High-Concerns [2;4+σ[ Neutral Good Panel C Bad Compensation

Positive environmental events P(Y=1|in category) P(Y=1|not in category) Net effect 0.33% 1.26% -0.92% 1.07% 0.43% 0.64% 2.61% 0.52% 2.09% 0.33% 1.33% -1,00% 1.2% 0.4% 0.81% 1.21% 0.58% 0.63% 0.18% 1.17% -0.98% 0.74% 0.56% 0.18% 0.87% 0.55% 0.31% 1.67% 0.44% 1.23%

Negative environmental events P(Y=1|in category) P(Y=1|not in category) 1.36% 2.22% 2.05% 1.46% 2.61% 1.58% 0.97% 3.39% 3,00% 1.18% 4.51% 1.52% 0.86% 2.63% 1.2% 1.71% 3.4% 1.36% 3.23% 1.36%

Net effect -0.87% 0.6% 1.02% -2.42% 1.82% 2.98% -1.77% -0.51% 2.05% 1.87%

This table presents the probability of experiencing an environmental event conditional on the level and category of environmental performance defined in Sect. 4.3

Results in Panel B show the probability of events according to the level of environmental concerns of the firm-years in our sample. We see that firm-years with no environmental concerns (ZERO-CONCERNS) have a lower probability of experiencing either a positive or a negative environmental event. Specifically, the probability of a positive environmental event is 1.00% lower (0.33% vs 1.33%) for zero-concern firm-years than for all other firm-years, while the probability of a negative event is 2.42% lower (0.97% vs 3.39%). For firms with positive concerns, low and high, the probability of a negative event is, respectively, 1.82% and 2.98% higher than for all other firms in our sample. To better understand these results, we consider four EP categories that combine different levels of strengths and concerns: (i) neutral (firms with zero environmental strengths and zero environmental concerns), (ii) good (firms that have nonzero strengths and zero concerns), (iii) bad (firms that have zero strengths and nonzero concerns), and (iv) compensation (firms that have nonzero strengths and nonzero concerns). The breakdown of observations in each EP category is available in Table 4. Compensation firms are more exposed to positive environmental events with a net probability of 1.23%, while both bad and compensation firms are more exposed to negative environmental events with a net probability of 2.05% et 1.87%, respectively. For the entire sample, we see that 13.53% of firm-years are in the compensation category, which can offer some explanation for the results above. Statistics vary greatly according to industry. For example, the percentage of firmyears in the compensation category varies from 2.75% for the finance industry to 46.93% for public services. Similarly, the percentage of firm-years in the bad category ranges from 2.08% for the finance industry to 36.92% for the materials sector. Going back to Table 3, Panel C shows the probability of events conditional on the EP category. We see that firm-years in the neutral category have a lower probability of experiencing an environmental event, either positive or negative, than any other categories. Firm-years in the good category have a higher probability of

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Table 4 Decomposition of environmental categories EP categories Neutral Good Bad Compensation Total

4605 1374 1018 1095 8092

N 56,91% 16,98% 12,58% 13,53% 100,00%

Oil & gas EP categories Neutral 174 30,21% Good 59 10,24% Bad 197 34,20% Compensation 146 25,35% 100,00% Total 576 EP categories Consumer services Neutral 880 75,28% Good 174 14,88% Bad 76 6,50% Compensation 39 3,34% Total 1169 100,00%

Positive events 10 0,22% 12 0,87% 15 1,47% 34 3,11% 71 0,88% Materials 59 14,43% 36 8,80% 151 36,92% 163 39,85% 409 100,00% Telecom 115 82,73% 9 6,47% 11 7,91% 4 2,88% 139 100,00%

Negative events 44 0,96% 22 1,60% 42 4,13% 56 5,11% 164 2,03% Industrial Consumer goods 559 44,76% 509 51,10% 236 18,90% 224 22,49% 204 16,33% 126 12,65% 250 20,02% 137 13,76% 1249 100,00% 996 100,00% Public services Finance 24 5,07% 1120 83,15% 64 13,53% 162 12,03% 163 34,46% 28 2,08% 222 46,93% 37 2,75% 473 100,00% 1347 100,00%

Health 507 69,83% 125 17,22% 29 3,99% 65 8,95% 726 100,00% Technologies 658 65,28% 285 28,27% 33 3,27% 32 3,17% 1008 100,00%

This table presents the decomposition of firm-years into environmental performance categories defined in Sect. 4.3

experiencing a positive event and a lower probability of experiencing a negative event than firms in other categories. Firms in the bad or the compensation category have a higher probability of experiencing negative environmental events than other firms. For firms in the compensation category, this observation can be explained by the fact that some firms with nonzero concerns and nonzero strengths invest in environmentally good projects in order to compensate for their poorer EP. If firms can increase their environmental strengths performance through improved environmental activities, they will be included in the compensation category. They will also have an improved aggregate EP, everything else being equal, which can explain some results from Table 1.

5 Conclusion This research is part of the continuously growing literature on the relationship between ESG and risk and examines whether a firm’ EP, as measured by an extrafinancial rating, truly impacts the probability of experiencing an environmental event, either positive or negative. We focus on the environmental scores obtained by MSCI-KLD for 819 firms and a sample of 557 environmental events spread over the period from 2000 to 2014, which yields over 8092 firm-year observations.

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By using the aggregate EP measure, our results show that the level of aggregate EP only explains the probability of occurrence of negative media events. Specifically, an increase in EP leads to a decrease in negative events. This negative relationship supports the negative relationship documented in the literature between ESG and EP measures and corporate financial risk measures. Further, consistent with our second research hypothesis, we observe that higher environmental strengths increase the probability of positive events and higher concerns increase the probability of negative events. This conclusion supports stakeholder theory which implies that firms with positive (negative) environmental activities can expect lower (higher) environmental and social risks. Indeed, positive environmental policies that result in an increase in the occurrence of positive events reduce the information asymmetry for the investor and thereby mitigate ESG-related reputation risk for the investor if this information is perceived as a signal of management quality (McGuire et al. 1988; Waddock and Graves 1997). Negative environmental activities, on the other hand, increase ESG-related reputation risk, as measured by the probability of occurrence of negative events. These firms may be perceived by investors as riskier investments as they are more prone to environmental crises and not well positioned to be in compliance with stricter environmental regulations in the future. Our results confirm that the disaggregated EP scores reflect the environmental risk experienced by firms by highlighting the inseparable nature of environmental issues and corporate reputational risk, as suggested by Peloza (2009). Indeed, companies have an interest in both minimizing controversial activities and improving their environmental activities in order to better manage their reputational risk associated with environmental issues. Also, consistent with our third hypothesis, we find that environmental concerns increase the odds of having a positive event while environmental strengths increase the probability of a negative event. Firms with high environmental concerns may be tempted to invest in environmental activities in order to increase their strength score. Firms with high concerns scores may thus also end up with high strength scores which can explain the positive link between environmental strengths and negative events. Finally, firms in the compensation category, that is, firms presenting simultaneously nonzero concerns and nonzero strengths, show higher probabilities of experiencing either positive or negative events.

A. Appendix: Construction of the Environmental Events Database To construct our database of environmental events, we proceed in the three steps explained below: 1. We establish a list of keywords that can be associated with environmental events. These keywords are based on previous empirical studies by Krüger (2015) and

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Bouslah et al. (2013). The list of keywords for the environment dimension is presented below:

Keywords for the Environment dimension Air pollution Oil Water stress Water pollution Forest Biodiversity Recycling Fuels Land use Energy Mining Raw material Hazard Ocean Regulatory Toxic Wildlife Activists Waste Fauna Mismanagement Chemicals Flora Climate change Emissions Drinking water Environmental Hazard Agriculture Public health Ecological Nuclear Contamination Ozone Gas Regulation

2. Each article collected in the first step is read and categorized either as a positive or negative corporate event. For example, if the event is associated with a lawsuit, a fine, a sanction, a complaint, etc. it’s considered to be negative for the firm. 3. If two or more articles are related to the same firm and the same event, they are combined and count as one event for the firm. For example, if 5 articles cover a specific lawsuit for firm i over a period of 2 years, they will be combined and counted as 1 even for firm i.

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Claudia Champagne is Professor of Finance at École de gestion, Université de Sherbrooke (Sherbrooke, Canada). She is the main researcher for the Desjardins Chair in Responsible Finance. She is a member of the editorial board for the IEB International Journal of Finance. Her research works have appeared in academic journals, such as the Journal of Banking and Finance, the Journal of Asset Management and Financial Management. Her current research interests include responsible finance, corporate social responsibility, financial network analysis, risk management, and financial institutions management. Samuel Chrétien is Senior Manager at the National Bank of Canada (NBC). He holds a Master’s degree in Finance from the University of Sherbrooke. He showed interest on the link between corporate social responsibility and finance, which he studied as the theme of his essay. Having evolved for many years at NBC, he has developed an expertise in securitization while being actively involved in the establishment of NBC’s Sustainability Bond Program. As part of his larger mandate within the Finance team, Samuel continues to be engaged in diverse initiatives related to sustainability within NBC.

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Frank Coggins is Full Professor in the Finance Department, École de gestion, Université de Sherbrooke (Canada). He is Chairholder of the Desjardins Research Chair in Responsible Finance. His research works have appeared in renowned journals such as the Review of Finance and the Journal of Banking and Finance. His current research focuses on assessing and managing financial and non-financial risks in a sustainable finance context. He is also collaborating with financial industry experts to develop applied research in artificial intelligence to ESG investing, ESG risk factor analysis, and zero-carbon investment strategies. Hajer Tebini is a full-time lecturer in management and the Coordinator of the Certificate in Sustainable Development at HEC Montréal (Montreal, Canada). She is a researcher associated with the Desjardins Chair in Responsible Finance (École de gestion, Université de Sherbrooke). She completed a postdoctoral program in finance at Université de Sherbrooke (Sherbrooke, Canada). She holds a Ph.D. degree in finance from UQAM (Montreal, Canada). Her primary areas of research interests include sustainable development and responsible finance.

Ethical Leadership as a Prerequisite for Sustainable Development, Sustainable Finance, and ESG Reporting Maria Krambia-Kapardis, Ioanna Stylianou, and Christos S. Savva

1 Introduction As highlighted by Elali (2021), economic and noneconomic crises in recent years have disrupted business commonalities and strengthened the importance of businesses long-term survival and resiliency. Against this backdrop Tanjung (2021, 387) advocated that environmental, social, and governance policies and disclosure of such policy implementation “serves as a guarantor that decreases risks and volatility while maintaining market efficiency.” Similarly some authors (Díaz et al. 2021, 2) have found that during the COVID-19 pandemic when the market was volatile, firms that disclosed their environmental, social, and governance (ESG) policies proved to be resilient while at the same time “firms with high ESG scores outperform the S&P 500 index and firms with low ESG scores underperform the S&P 500.” How do firms achieve long-term survival, and what makes firms resilient to economic and noneconomic shocks? Radi (2021) maintains that a company’s culture and activities affect the organization’s sustainability. This does prove the importance of contextualizing sustainable development, sustainable finance, ESG reporting, and ethical leadership. In this chapter the authors will attempt to answer the following two research questions: Does the industry of a company affect its ESG reporting? Is ethical leadership driving ESG reporting? In the second decade of the twenty-first century, companies had to address among other issues, modern slavery cases and disclosure requirements, environment and climate change, the COVID-19 pandemic,

M. Krambia-Kapardis (✉) · C. S. Savva Cyprus University of Technology, Limassol, Cyprus e-mail: [email protected]; [email protected] I. Stylianou University of Central Lancashire, Larnaka, Cyprus e-mail: [email protected]

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_6

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and the Russian invasion of Ukraine. Thus, there is a call from regulators and policy makers for organizations to address these socio-economic-political issues, report on ESG in an effort to appear more attractive to investors and achieve sustainable finance. A driving force in these expectations is the skills and toolsets the leaders of the organization possess. Let us set the scene by firstly contextualizing sustainable development.

2 Contextualizing Sustainable Development Sustainable development’s first ever definition was introduced by the Brundtland Report in 1987 as “the development that meets the needs of the present without compromising the ability of future generations to meet their own needs” (IISD 2021). This concept had already been adopted since 1960 when it was first proposed as an answer to environmental problems and the outburst of social injustice which occurred from the industrial revolutions (Lenka and Kar 2021, 202). Sustainability can be seen as an equilibrium between the business inputs that are taken away from its resources and the outputs that come back to the environment from raw materials, work-life balance to bottom-line profit (Moore and Wen 2008, 173; Figge and Hahn 2005). Also, sustainability’s current global framework is based on the 2030 Agenda for Sustainable Development and the 17 Sustainable Development Goals (SDGs) which were launched in 2015 (IISD 2021). Their targets are the following: (1) to end poverty around the world in all forms; (2) to end hunger and achieve food security, nutrition improvement, and promotion of sustainable agriculture; (3) to guarantee healthy lives and promote well-being for all people no matter what their age is; (4) to encourage lifelong learning opportunities and guarantee full and fair quality education; (5) to accomplish equal gender rights and empower all women and girls; (6) to make sure that there is available and sustainable management of water and sanitation for all people; (7) to confirm that there is access to reasonable, affordable, sustainable and modern energy for all people; (8) to develop for all people sustained, inclusive, and sustainable economic growth and full and productive employment; (9) to promote innovation, foster full and sustainable industrialization, and set up resilient infrastructure; (10) to diminish inequality within and between countries, (11) to construct cities and human settlements based on inclusiveness, safety, resilience, and sustainability; (12) to ensure sustainable consumption and production patterns; (13) to take necessary and immediate actions to fight climate change and its consequences; (14) to preserve and utilize sustainable marine resources, oceans, and seas for sustainable development; (15) to restore, protect, and promote sustainable utilization of earthly ecosystems, sustainable management of forests, fight desertification, pause and change land degradation, and arrest biodiversity loss; (16) to encourage peaceful and inclusive societies for the development of sustainability, give access to justice for all people and construct institutions that are inclusive, effective, and accountable at all levels; and (17) to reinforce the application methods and re-energize the global partnership of sustainable development

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(United Nations website 2021). The aim of these goals is a promise to “leave no-one behind,” thus, replacing at some point the 8 Millennium Development Goals (MDGs) which were created back in 2000 (Eurosif 2018, 55). The European Union considers sustainable development as its central policy objective, and the very first EU Sustainable Development Strategy was formed in 2001. This strategy was a unique, reasonable plan on how to address the EU’s sustainable development challenges (Eurosif 2018, 65). The plan was revised in 2006 and 2009 with the purpose to improve quality of life and establish prosperity, environmental protection, and social cohesion (Eurosif 2018, 65). Next, the European Council on the 17th of June of 2010 adopted the Europe 2020 strategy which prioritizes smart, sustainable, and inclusive growth that represents the EU’s application policy agenda for sustainable development (Eurosif 2018, 65). Thus, all these initiatives and plans suggest that European Union’s primary goal is to make its economy green, more resilient, and circular (Martini 2021, 11). In making sustainable decisions, organizations ought to focus and report on energy usage, water management, biodiversity, and carbon emissions (i.e., environmental issues (E)) and human capital management, human rights, diversity, health and safety, and modern slavery (i.e., social issues (S)) and shareholder transparency, board structure and ownership structure, as well as how a company is managed (i.e., governance issues, (G)). Martini (2021, 7) argues that the necessity of sustainable development is high in achieving successful performances in the long term. Certainly, companies can contribute to sustainable development by their operations management in ways of increasing economic growth and competitiveness, thus at the same time protecting the environment and encouraging social responsibility with the inclusion of consumer interests (Samy et al. 2010, 204). Lenka and Kar (2021, 203) describe sustainable development in the corporation context as the way to accept business strategies and activities which meet the stakeholders and organization needs and at the same time ensuring, assisting, and increasing the human and natural resources which are going to be beneficial in the meantime. So, when financial institutions and businesses focus on sustainability regarding their decision-making and when they foster innovation in solving their environmental challenges, then their contribution to worldwide society is significantly positive, and they also increase their competitiveness. Therefore, achieving a sustainable future is considered the best return on investment (IPSF 2020, 2). Thus, the main responsibility of a business corporation is to sustain its profit by ensuring sustainable development goals, achieve human development, and sustain the volume of natural system to offer to economy and society the necessary natural resource and ecosystem services (Lenka and Kar 2021, 204). Lenka and Kar (2021) also argue that achieving sustainable development goals in a company is difficult but not impossible if there are rules and regulations. In agreement with Lenka and Kar (2021, 204), the authors believe that this can be achieved by placing simple and understandable guidelines describing what employees and employers should avoid and what they are expected to do. Therefore, companies recognized the importance to become sustainable by becoming socially responsible businesses (Moore and Wen

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2008, 174). The idea of social responsibility became well-known in businesses in the 1950s, and since then many organizations took “social responsibility programs by the rise of consumerism, the heighten public awareness of environmental and ethical issues and the increased pressure of organized activist groups” (PapasolomouDoukakis et al. 2005, 264). It has been advocated that those businesses which adopt sustainable approaches to protect the environment and care for society can have a long-term value in many areas (Moore and Wen 2008, 174). Long-term value is created through the acceptance of opportunities and management of risks which arise from economic, environmental, and social developments (Fowler and Hope 2007).

3 Disentangling Sustainability and ESG Sustainability has its roots in corporate social responsibility. For organizations to be considered sustainable, one would look at the environmental, social, and governance factors. ESG factors measure the activities of the organization’s actions and evaluate how advanced they are with sustainability. In fact, the Edelman (2022, 26) trust barometer has found that 88% of institutional investors are “subject ESG to the same scrutiny as operational and financial considerations.” Thus, ESG is important to sustainable finance. It has been advocated that companies that behave responsibly toward the environment and society aim to make the world a safer place. Thus, by disclosing their ESG policies they are sustainable and earn “a reputation that the firm is reliable and honest” (McWilliams and Siegel 2001, 120). Governments, therefore, ought to encourage and foster ESG reporting if they wish to attract capital inflows and boost investor’s confidence (Nasrallah and El Khoury 2022). Having a high ESG score will attract potentially prominent and wealthy investors (El Khoury et al. 2021), and at the same time better-performing companies have more financial resources to use on ESG (Margolis et al. 2007). It appears more like the chicken and egg causality dilemma. Tanjung (2021, 387) in advocating for ESG disclosure and implementation of ESG policies highlighted that “ESG performance serves as a guarantor that decreases risks and volatility while maintaining market efficiency,” and at the same time information asymmetry is reduced because trust is developed between investors and stakeholders (Martínez-Ferrero et al. 2016; Siew et al. 2016). It therefore implies that responsible managers and investors are attracted to companies that disclose and implement ESG policies (Przychodzen et al. 2016) because they reduce the exposure of the entity to the severity and harmful effect of economic crisis (Bouslah et al. 2018). It is worth noting however, that studies over the years have highlighted that ESG scores and methodologies lack data transparency and inconsistencies (Fiaschi et al. 2020), while Tanjung (2021) explains that ESG ratings and indexes are important for benchmarking for the benefit of companies, investors, and government regulators. In this chapter, however, we are not looking to evaluate or determine the reliability of ESG indexes but the mere disclosure of ESG policies and

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practices of companies that can enhance the sustainability of the company and its finance. Thus far the paper has put into context sustainable development and placed it within the expectations of stakeholders. The underlying prerequisite and driving force for companies is to be sustainable and to disclose their ESG policies which, in turn, would lead to sustainable investment and finance. The driving force however behind both is the leadership of the company and the corporate culture fostered by the leader, but let’s briefly look at sustainable finance/investment before looking at ethical leadership.

4 Sustainable Investment Fowler and Hope (2007, 243) acknowledged that investment screening goes back 100 years and that some industries that were considered “sin industries” like tobacco and alcohol were excluded from the screening. They also acknowledge that most studies “have concluded that the returns of socially responsible investment vehicles have underperformed.” While this may have been the case in the first decade of the twenty-first century, the pandemic and the volatility in the markets highlighted the importance of ESG reporting (Díaz et al. 2021). A study by Morningstar (2018) aimed to gain a greater understanding of investors’ profiles and intention to integrate ESG reporting in their investment decisions. They found that while popularity over ESG investing has grown over the past few years, financial advisors find it difficult to identify the investors who are interested in ESG investing as it appears that millennials and women tend to be those attracted to such investments. This finding was overturned by Tucker and Jones (2020, 72) who found that “the demand for ESG investing is strong not only for millennials, but also for boomers and Gen Xers.” They also found that “the difference in gender preferences for ESG investing is negligible.” One may of course advocate that as more females and younger generation investors become investors, then they are likely to care more on ESG reporting and sustainable finance; thus it is rather premature to argue for gender or generation differences. In their global sustainable investment survey, Blackrock (2020, 3) have found “that investors recognize the importance of sustainable investing to risk-adjusted returns and are backing up this conviction with their asset allocation plans,” a trend which is likely to be doubled in the next 5 years. According to the same survey, investors in Europe, Middle East and Africa are twice more likely to consider sustainable investment than their counterparts in the USA, and 75% of the global investors are “currently or considering” integrating ESG in their investment decisions (p. 9). Investors appear to be focusing on environmental issues with the climate still being the “king” and are interested to see the policies implemented on climate change. The same study, however, has found that there appears to be an increasing interest in social issues, created by the “pandemic that has stemmed from COVID-19 and from other developments nationally and internationally; and in part due to

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greater transparency by companies on these social issues” (p. 29). The respondents to the Black Rock 2020 survey have noted that they are planning to allocate their investments to the following: 1. 2. 3. 4. 5.

Climate actions (51%) Affordable and clean energy (50%) Clean water and sanitation (37%) Good health and well-being (32%) Sustainable cities and communities (29%)

5 Legislative Interest in Sustainable Finance Sustainable finance does not exist in a vacuum. The European Union has demonstrated its interest in ESG and sustainable finance actions by implementing in 2018 its financing sustainable growth action plan (European Commission 2018). It is worth mentioning that there are also developments regarding sustainable finance in European Countries (e.g., Italy, Netherlands, Poland, Sweden) that have undertaken initiatives to foster sustainable finance (Brooksbank 2018; Eurosif 2018). For example, in Norway, the EU’s regulations through the European Economic Area (EEA) Agreement are being incorporated into Norwegian law (Norwegian Ministry of Foreign Affairs 2013). An example is the incorporation of the Regulation on EU climate benchmarks and benchmarks’ ESG disclosures into Norwegian law in May 2020 (IPSF 2020, 19). Similarly, the UK in 2019 published its Green Finance Strategy (Davies and Green 2019) which reflects national and global goals and supports the country’s economic policy on balanced, solid, and sustainable growth (IPSF 2020, 20). Finally, the City of London founded the Green Finance Initiative (GFI) which targets to boost sustainable’ s infrastructure projects financing choices and help the sector’s growth (Green Finance Initiative 2021; IPSF 2020, 20). In Malaysia on September of 2019, a Joint Committee on Climate Change (JC3) was created (MIFC 2021) in order to give guidance and support inside the financial sector regarding their climate change actions (IPSF 2020, 16). Furthermore, in Malaysia there are Islamic financial institutions (MIFC 2021) which established guidelines regarding the implementation of ESG risk considerations in the decisionmaking of finance and investing for specific sectors (IPSF 2020, 16). Additionally, in 2020, the Ministry of Environment of Japan has issued new updated Green Bond Guidelines (Green Finance Platform 2015), enlarging the purpose to provide green loans and sustainability-linked loans to sustainable finance markets (IPSF 2020, 17). Meanwhile in Thailand, in order to promote sustainable finance, a sustainable finance framework (PDMO 2020) was developed in an effort to undertake social and environmental investment projects in the context of the United Nations Sustainable Development Goals (UN SDGS) (IPSF 2020, 17). Thus far the paper has put into context sustainable investment and development and placed these within regulatory frameworks or conceptually within the expectations of stakeholders. The underlying prerequisite and driving force for companies is

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to be sustainable and to disclose their ESG policies which, in turn, would lead to sustainable investment. It is asserted by the authors that the driving force is the leadership of the company and the corporate culture.

6 Ethical and Resilient Leadership At the Business Roundtable (2019), the principles of the role of the corporation were “modernized” and changed from those implemented in 1997 which stated that “the]. . .corporation exist principally to serve their shareholders” to “. . .We share a fundamental commitment to all of our stakeholders. We commit to: Delivering value to our customers. . .Investing in our employees. . .Dealing fairly and ethically with our suppliers. . .Supporting the communities in which we work. . .Generating longterm value for shareholders, who provide the capital that allows companies to invest, grow and innovate. . . .” This important commitment was signed by the majority of the influential group of CEOs illustrating that the CEOs realize that they need to look beyond the bottom line. In this context, the theories behind sustainability are, firstly, the stakeholder theory which assumes that several groups coexist within a system and they aim to achieve a win-win situation for all stakeholders involved (Freeman 1984) and, secondly, the agency theory (Jensen and Meckling 1976; Watts and Zimmerman 1978; Watts et al. 1983) which describes the relationships between the managers and shareholders where managers have the power and position to make decisions that may be in their own self-interest rather than the interest of the shareholders illustrates the significance of leadership skills and traits needed by the CEOs. In order to achieve sustainability, companies not only have to launch social responsibility initiatives, but its employees have to establish also socially responsible behavior in their everyday work life through the influence of ethical leaders who shape the concept of organizational virtuousness (Zhang and Liu 2019, 1). Thus, every organization needs a leader who will preserve the balance of triple bottom line (i.e., profit, people, and planet) (Lenka and Kar 2021, 202). But most importantly organizations need leaders who place sustainable strategies high on their agenda (Saha et al. 2020, 424). According to Brown et al. (2005, 120), “ethical leadership is defined as the demonstration of normatively appropriate conduct through personal actions and interpersonal relationships and the promotion of such conduct to followers through a two-way communication, reinforcement, and decision-making.” Personal characteristics like integrity are imperative in safeguarding a leadership effectiveness process (Brown and Treviño 2006, 2). The concept of ethical leadership arises from various sources like management’s concerns regarding greater good and well-being of both employees and society in decision-making, the fairness and ethics approach in administration and decision-making, the examination of social and environmental impacts, the ability to be honest and reliable, and the consideration for the emergence of successful results (Amisano 2017, 81; Brown et al. 2005;

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Eisenbeiss 2012; Kalshoven et al. 2011). Let’s not forget that the concept of ethical leadership constitutes the leader’s dynamic efforts to impact his/her employees’ ethical and unethical behavior (Brown and Treviño 2006). Thus, moral managers form ethics as a direct part of their leadership development by the ethics and values communication, by clearly and purposely role modeling ethical behavior and using rewards and discipline to make followers responsible for ethical conduct (Brown and Treviño 2006, 3). Therefore, a company needs ethical leaders; otherwise the lack of ethical behavior represents one of the main reasons for unsustainable results (Tarkang Mary and Ozturen 2019). Sustainable and ethical leadership’s role in the financial sector rose significantly since the financial crisis of 2007–2009 as many firms engaged in careless and unethical behavior (McCann and Sweet 2014, 373). Leaders were and are still expected to conduct business ethically and at the same time preserving stakeholder interests and secure their firm’s environmental, social, and financial well-being factors (Amisano 2017, 76) even though shareholders are primarily interested in their short-term profits instead of the ethical or sustainable long-term decision-making (McCann and Sweet 2014, 373). Some authors have acknowledged that over the years on average, 50% of environmental concerns are due to the unethical activities in the organization (Lenka and Kar 2021, 202; Ferrell et al. 2008; Bennett-Woods 2018; Daft and Marcic 2016). Moreover, an organization’s hunger for profit made employees abandon their duties and responsibility toward the society and environment and endeavor to exploit the system as much as possible (Lenka and Kar 2021, 203). Therefore, the ultimate environmental humiliation occurs mainly to maximize profits (Lenka and Kar 2021, 203). While McCann and Sweet (2014, 373) have found that most leaders nowadays are indifferent and misguided, Kalshoven et al. (2011) found that guidance to people, fairness, sustainability, integrity, openness, and clear ethical directions at their workplace (Amisano 2017, 77) are skills expected of leaders in the twenty-first century. When ethical leaders have open communication with their employees and focus on moral conduct, then they illustrate to their employees that there are synergies between their objectives and that are both on the same way of thinking (Gul et al. 2021, 1892). Thus, leadership is a key factor of the environmental and organizational aspects of business ethics which has been a necessary management practice over the years (Sarwar et al. 2020, 2). Ethics can be defined as “a tool that guides the conduct, attitude and behavior of a person” (Sharma et al. 2019, 714). In corporations the role of ethics is crucial in building honesty, sincerity, equality, transparency, and the trustworthy relationship between people that work in the same workplace (Sharma et al. 2019, 714; Ponnu and Tennakoon 2009; Yukl 2006; Karakose 2007). To adopt the procedures and policies that will achieve sustainability, a leader ought to be a role model for his/her employees in an effort to motivate them (Sharma et al. 2019, 714). Heres and Lasthuizen (2012) found in their survey that all managers admitted that ethical leadership is a matter of role modeling the right behavior. This will certify the credibility of a leader and build up or disable the leader’s message that needs to be delivered. The same authors advocated that “role modelling communicates the

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underlying principles that the leader tries to maintain” (Heres and Lasthuizen 2012, 453). Sharma et al. (2019, 712) believe that an ethical leader is someone who greatly believes in following the right set of values and principles in his/her decisions, actions, and behavior. Also, an ethical leader must be honest and possess high integrity, be people-oriented, have effective communication, and be responsible in cases of assuming unbiased decisions which are in benefit and interest to his/her employees and corporation (p. 712). Ethical leaders need to also be effective leaders by educating their employees about the significance of following standards for business behavior and to handle each other with respect, sincerity, and honesty (Duggan 2018). A leader has an inspirational role model to play as he/she is expected to increase organizational engagement, job satisfaction, and cognitive commitment toward the organization (Sharma et al. 2019, 713). Furthermore, McCann and Sweet (2014, 373) assert that the leader ought to inspire his/her employees and have a vision to accomplish moral good and integrity through trust. Subsequently, responsible leaders care; show compassion; understand their employee’s needs, interests, career expansion, and personal growth; and establish a caring working environment in their workplace which will augment the emotional commitment of employees with the organization who in turn will spend time and energy for implementing sustainable policies (Yasin et al. 2020; Boiral et al. 2014). Liu and Zhao (2019, 4) maintain that ethical leaders care about their employees, assist them when they have problems, focus on sustainable development of corporations, are ethical, and apply corporate social responsibility. Most importantly, however, they argued that leaders are significant supporters of green behavior and innovation in organizations (Liu and Zhao 2019, 4). Brown and Treviño (2006) also advocated that leaders ought to be honest, trustworthy, fair, principled decisionmakers who are compassionate about people and society, who show ethical behavior in both their personal and professional environment. It is apparent that researchers in recent years are cognizant of the qualities, personality traits, and the altruistic motivation leaders ought to possess to lead their organizations to sustainability and their employees toward working toward the same goal (Brown and Treviño 2006). Some additional traits ethical leaders ought to possess over and above being ethical are authenticity, visionary, and emotional intelligence (Bendell et al. 2017, 422), be leaders that merit confidence and respect, and have appropriate behavior while interacting with their employees (Gul et al. 2021, 1891) but at the same time have the ability to motivate their employees (Roper et al. 2010). Tarkang Mary and Ozturen (2019, 1) found that ethical leaders motivate employees because they are trusted by their employees; thus the driving trait is ethical leadership. The role of ethical leadership is to expect and meet the moral needs of the firm which in turn has an internal obligation with moral standards and its participation in ethical actions with the purpose to benefit society (Saha et al. 2020, 416). Also, the core task of ethical leadership is to encourage and create an ethical culture inside an organization (Saha et al. 2020, 417). Roeck and Farooq (2018) found that ethical leadership promotes social responsible behavior between employees. In addition, Kalshoven et al. (2011) consider the leader as a fundamental source of ethical

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direction in relation to employees, because employees under ethical sustainability leadership are expected to find cost-saving methods to accomplish the triple bottom line of people, planet, and profit (Roeck and Farooq 2018). This indicates that an organization’s performance is reflected in the ethical characteristics possessed by the leader (Saha et al. 2020, 423). It should be noted that ethical leadership promotes and preserves awareness for ethical values and peoples’ integrity in crucial situations (Rahaman et al. 2021, 633) and for the development of positive effects like followers’ commitment toward the organization, organizational identification, and trust can enhance this leadership relationship (Sharma et al. 2019, 712). For this purpose, Sharma et al. (2019) have created a ten-point framework that provides the four principal factors for the ethical leadership development. More specifically, through the first principal factor which is personality, the key elements that are needed for ethical leadership’s development are values and ideals, honesty and integrity, responsibility and orientation toward people, and communication and decision-making (Emerald 2020, 48). Concerning the second factor which is leadership, one needs transformational leadership skills, authentic leadership capabilities, and spiritual leadership in achieving ethical leadership growth (Emerald 2020, 48). Next, the third principal factor is outcomes where there is demand for organization commitment and identification within an organization (Emerald 2020, 48). The fourth factor is influence with added emphasis on the trait of trust (Emerald 2020, 48). Emerald (2020, 48) advocates that honesty and integrity are traits needed by leaders as these would increase the observance and commitment of employees. In the second decade of the twenty-first century (due to the socio-economicpolitical crisis of the COVID-19 pandemic, the invasion of Ukraine by Russia and the financial repercussions of both of these sociopolitical events), it is evident that another trait is also very important that of a resilient leader, one who will be ready to respond to crises, recover, and become stronger (Eliot 2020, 404). Because companies and their leaders commonly face unexpected events that have economic and noneconomic implications that have direct and indirect impact on the employees and society’s well-being (Eliot 2020, 404), they need a resilient leader to embrace and encourage a resilient workforce (Eliot 2020, 404) that will foster sustainability. Resilience is expressed as a personal quality that persuades others to rebound back in the face of loss (Allison 2012, 79). It has been advocated that “resilience is recognized as a capacity which can enable an organization to face a crisis and capitalize on the event, potentially avoiding the negative consequences and ultimately growing and becoming stronger” (Eliot 2020, 409). Moreover, “resilient leaders, do more than bounce back-they bounce forward with speed and elegance, resilient leaders take action that responds to new and ever-changing realities, even as they maintain the essential operations of the organizations they lead” (Allison 2012, 79–80). Allison (2012) suggests that a leader who observes the signs of times and acknowledges both opportunities and disaster’s indicators, then he/she can control the identified resilience in his or her business. What is more, Youssef and Luthans (2007) add that resilience can also be the starting point and opportunity for development in boosting a corporation’s balance.

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To sum up, leaders who have strong resilient levels are in position to respond positively to crises in their organizations and with the resilience they possess which has a positive impact, then they will be able also to augment the resilience level of their employees (Eliot 2020, 415). If leaders face environmental pressures, then they will reshape and consider environmental protection as part of their organization’s identity (Liu and Zhao 2019, 5) and will “choose resilience over defeat” (Allison 2012, 82).

7 Methodology and Findings In an effort to answer empirically the research questions posed earlier (a) does the industry of a company affect its ESG reporting? and (b) is ESG reporting driven by ethical leaders? The authors of the current paper have merged three different datasets to collect data on the firm’s industry, sustainability, and ethics, in the context of a panel model in an effort to respond to the two research questions. First, from Compustat Fundamentals (2022) the authors obtained information regarding the industry and other financial data which were used as controls, including the company’s size, growth, current and solvency ratio, leverage, and innovation proxied by research and development (R&D) expenditure. Second, from Refinitiv (2022) the authors collected the ESG (environmental, social, and corporate governance) index which reflects a company’s relative ESG performance, effectiveness, and commitment across ten main themes based on publicly reported data including, resource use, emissions, and innovation (environmental); workforce, human rights, community, and product responsibility (social); and, finally, management, shareholders, and CSR strategy (governance). Third, the authors utilized the Ethisphere’s 2021 World’s Most Ethical Companies Honoree List which includes corporations awarded for their ethics and commitment to society to identify the most ethical companies. In particular, the list includes information if a certain company is characterized by ethical leadership and corporate ethics. Our final merged dataset including all sources (Compustat, Refinitiv, Ethisphere) which comprises of 163 US companies over the period 2002–2021 was used for the estimation of the panel model. Notably, 72 out of the 163 are initially included in the extended Ethisphere’s list as companies characterized by ethical leadership and corporate ethics, where the remaining 91 are noted from the authors as companies not described by ethical leadership and corporate ethics. Thus, the 91 companies are used as a control group. The first part of our empirical analysis includes exploring the characteristics of the companies included considered to be the most ethical (as per literature and the Ethisphere’s 2021 List), while in the second part, we directly address our research questions using econometric analysis in the context of a panel model.

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Company Profiles Included in the Ethisphere’s 2021 List

The Ethisphere’s 2021 World’s Most Ethical Companies Honoree List includes 135 corporations awarded for their ethics and commitment to society. In addition, to increase our sample, another 18 companies were identified from the literature as being committed to maintaining high ethical standards for the year 2021, with a final extended sample of 153 companies. Table 1 provides information of the location of the head office of the companies identified as the most ethical companies for 2021. From the table above, it is evident that ethical companies are located in various countries, not necessarily all from the G20 list. While the biggest proportion of companies is in the USA, this is to be expected due to the number of companies having their head office in such a large country. Thus, it can be drawn from the above table that the location of the head office of a company does not influence or determine how ethical a company is or if it will have an ethical leader. The companies identified as ethical were classified using the Global Industry Classification (2021) Standard rather than the NAICS classification which is used later on in the analysis because the former is a lot more detailed and the authors wanted to ensure all industries and industry groups are represented in the dataset. As illustrated in Table 2, above, it appears that all industries are represented in the ethical companies identified. Thus, on the first instance, it does not appear that the industry a company belongs to will influence how ethical a company. In the second stage of the analysis, the author uncovered (from the Refinitiv 2022) the ESG policies of 72 companies reported in the extended Ethisphere’s list and therefore characterized by ethical leadership and corporate ethics. From a first glance, it was found that these companies were primarily interested in addressing climate change by reducing their emissions, using renewable energy sources, adopting the 17 UN’s sustainable development goals, and setting targets for going carbon neutral by either 2025 or 2030. Furthermore, all of these companies received awards for their environmental or ethical practices and had implemented codes of conduct in their organizations, and none had any leaders, CEO, or board members implicated in any publicly available information on scandals or unethical or illegal behavior. Thus, it can be argued that companies that disclose ESG reporting and are sustainable have ethical and resilient leaders.

Table 1 Country where the Head Office of the ethical companies is located The US (106) The UK (10) Canada (4) France (3) Guatemala (1) Thailand (2)

Portugal (1) Mexico (2) Spain (1) Italy (1) Ireland (2) Switzerland (3)

Greece (1) Ecuador (1) Japan (2) Australia (1) Hong Kong (1) India (3)

Sweden (1) Brazil (1) Finland (1) Poland (1) The Netherlands (3) Scotland (1)

Consumer products (3)

Diversified machinery (2) Electronics and components (2)

Banking and financial services (1)

Banks (14)

Business services (2)

Construction and building materials (2) Consulting services (4)

Conglomerate (1)

Chemicals (2)

Apparel accessories sports equipment (1) Automotive (4)

Accident and life insurance (2) Apparel (2)

Forestry paper and packaging (2) Health and beauty (4)

Food beverage and agriculture (7)

Environmental services (1) Financial services (9)

Energy and utilities (9) Engineering Services (2)

Table 2 Industry profile of the most ethical companies

Industrial manufacturing (8) Information technology (3) Insurance (6)

Healthcare providers (7) Imaging technology (1)

Health insurance (4) Healthcare products (1)

Metals minerals and mining (3) Nonprofit business services (1)

Medical devices (2)

Insurance brokers (1) Integrated healthcare system (2) Leisure and recreation (1) Machine tools and accessories (1)

Scientific and technical services (1)

Retail (3)

Real estate (4)

Property and casualty insurance (1)

Pharmaceuticals (2)

Oil and gas, renewables (3) Payment services (2)

Water and sewerage utility (1)

Telecomm (3)

Sourcing services (1) Staffing and outsourcing services (2) Technology (6)

Software and services (4)

Semiconductors (3)

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Findings: Econometric Analysis

The authors investigated further the above research questions using a standard panel model over the period 2002–2021 for 163 US companies yit = ai þ β0xit þ uit , where the dependent variable yit is a scalar and measures the ESG company score taken from Refinitiv, xit is a k × 1 vector of ESG determinants, β is a k × 1 vector of unknown parameters, uit is an i.i.d. error term for firm i = 1, 2, . . ., 163, and time t = 2002–2021. Where the ESG score is (a) between 0 and 25, it indicates poor relative ESG performance and insufficient degree of transparency in reporting material ESG data publicly; (b) between 25 and 50, it illustrates satisfactory relative ESG performance and moderate degree of transparency in reporting material ESG data publicly; (c) between 50 and 75, it illustrates good relative ESG performance and above average degree of transparency in reporting material ESG data publicly; and, finally, (d) a score 75 to 100 reflects an excellent relative ESG performance and high degree of transparency in reporting material ESG data publicly. Notably, the average ESG for the 72 companies considered to be the most ethical companies (from the literature and the Ethisphere’s list) is 60 indicating a good ESG performance. To answer the first research question regarding the effect of the industry on the ESG score, we include in the set of regressors xit dummy variables based on information obtained from Compustat taking the value 1 indicating the specific industry following the North American Industry Classification System (NAICS) system and zero otherwise. Further, to answer the second hypothesis emphasizing the role of ethical leaders on ESG, we use the information provided from the extended Ethisphere sample and include in the set of the explanatory variables xit a dummy variable taking the value 1 when a company is characterized by ethical leadership and corporate ethics and zero otherwise. In addition, in this model we control for a set of firm-specific characteristics incorporated in xit from Compustat including the size of the company by considering the natural logarithm of total assets, the growth potential of the firm using the ratio of its intangible assets to total assets, the current ratio which is the ratio of current assets to currents liabilities reflecting the ability of the firm to repay its short-term obligations, the solvency ratio to capture the firm’s ability to cover its long-term obligations with its assets, the leverage ratio which is the long-term debt to shareholder’s equity to capture the firm’s ability to take on more debt, and, finally, research and development expenditure reflecting the innovation initiatives of the company. Table 3 shows the main empirical results for the two research questions. The second and third columns illustrate the regression coefficient and the corresponding robust standard errors for the linear panel model. Regarding the first research question, if the industry drives corporations to opt to be sustainable, we have considered the North American Industry Classification

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Table 3 Panel estimation results

Variable Ethical leadership/corporate ethics Size assets Growth Current ratio Solvency ratio Leverage R&D expenditure Industry Manufacturing 1: food, beverage, tobacco, clothing, textile, leather Manufacturing 2: wood, paper, petroleum, coal, chemical, plastic, rubber Manufacturing 3: metal, machinery, computer, electrical and transportation equipment, furniture Wholesale trade Retail trade Information Real estate and rental/leasing Professional, scientific, and technical services Healthcare and social assistance Other/nonclassified Constant

Coefficient 13.9963 *** 11.3899 *** 15.4693*** 0.6178 2.6529*** -0.0042 0.0015*

Robust standard error 5.4080 0.7349 4.5482 0.5558 0.8672 0.0101 0.0008

8.6808

8.3815

0.4986

6.5208

-1.2359

5.9327

-25.5676*** 7.2514 -3.4273 -5.8729 0.0834 18.3713* -9.2239 -5.6865

9.8522 8.6811 7.9217 12.5993 9.6973 10.7416 17.4591 6.1810

Note: Asterisks denote statistical significance at the 1% (***), 5% (**), and 10% (*) level using a two-tailed test. The results remain robust under a series of misspecification tests

System (NAICS) and included dummy variables taking the value 1 if a certain company belongs to manufacturing, wholesale, or retail trade; information; real estate and rental/leasing; professional, scientific, and technical services; and, finally, healthcare and social assistance. It has been found that when a company belongs to the wholesale trade, it has a lower ESG score (-25.5676) at the 1% significance level. In contrast, a healthcare and social assistance company has higher ESG score (18.3713) at the 10% significance level. Notably, all the remaining industries are not statistically significant. Therefore, apart from the health sector, social assistance company, and the wholesale trade, it does not appear that the industry of a company will affect its ESG reporting and thus sustainability. Regarding the research question, if sustainable organizations are driven by ethical leaders, the results in Table 3 reveal that the effect of Ethical Leadership/Corporate Ethics on ESG is positive (13.9963) at the 1% level of significance, supporting strongly the second hypothesis. This finding does confirm the earlier assertion made by the authors that companies will be sustainable and report their ESG if they have ethical leaders.

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Finally, considering the role of the controls, the firm’s size, growth, and ability to cover its long-term obligations with assets and innovation are related positively with the ESG score. The authors suggest that future research could look at the relationship of the above variables and sustainability in more detail.

8 Conclusion In this chapter the authors have illustrated the significance of sustainability and the association of sustainability to the ESG reporting factors. In addition, the authors have discussed the relevant literature and asserted that ethical and resilient leadership is needed for companies to be sustainable. While it was not possible to identify the leaders who have been classified as resilient, other researchers have shown that companies which are sustainable are resilient to socio-politico-economic crisis. A limitation of the study was that it was not possible for the authors to identify an empirical and statistical dataset that incorporated resilient leaders, but they did identify a dataset of companies that were considered to be the most ethical. A dataset of the most ethical companies for 2021 was developed by the authors that also included information about the industry, country, characteristics of the CEO including if the CEO was ever charged or accused of being unethical or illegal, and the ESG index of those companies. Utilizing then another two datasets, it was possible to have a control group of companies and to test the two research questions. It was found that ethical companies that disclose their ESG are sustainable and can be found primarily in all industries with the exception of the health industry and the wholesale trade. In the former it was found that the companies in the health sector are more likely to report their ESG policies rather than those in the wholesale trade. The authors found that in response to the second research question, companies that are considered ethical and have ethical leaders also more likely to report their ESG policies and thus be sustainable and have sustainable finance. Thus, sustainable companies are those that report their ESG and have ethical and resilient leaders. Acknowledgments The authors would like to thank Katerina Christou for assisting with the literature search.

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Maria Krambia-Kapardis is Professor of Accounting (with a specialization in Forensic Accounting) at the Cyprus University of Technology (Cyprus). She has also served as the Associate Dean of the School of Management and Economics at the same University. Prof. Krambia-Kapardis is the founder and first Chair of Transparency International-Cyprus (2010-2017), the founder and first president of the Economic Crime and Forensic Accounting Committee of the Institute of Certified Public Accountants of Cyprus (2010-2014), and a co-founder of the Cyprus Branch of the Association of Certified Fraud Examiners (ACFE-Cyprus) (2017-2020). She is a Fellow member of Chartered Accountants of Australia and New Zealand and a Certified Fraud Examiner. Prof. Krambia-Kapardis’ research interests include: corruption and anti-corruption; ethical behavior and ethical leadership; fraud detection, investigation and prevention; modern slavery; gender issues. Her latest books are: Corporate Fraud and Corruption: A Holistic Approach to Preventing Financial Crises (Palgrave Macmillan, 2016); Financial Compliance: Issues, Concerns, and Future Directions (Palgrave Macmillan, 2019). Ioanna Stylianou is an Assistant Professor in Economics and Statistics at the University of Central Lancashire Cyprus (Cyprus). Currently, she is the Deputy Dean of the School of Business and Management at UCLan Cyprus. Since 2014, she is a Research Fellow in the Department of Economics at the University of Cyprus and member of the National Committee of the European Social Survey Cyprus. She has published in various international refereed journals, such as European Economic Review, Empirical Economics, and International Marketing Review. Christos S. Savva is a Professor of Econometrics at Cyprus University of Technology (Cyprus). His research utilizes sophisticated econometric models to examine some specific financial and monetary relationships. He has published in various international refereed journals such as Management Science, Journal of Financial Econometrics, Journal of Applied Econometrics, Journal of Royal Statistical Society: A Journal of Banking and Finance, and Econometric Reviews. Currently, he serves as a Head of the Department of Commerce, Finance and Shipping, at Cyprus University of Technology.

Ethical Leadership and Ethical Organizational Culture: Two Pillars for Fighting Against Corruption in the Organizations Carole Doueiry Verne

1 Introduction Talking about ethics in a world where immoral acts abound is no challenge, because this concept, which boils down to the notion of good, value, and morality, focuses on what individuals most desire in the face of culminating and recalcitrant corruption. These ethical considerations also include what is right or wrong as well as understanding the underlying reasons for these behaviors (Bishop 2013). In developing countries, ethics is a utopia antithetical to corruption that plagues all the foundations of society and whose deleterious effects reverberate over several years (Doueiry Verne and Verne 2020). In these countries, acts of corruption take many forms ranging from petty offenses to the most pernicious acts. In the local or international market, companies are encouraged to adopt ethical behavior, in order to be competitive and to solicit ethical behavior from all human resources by establishing structures for the implementation of ethics. Multinational companies have understood that, in an ultracompetitive market, ethics is the key to success as well as a discipline of life to be applied on daily basis. Several studies (Shin et al. 2015) examining the link between top management ethical leadership and organizational performance show that the management shapes the ethical climate and culture of a firm (Treviño et al. 1998; Victor and Cullen 1988) as well as the strategy of a company (Freeman et al. 1988). In fact, according to Treviño (2003), the ethical dimension of top management leadership should be considered as the relevant factor that influences organizational efficiency. The leader then plays a prominent role in public and private organizations and is the main catalyst that promotes ethical or corrupt behavior. In the presence of a corrupt leader, acts of corruption abound, but when the leader is ethical, employees C. D. Verne (✉) Saint-Joseph University of Beirut, Beirut, Lebanon e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_7

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are more inclined to apply the rules in force. Indeed, Mayer et al. (2009) argue that ethical leadership affects employee behaviors by exerting a cascading effect on middle-leader managers and employees. Thus, by giving such an example of ethical behavior, the leadership paves the way for the firm financial performance. The financial performance of the organization, especially in developing countries, results from the will of ethical leadership to fight against corruption. For example, in public or private companies, ethical leadership proves to be one of the solutions to counter corruption and establish an ethical climate in the company. The behavior of an ethical leader can be institutionalized in the company through a solid ethical organizational culture that applies to all levels of the hierarchy. Ethics is therefore integrated into the very culture of the company and plays a role in individual and organizational culture. We will therefore tackle the antinomic concepts of ethics and corruption. We will then demonstrate the importance of the ethical leader to counter the problems of corruption and therefore establish an ethical climate necessary to lead the company toward the right way notably through a solid ethical organizational culture.

2 Antinomic Concepts of Ethics and Corruption There are many definitions of ethics. However, they all converge on the notions of morality, responsibility, and social justice. The word “ethics” comes from the Greek words “ethikos” and “ethos” meaning customs and behaviors. According to Aristotle (1856), ethics reflects the character of persons (individuals and firms as well). Ethics is therefore the main foundation defining what kind of people we are or what type of company we represent and the discipline regarding what is morally good or bad and morally right or wrong. What is ethical is therefore right. This notion of justice, which defines ethics, was evoked by John Rawls (1971) in his book Theory of Justice. This moral philosophy which is ethics includes a set of moral evaluations, commandments, norms, virtuous acts, and manifestations of conscience (Brugger and Baker 1972). Ethical behavior could be simply defined as a strong connection between the concepts of right, proper, and fair (Hosmer 1987). In most developed countries, ethics is a discipline of life, an integral part of everyday life, governing individual, human, institutional, or organizational private and public relations. As one of the most discussed issues of our time, business ethics stands as the number one priority to a corporation’s clients, to stakeholders, and to its employees (Yang 2014). Moreover, behavior in private and public companies can be unethical, especially in developing countries where corruption is rampant at all levels. As a result, we cannot talk about ethics without talking about corruption as the other side of the coin. The border between the various facets of corruption is often very fine to draw so that certain definitions are similar since they evoke the same behavioral traits. Treisman (2000) gives the following definition: “Misuse of public office for private gain.” Corruption is therefore defined as the act by which a person invested with a

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public or private function solicits or accepts a gift, an offer, or a promise with a view to performing, delaying, or omitting to perform an act falling within the scope of his duties (Rocca 1993). Robert Klitgaard (1998) translated the mechanics of corruption into a simple equation: C ðCorruptionÞ = M ðmonopolyÞ þ P ðDiscretionary PowerÞ - R ðResponsibilityÞ In addition to these definitions, O. Kurer (1993) argues that: “Corruption is defined as behavior violating laws, rules, and regulations aiming at private gains”. Generally, corruption refers to the behavior of someone who diverts a person from his tastes, traditions, and duties, by promises of money or security. The beams of corruption are quite numerous: influencing a person, influencing a decision, diverting a human group from its natural vocation, etc. Similarly, corruption appears when someone exerts pressure for his own benefit by taking advantage of the ascendancy provided by either personal charisma or a position of power. Corruption exists everywhere and at all levels. It is tolerated when its effects are not too visible and harmful. But it is rejected when it causes degradation and alteration. Corruption is shamed and becomes hounded. Most of the time, it is related to money (Daniel 1999). There is corruption when there is a power and laws to transgress. According to the United Nations (UN), “corruption is a serious impediment to the rule of law and sustainable development,” and it is estimated that corruption adds approximately 10 percent to the cost of doing business globally (Bray 2007; Fedotov 2012). From a legal point of view, corruption is criminally incriminated behavior by which are solicited, approved, or received offers, promises, gifts, or presents, for the purpose of accomplishing an act, abstaining from an act, or obtaining special favors or advantages. Apart from the notion of bribes, very common as an example of corruption, the theme of corruption covers a range of different prominent behaviors including clientelism, nepotism, breach of trust, fraud, falsification, money laundering, kleptocracy, abuse of power, favoritism, etc. (Transparency International 2001). For example, in some developing countries, clientelism is rooted in the culture of these countries and reaches its climax with some managers who think they are allowed everything, even if it means not respecting the regulations in force. Thus, it is no longer the best who wins but the one who pays more, bribes more, in a word, the one who is the most corrupt. This endemic situation concerns both public and private institutions, and by acting in this way, managers undermine the rules of justice and meritocracy. The whole theme of corruption applied by these managers has as its main catalyst the lack of accountability. They are accountable to no one and life in the company becomes like a lawless jungle, where everyone tramples on their values to achieve their goals. Sometimes, among the most honest, it is a survival instinct in order to always be able to “exist” in the market without being marginalized. In this case alone, corruption sometimes acts as a catalyst for economic activity and can lubricate the wheels of a sclerotic administration. Otherwise, in any case, corruption is

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inefficient both economically and ethically. Thus, whatever the kind of corruption, it undermines the institution. In order to fight against corruption in all its facets and improve individual and organizational relations, it is, therefore, necessary to go further than the political and legal framework supposed to guarantee the practice of ethics and the sanction of corrupt behavior. Moreover, all anti-corruption efforts are futile without the presence of ethical leadership that sets a good example and leads the company in the right way as well as to sustainable organization and finance.

3 The Role of the Leader as a Guarantee of the Success of Ethics in the Company Inside organizations, leadership is seen as making the relationship between a leader and his followers (Güngör 2016). He plays an important role in offering a management method that paves the way to the organization’s success in terms of reaching specified goals such as financial profitability (Kanungo and Mendonca 1996). Ethical leadership is a leadership that focuses on honesty and integrity and conforms to ethical standards and values. It is characterized by ethical personal behaviors and acts as well as ethically based interpersonal relationships (Brown et al. 2005). From the first definition of ethics, the accent is placed on practice (behavioral science; behavior reflecting the character of both physical and moral persons). In other words, ethics includes the principles that any reasonable person will be able to use to govern and control social behavior, provided that person is sure and certain that he can start by applying them himself. This necessarily implies the real application by the leader of what he publicly advocates. He must therefore set a good example, and his actions must be consistent with his words so that he is credible and can contribute to pushing his human resources to act in the same direction. Associated with ethics, ethical leadership refers to an individual who models behaviors that significantly influence groups or group members to encourage and guide them toward achieving a common goal (Mendonca and Kanungo 2006). Over the years, ethical issues and corporate scandals have highlighted the importance of ethical leadership. The ethical leader uses their power to highlight their morality and uses the reward system and communication to endorse their ethical behavior (Yang et al. 2020). An ethical leader is a key to the success of ethical programs. Subsequently, a leader who does not apply ethics reflects a very bad image for the whole institution and implicitly transmits the message that unethical acts, if they are not officially permitted, in any case, are not sanctioned. To be an ethical leader, the manager has to build ethical rules, values, and beliefs. He must use them to lead the organization (Starratt 2004). In fact, such a leader adopts ethical behaviors himself before applying them inside the organization. More precisely, these behaviors lie in honesty, fairness, doing the right things, and leading his personal life in an ethical manner. Indeed, Kalshoven et al. (2011), Yukl et al. (2013), and Zappalà and Toscano (2020) argue that honesty and integrity are doing

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the real thing for the right reasons in the correct way. These personal attitudes translate into ethical decision-making within the company by notably having good communication and listening to the subordinates (Brown and Treviño 2006). The ethical leader keeps his promises and behaves more consistently and predictably. In addition, the leader by promoting ethical principles and respecting the employees increases their responsibilities by holding them accountable for their performance which they can control. According to Sahab et al. (2021), “this makes accountability a mechanism by which responsibility for outcomes is given to individuals and teams.” The role of the leader is to promote and ensure the proper application of values and to discourage bad behavior. Another key element for the proper application of ethics is trust. A lack of trust is a factor in the dysfunction of the group, the company, and the economic system (Richardson and McCord 2004), especially when it comes to a breach of trust. Among unethical leaders, we observe a schism between what is theoretically advocated in speeches and in the media and what is actually applied in daily activities. Ethical leaders embody moral qualities such as integrity, reliability, and loyalty. They take responsibility for their decisions and use the system of rewards and punishments necessary to encourage ethical behavior and eliminate unethical behavior (Piccolo et al. 2010). Establishing and maintaining a climate of trust is essential in the company to optimize relations between managers and subordinates or interpersonal relations between colleagues. According to Amisano and Anthony (2017), the influences of ethical leadership are present in organizations via leader orientations to ethics, ethical decision-making, and individual behaviors in the workplace. Managers must be sufficiently involved in the organization and concerned with ethics in order to transmit this commitment to the entire group. If the leader acts unethically by not respecting the regulations in force, accepting bribes or other tools of corruption, or by allowing corrupt behavior to linger, the image of the company will be seriously damaged, and all the hierarchy will be affected because no one will feel obliged to respect ethics. Ethical leadership has an influence on job satisfaction, organizational commitment, organizational citizenship, turnover intent, and stress (Çelik et al. 2015; Demirtas and Akdogan 2015; Walumbwa et al. 2010; Yang 2014). Ethical leadership inevitably contributes to influencing the ethical behavior of subordinates by encouraging them to act ethically. The leader must be honest and behave ethically in favor of sustainable development (Treviño et al. 2003) and to perpetuate ethical behavior in the company. This will inexorably lead to sustainable finance. The notion of ethical leadership is closely linked to the notion of financial performance in organizations because the presence of ethical leadership increases organizational performance through the application of ethics at all levels of the company as well as by the justice that is essential to clean up the business climate (Shin et al. 2015). People working in these companies are therefore responsible for their actions. Moreover, ethical leadership goes beyond its singular pursuit of profit maximization. Ethical leadership fosters accountability and sustainability orientation, which are conducive to organizational success (Wang et al. 2017).

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Ethical leadership is essential to achieving a sustainable organization. It makes the company fast and resilient, which makes them competitive and attractive to all stakeholders (Avery and Bergsteiner 2011a, b). According to Amisano and Anthony (2017), financial benefits may be one reason why firms adopt environmental sustainability programs. These authors, by leading a study on 80 members of small businesses in Miami, found that ethical leadership behaviors did not have a significant correlation with financial sustainability even though some ethical leadership behaviors did correlate with environmental and social sustainability elements. Indeed, small correlations exist between fair decision-making and net profit margin as well as between personal compliance with ethical codes and net revenue (Amisano and Anthony 2017). These correlations suggest a small positive relationship between the ethical behavior of the leadership and sustainable finance, but these correlations are not strong enough to be statistically significant. However, leadership and financial performance often have indirect relationships. Shin et al. (2015) determined that ethical leadership had links to overall financial performance through ethical climate, procedural justice, and organizational citizenship behaviors. In fact, leaders who practice ethical leadership generate trust and have individual collectivist values that also generate ethical climates and environments (Christensen et al. 2014; Shin et al. 2015; Wang and Young 2014). Thus, this behavior of ethical leadership paves the way to sustainable finance. According to Lambert (2011), “if sustainable leadership is to have any measurable impact on the organization, it needs commitment from all levels of the organization to create a culture in which leadership skills can be developed.” In order to achieve a sustainable organization, sustainable leadership is a necessity. It requires taking a long-term perspective in making decisions; fostering systematic innovation aimed at increasing customer value; developing a skilled, loyal, and highly engaged workforce; and offering quality products, services, and solutions (Avery and Bergsteiner 2011a, b). For example, in the multinational Honda, in Japan, ethical leadership manifests itself through social responsibility as well as through several activities applied locally and internationally. The company’s objective is to encourage sustainable development and to achieve the highest level of safety and environmental performance. Such social responsibility also consists in communicating effectively with the stakeholders of the organization including customers, suppliers, shareholders, investors, and all communities in order to help them develop a sustainable society. Honda’s main concern is to respect ecology by producing nonpolluting cars in order to promote energy-saving and fight against pollution (Doueiry Verne and Meier 2018). The objective of sustainable leadership will then be to take into account the current situation of the company and to contribute to a viable and long-term success in the future (Casserley and Critchley 2010; Hargreaves 2007). In addition, the presence of an ethical leader contributes to reducing the cognitive dissonance observed in the behavior of certain managers or employees in the company. Indeed, according to Festinger (1957), an internal contradiction is experienced by individuals, following the psychological discomfort generated by the belief in ideas or values that contradict each other. The balancing of personal demands and social

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expectations takes the form of conflicting loyalties. This cognitive dissonance strongly observed in the company is manifested by the fact that individuals have personal requirements that deeply aspire to ethics, but their behaviors are corrupt. Therefore, ethical leadership will contribute via this ethical climate to help these individuals to fight for ethics and to modify their attitudes and knowledge to accord them with the new cognition (knowledge or opinion on the environment, on oneself, or on one’s own behavior) called “rationalization process.” Thus, in order to crystallize and perpetuate ethics in the company, the leader should ensure the establishment of an ethical organizational culture guiding all individuals in the company in their behavior in order to achieve the objectives set.

4 The Establishment by the Ethical Leader of the Ethical Organizational Culture According to Chadegani and Jari (2016) and Shafritz (2005), the concept of corporate culture emerged at the beginning of the 2000s. It has been developed by Denison (1990) for who the corporate culture became a frequent headline in business studies and a tool for companies to increase their performance and success. Regarding this concept, we can say with Schein (1985) that corporate culture can be seen as a pattern of shared beliefs and assumptions that individuals learn from problems. He argues that culture is a complex mixture of values, control systems, missions, structures, and symbols that fit together in order to determine what is appropriate for an organization. Ethical culture is a theme that is not new since the end of the nineteenth century, Shepard et al. (1892) approached this theme in the educational sector and emphasized the fact that the ethical culture begins at home but is completed in schools, from the earliest age (in the kindergarten) until primary school, and then secondary and finally to university. In the latter, students understand that an authentic education has an ethical purpose. They will thus be guided, in their ethical training, by three conditions constituting the strengths to be acquired in their journey: “right” thoughts, “right” emotions, and “right” actions. The interest in research on ethical culture has only increased since then, given the importance of this theme in business. Organizations have different cultures (in terms of guide service and product quality) and more precisely different corporate cultures founded on the corporate ethical culture. Treviño et al. (1995) show that ethical culture establishes and maintains the standards that explain the right behavior and the right conducts of the leadership and employees. They also argue that by introducing the ethical aspect of corporate culture into practice, we defined the corporate ethical culture. In fact, the concentration of corporate ethical culture is on leadership, and the role of managers in conducting ethical culture in an organization is primordial. About this assertion, Hunt et al. (1989) and Baker et al. (2006) using corporate ethical culture terms argue that when ethical standards and norms are accepted and observed by top managers

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and widely shared among an organization’s members, organizational success will be enhanced. In the 1980s, organizational culture was identified as a potential element in business success (Peters et al. 1982) and concerns both the private and public sectors. An enterprise’s ethical culture comprises the assumptions and expectations of its employees regarding the ways in which the enterprise prevents unethical behavior and stimulates ethical behavior (Kaptein 2009). Organizational ethical culture is the invisible force that promotes business success and contributes to organizational change, productivity, efficiency, control, innovation, and communication (Feldman 2002). The awareness of the need for an ethical culture in the company requires the presence of an ethical leader contributing to the rooting of this culture within the company. Ethical leadership fosters justice climates as well as financial performance (Shin et al. 2015), according to a study conducted across Korean industries. It helps to concretize the application of the ethical culture and to show that it is not confined to theory. For example, L’Oréal is one of the first French companies to have enacted an ethics charter, and its ethics program is based on four strong ethical principles: integrity, courage, respect, and transparency. In American company 3M, ethical culture occupies a preponderant place in the activities and strategies of the company, and any breach of ethics has significant legal and financial consequences. Similarly, the example of Itochu Corporation, ranked “Top 2 Trading Company” shows how a multinational company, in a context of ultra-competition, can succeed in practicing ethics, by taking care of the human resources and in particular their physical and mental health. Moreover, the Tomy Company has marketed sustainable products and thus helps to promote a sustainable organization and finance: the raw materials used for their manufacture are, in the long-run period, beneficial for the environment because they are made from plants such as maize and sugar cane, instead of using plastic-based raw materials (Doueiry Verne 2020; Doueiry Verne and Meier 2018). Ethical culture promotes the establishment of ethical benchmarks within organizations in order to reduce the stress experienced by managers, particularly when they have to resolve the ethical dilemmas that arise (Huhtala et al. 2011). The ethical principles must then be explained and communicated by the ethical leader to the company’s human resources in order to successfully integrate ethics into the company’s culture (Treviño and Nelson 2007) and contribute to a strong cultural organizational ethics. It should be noted that the establishment of an ethical culture within the company via the ethics program is based on the ethical training of human resources, the codes of ethics, and the hotline. All companies are nowadays aware that perfect control does not exist (Merchant 1985). As a result, despite the existence of a control system, some companies still note the existence of unethical behavior. For example, a third of fraudulent activity in private companies is only discovered accidentally. Employees are the people most aware of these unethical behaviors, hence the need to include them imperatively in the fight against these corrupt behaviors or legal problems (Treviño et al. 1999). The question for the ethical leader is how to prevent members of the organization from being passive and encourage them to be proactive in always speaking out against ethical violations. Moreover, in

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the public service, agents inevitably encounter problems related to ethics. The frequency of encountering this type of problem is higher than in other sectors because these employees constantly communicate with users, helping them to solve their problems and informing them of government decisions. As a result, when individuals are in constant contact with civil servants, they are led to pass judgment on their ethics and therefore on their morality based on their behavior. They constantly ask themselves the question of the place occupied by ethics in their organizational culture. For this reason, ethics should occupy an important place in public companies. Ethics does not only concern communication with consumers but also the mutual relations between colleagues and employees within the same institution (Perkumiené and Raupeliené 2008). Ethics are essential in public companies and must be deliberately discussed between the different hierarchical levels. In the public sector, organizational culture should be an integral part of the responsibility of every public servant. Wrong actions can harm colleagues and citizens. In addition, it is essential that the level of ethics of leaders should be very high because they reflect the image of the institution as a whole (Perkumiené and Raupeliené 2008). The higher the level of ethics, the greater the esteem of citizens and the motivation of human resources. In the public sector, civil servants and agents must be well trained in order to detect problems related to ethics and to be able, consequently, not only to solve them but above all to ensure that they do not happen again. Ethical organizational culture is a specific dimension of organizational culture describing organizational ethics and the ethical behaviors that flow from them (Key 1999). For example, when ethical behaviors are encouraged by the organizational culture, they tend to occur more frequently. On the other hand, if the organizational culture encourages unethical behavior, the latter will be more easily applied by the majority of human resources. Hofstede et al. (2010) defined culture as “a collective programming of the mind that distinguishes members of one group from another.” They view culture as an important variable influencing consumers’ ethical decisions and behavior. Ethical practices can have a positive multiplier effect, at all levels of an organization or a society, when leaders actually apply them. Ethical practices are acquired through a continuous process of ethical learning (Bisoux 2021). According to Llatas and Silva Junior (2005), the virtues resulting from adequate ethical behavior are justice (including honesty and fairness in judgments), prudence (including patience, gentleness, and humility), and courage (including audacity to dare to change things, goodwill, perseverance, and resilience). Thus, any individual working in the company is influenced by a set of factors that will guide his choice in daily life. Unethical decisions made by the leader in an organization necessarily lead to an overall reduction in performance and misuse of economic resources: financial embezzlement, fraud, bribes, etc. (Marani et al. 2018). The management team plays an indispensable role in promoting the ethical organizational culture in the company, notably through an ethical leader showing the way to be followed by the employees of the company, as well as the objectives to be achieved, the decisions, the solutions, and required communications (Nel et al.

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2011). An ethical organizational culture is a key to success for companies wishing to survive. According to the “Ethics Resource Center (2010),” ethics is an essential concept of corporate governance and contributes to the fight against corruption. A strongly ethical culture helps the company more easily and more effectively achieve all of its objectives, including those that contribute to sustainable development and sustainable finance. The example of the multinational Panasonic highlights how ethical culture is at the heart of corporate actions and decisions. According to Panasonic, “A company is an Entity for Society.” Indeed, the purpose of the company is to help people and not just to make money. Panasonic’s ethical organizational culture is demonstrated mainly through the application of a regularly reviewed code of conduct. This code includes respect for laws, regulations, and business ethics by all members of the company. Panasonic is particularly careful not to resort to any embezzlement whatsoever and to respect the social ethics governing the offer of benefits of all kinds (including gifts, meals, and entertainment). In short, the company does not want its members to receive any personal benefit from any stakeholder. Finally, in the event of suspicion of noncompliance with its laws and ethical standards, members of the company are required to report this information to a superior or the legal department. Panasonic also pledged to adhere to sustainable goals from product design and throughout the production process, reducing CO2 emissions at all production plants and striving to bring energy-friendly products to market (Doueiry Verne and Meier 2018). Thus, these few examples show that companies create value through an ethical culture experienced by the members of the group; legislation alone is not enough. Ethical behavior can be legal. However, behavior that is merely legal may not be ethical and may not conform to the company’s code of conduct. Indeed, the unethical leader often acts in a legal way, in accordance with the powers conferred on him, but his action is devoid of ethics, creating injustices and frustrations around him. The notion of ethics is therefore intimately linked to that of organizational culture (Armstrong 2006). The organizational ethical culture is considered for the company as a guarantee of efficiency, stability, flexibility, transparency, and sustainability. The personal moral development and the authenticity of the leaders are essential for a good establishment of the organizational ethical culture within the company.

5 Discussion and Conclusion Managers and particularly the ethical leaders in the organizations are responsible to create and embed ethical culture within the organizations (Morris 2009). In fact, a strong corporate ethical culture starts with the organization’s leaders which are called “tone at the top” (Amernic et al. 2010). Aquila and Bean (2011) define tone at the top as a level of commitment to integrity that leads to the right conduct regardless of the consequences such conduct might have on financial performance. This link between corporate ethical culture and ethical leadership has been shed in light by Schwartz (2013) who has developed the Ethical Corporate Culture (ECC)

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model. Such a model can be seen as multidimensional regarding corporate ethical culture. Thus, the ECC model includes three pillars that contain: – The core ethical value includes trustworthiness, respect, responsibility, fairness, caring, and citizenship. Thus, ethical leadership plays an important role in the set of the ethical core values infused throughout the organization in its policies, processes, and practices. – The formal ethical program refers to the establishment by the ethical leader of a formal ethics program containing a code of ethics, ethical training and ethics hotline, and an ethics officer. – The third pillar is related to the presence of ethical leadership who implements the other pillars by transmitting ethical values and establishing the ethical program as relayed by the board of directors, senior executives, and managers. Moreover, the corporate ethical culture with which the ethical leadership assures the ethical management of the organization has two dimensions (Chadegani and Jari 2016). The first one is to promote ethical conduct, and the second one is to prevent unethical conduct and corrupt acts as well. Thus, an ethical leader leads through examples and traces the ethical way to be followed by the stakeholders and shareholders with whom he works. Ethical leadership guarantees the prevention as well as the fight against all forms of corruption and even leads the company toward sustainable development. The corporate ethical culture endorsed by the ethical leadership applies in all departments and at all levels of the hierarchy, which will result in financial and managerial performance consistent with sustainable development. When companies reach a high level of sustainability, it means that they have already achieved a strong and effective ethical culture. This implies that they have been able to fight, in the first instance, against all concerns relating to corruption, from minor infractions to the most pernicious acts, to finally arrive at sustainable business and sustainable finance. Reaching this goal could not have been done without ethical leadership intimately linked to an ethical organizational culture allowing the company to attain this high level of ethics. The role and mission of these leaders will be to train other leaders so that they can perpetuate this ethical organizational culture in the company. In conclusion, it is therefore essential, even vital, to instill in future managers the foundations of ethics so that they understand that ethics is not theoretical but practical. Their duty as leaders will be to apply ethics on a daily basis in their companies or institutions and thus become vectors of change inspiring the future generation of leaders.

References Amernic J, Craig R, Tourish D (2010) Measuring and assessing tone at the top using annual report CEO letters. The Institute of Chartered Accountants of Scotland, Edinburgh

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Carole Doueiry Verne is a Professor-HDR at the Faculty of Business and Management, SaintJoseph University of Beirut (Lebanon) and former Vice-Dean (2018-2020). In 2020, she was appointed member of the Middle East and North Africa Advisory Council (MENAAC) of AACSB. Her main areas of research and publications focus on the economic analysis of ethics and corruption, corporate social responsibility, cross-cultural management, and the influence of culture on international marketing. Her most recent book (co-authored with Olivier Meier) is Culture & Éthique. Regard sur le Japon et les grandes entreprises japonaises (VA Editions, 2018).

The Development of Sustainable Finance and the Axiological Strategies Against Corruption in Organizations: Enhancing Virtues or Emphasizing Moral Duties? Michel Dion

1 Introduction Sustainable finance can hardly be separated from prevention strategies against corruption since corruption adversely affects corporate (and industry) reputation, the credibility of the corporate discourse about moral/ethical issues, and thus the shareholder value creation. Corrupt practices increase the degree of corporate risks (including the risk of lawsuits, the risk of damage corporate/industry reputation, and moral laxity in the organizational culture). Moral/ethical decision-making processes are involved in every sustainable development issue. The moral/ethical framework decision-makers have chosen directly influences the kind of prevention strategies (against financial crime) they will enhance and strengthen. There are two basic axiological choices (and strategies) that an organization could take, when developing and implementing its core values throughout its corporate culture. On one hand, a virtue-based approach (Aristotle) puts the emphasis on the continuous practice of virtues, in the organizational setting. In this case, the prevention strategies against corruption and the development of sustainable finance are centered on the search for the ethical aim, at the organizational, industry, institutional, or societal level. On the other hand, a duty-oriented approach (Kant) is centered on moral norms that would be acceptable for all rational beings and thus for all organizational members of a given company. In this case, the prevention strategies against corruption as well as sustainable finance strategies emphasize moral duties (and imperatives), regardless of circumstances. The analysis of the basic conditioning factors of corruption (and thus the plurality of moral tones about corruption: in globalized markets, in the national culture, and in the political/legal environment) provides the general context in which axiological choices are made. The axiological choice of prevention M. Dion (✉) Sherbrooke, QC, Canada e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_8

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strategies against corruption largely depends on the basic orientation of the corporate discourse about questionable behaviors (either the search for the ethical aim or the strict compliance with universalized moral norms). Whether an axiological choice of prevention strategies against corruption implies to endorse Aristotelian or Kantian ethics, it has a deep impact on sustainable finance (sustainable investments, corporate sustainable development).

2 The Basic Conditioning Factors of Corruption in the Organizational Culture: The Plurality of Moral Tones Corruption may be defined in various ways: attempt to create and strengthen a culture of individual self-interest (Gopinath 2008, 749), abuse of authority for personal gain (Aguilera and Vadera 2008, 433; Ngo 2008, 28; Nyblade and Reed 2008, 927), infringement of rules and laws to favor individual or group/organizational/institutional interests (Hyslop 2005, 776; Chatziioannou 2008, 1; Divjak and Pugh 2008, 373), misuse of power for getting fraudulent gain (Jiménez 2009, 256), and abuse of decision-making processes (Beresford 2010). Corruptors use rationalization strategies as “post hoc justifications” (Rabl and Kühlmann 2009, 282). They attempt to create a “no-blame” culture, as a way of salving their own conscience. Corruption grows because of various conditioning factors which could be interconnected: the propensity of globalized markets to favor/penalize bribery, the capacity of national culture to criticize/denounce bribery, and the political will to fight corruption through effective regulations and laws. In each case, a potentially different “moral tone” is provided. A moral tone is the directionality of the constellation of moral beliefs and values. It deeply affects the meaning system of an individual (including values and norms of behavior, ideas and representations, convictions and beliefs, rituals, and symbols). By analogy, every organization, social institution, or national culture has its own moral tone. On the individual level, a moral tone requires self-awareness. On the organizational and industry level, a moral tone needs either consensual decision-making processes or a top-down value-orientation. On the institutional and societal level, a moral tone stems from daily habits and deeds which express the evolution of the social fabric. Every conditioning factor provides a specific “moral tone,” when influencing and/or strengthening corrupt practices in organizations. The plurality of moral tones about corruption could eventually make prevention strategies ineffective and unrealistic.

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The Moral Tone of Globalized Markets

The moral tone of globalized markets is centered on integrity and mutual trust either between competitors or between business partners. Organizations could deny their engagement in bribery, when operating in more corrupt environments. It is particularly the case, when organizations “conduct business in a more competitive setting and when they are less identifiable” (Gago-Rodríguez et al. 2020, 622). Market penalties against bribery seem to be stronger when top managers and/or directors are involved in the bribery (Sampath et al. 2018, 756). In developing countries, the macro-governance environment is often weak. Such context could favor the arising of corrupt practices in the daily life. However, family control could reduce the propensity of younger entrepreneurial companies to adopt bribery behaviors (Ding et al. 2016, 651). Corruption does not always reduce foreign investment into corrupt countries (Malhotra et al. 2010, 504; contra: Ampratwum 2008, 80): for instance, in China, Indonesia, and Brazil. Bribery could have bad macroeconomic impact (unfair competition, distorted markets), national impact (bad governance, increased poverty, low quality of life, political instability, organized crime/terrorism, and threats to human security), and even moral/ethical consequences, such as human rights abuses and hindrances to trust and integrity (Malgwi 2016, 962).

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The Moral Tone of National Culture

The moral tone of national culture is centered on integrity and transparency in social institutions (business, government, judicial system, education system, healthcare system). National culture plays a major role in explaining the intensity and development of bribery. The fairer and more egalitarian cultures are less prone to adopt and justify bribery behaviors than unfair/inequal cultures (Akbar and Vujić 2014, 208). But what is the exact meaning and implications of an “egalitarian” or “unfair” culture? It is not crystal-clear. The propensity to pay bribes in the international context may be strengthened by firms’ attitudes and behaviors related to bribery in its own country (Sanyal and Guvenli 2009, 296; Baughn et al. 2010, 17, 23), or even to practices of domestic transparency and integrity (Calderón et al. 2009). Sampath and Rahman (2019, 832) have identified the impact of corruption culture distance (and thus the perceptions of bribes) between the home and host countries. They concluded that corruption culture distance may lead to corrupt behaviors. Thus, bribery could have societal/cultural, economic, and political causes (national level). However, the phenomenon of bribes is also provoked by institutional causes (meso level), particularly by the regulatory voidness (Bu 2018, 189). Corruption may be tolerated because of the way social relations are evolving (Reno 2008, 400). Systemic corruption implies that large proportion of people in given group, organization, or institution are corrupt and cooperate in corrupt behaviors and attitudes (“schematic corruption”: Aguilera and Vadera 2008, 442). In such situation, there are less

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probabilities that corrupt behaviors will be denounced and even condemned (Kimuyu 2007; Blackburn et al. 2010, 8). However, it is one thing to say that corruption is a social construct (Shehu 2004, 70; Bailey and Paras 2006, 63; Okogbule 2006, 95). It is quite another thing to assert that its social/cultural dimension is the dominant dimension of corruption. The causes of corruption could vary from one country to another (Bayar 2005, 278). Prohibitions of corruption could be culturally and socially induced. The motives behind such prohibitions could then vary from one country to another (Bierstaker 2009). They could even depend on the type of societal culture: a rule-based culture or a relationship-based culture (Hooker 2009, 254). When a given moral philosophy is largely shared in a country, then it could influence the way people perceive and criticize corrupt behaviors (Tian 2008). But if it is the case, then the phenomenon of corruption becomes a purely subjective phenomenon that may hardly be measured (Ng 2006, 823). Unlike gift-giving, bribes are given either “without any emotional bondage or sensitivity” (D’Souza 2003, 32) or without any concern for the quality of relationship between given and recipient (Werner 2000, 17). We should always be aware that gift-giving could open the door to disguised bribes (Chang et al. 2001).

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The Moral Tone of the Political and Legal Environment

The moral tone of the political and legal environment is centered on public trust toward political and legal institutions. Anti-corruption strategies could produce political instability (Johannsen and Pedersen 2011, 330). Indeed, they strongly shake the foundations of the social, economic, and political status quo. However, the efficiency of anti-corruption strategies largely depends on the political will, that is, the political leaders’ will (Della Porta and Vannucci 2007, 835; Abdulai 2009, 409; Ristei 2010, 342). Nonetheless, if the state is unable to get high rates of detection, then it could send the message of tolerated corruption. So, efficient anticorruption strategies should accompany the political will (Wedeman 2005, 114). Moreover, corrupt states could facilitate organized crime activities (Holmes 2008, 1012). Corruption opens the way to related financial crimes (such as fraud and money laundering). Bribery could endanger democratic institutions since it could reduce the public’s trust in democratic mechanisms, institutions, and processes (Pacini et al. 2002, 389; Newell 2005, 164; Yu et al. 2013, 76). The propensity to pay bribes in foreign countries could be strongly influenced by their legal environment. If legal systems tolerate corruption, then they could implicitly encourage foreign multinationals to adopt corrupt behaviors (Wu 2009, 79). The weakness of anti-corruption regulations could be a “silent” justification for corrupt practices.

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The Plurality of Moral Tones and the Need for Ethical Reflection

If bribery is cooperative and extorsion is antagonistic (Khalil et al. 2010), then prevention strategies against bribery become much less efficient and even relevant. Prevention strategies against bribery could be more effective when they mix rulebased approach (emphasis on regulations and laws) and value-based aspects (emphasis on the internalization of values/virtues) of corruption prevention (Scott 2013). The potential interconnectedness between the basic moral tones (from globalized markets, the influence of national culture, and political/legal environment) makes prevention strategies against corruption more difficult to design and apply efficiently. That is why the ethical reflection about the (“axiological”) choices of decision-makers, when confronted to corrupt practices, should be deepened. The plurality of moral tones remains problematic since all moral tones are not necessarily compatible with one another. The moral tone about bribery generally enhances integrity and trust. However, the meaning of integrity and trust may be quite different, when applied to business partnerships and relations with competitors (the moral tone of globalized markets), to various social institutions (the moral tone of national culture), and to the political and legal institutions (the moral tone of the political and legal environment). Ethical reflection is thus needed to explore different ways to resolve possible contradictions between moral tones. Corporate strategies against corruption presuppose an “axiological choice,” that is, a paradigmatic choice (either a virtue-focused framework or a duty-centered framework) and a choice of moral commitments (choice of virtues or choice of moral duties). There are other paradigmatic choices. However, the alternative of virtues and moral duties remains one of the most usual ones.

3 The Corporate Moral/Ethical Discourse and the Axiological Choice of Prevention Strategies Against Corruption The corporate “ethical” discourse includes various kinds of narratives. Narratives could be either written or related to actions. Written narratives about ethical issues include corporate value statements and corporate social responsibility/sustainability/ citizenship reports. In corporate value statements, the hermeneutic challenge is to clearly define the meaning of values and their scope of application, given that those values could be interrelated. The most important interpretative pitfall lies in the incapacity to make organizational values understandable and easily applicable in the organizational culture and life. In corporate social responsibility/sustainability/citizenship reports, the hermeneutic challenge is to understand how corporate activities and projects could be related to core organizational values. The most important interpretative pitfall stems from the absence of axiological interconnectedness

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between core organizational values (related to corporate culture) and the basic values enhanced in those reports. When dealing with the issue of corruption, the corporate ethical discourse enhances the internalization of core values by all organizational members. It proposes a model of virtuous life, given that the continuous practice of organizational values gives birth to virtuous behaviors. Thus, corporate strategies against corruption are then “virtue-oriented.” The corporate “moral” discourse is a written narrative that emphasizes the norms of organizational behavior (organizational policies, corporate code of ethics). It can be either compartmentalized or totalized. The compartmentalization of moral normativity is clearly expressed in organizational policies about various organizational issues: health and safety in the workplace, protection of the environment, prohibition of harassment and discrimination, relations with suppliers, and so forth. In organizational policies, the hermeneutic challenge is to avoid the compartmentalization of moral norms through various corporate policies and issues. The most important interpretative pitfall lies in the incapacity to adopt a large perspective about moral issues and to grasp the interconnectedness between moral norms. The totalization of moral normativity is rather conveyed in corporate codes of ethics since all moral issues should supposedly be covered by its provisions. Each organizational policy puts the emphasis on specific moral issues. The corporate code of ethics rather claims to cover all moral norms of behavior in the workplace. In corporate codes of ethics, the hermeneutic challenge is to avoid totalization processes about moral norms. The most important interpretative pitfall is expressed in the absence of critical judgment, when being confronted to “totalizing” moral norms. When dealing with the issue of corruption, the corporate moral discourse puts the emphasis on organizational members’ compliance with basic moral standards and duties (moral normativity). It describes a set of moral norms (and thus moral duties) which should always orient organizational behavior, regardless of circumstances. In doing so, corporate strategies against corruption are then “duty-based.”

4 Aristotelian Ethics and the Search for the Ethical Aim in the Organizational Culture: Virtue-Oriented Strategies for Preventing Bribery Paul Ricoeur (1996, 200–202, 211, 227, 1999, 259–262) defined the ethical aim as the attempt to get a good life with others and for others and to safeguard just institutions (institutional and social justice). Human being is defined through freedom and subjectivity (Aristotle 1943, 133). Being free is being one’s own end. It presupposes that people are not others’ end (Aristotle 2000, 9). Aristotelian virtues could be used to widen and deepen the way management consulting develop and improve their consultancy interventions and relationships with their clients (Shaw 2020). If a given organization chooses a virtue-focused framework, then it searches

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for the ethical aim. However, the organization is confronted to a philosophical questioning which follows from its axiological choice.

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How Could Virtuous Life Allow People to Improve Their Emotional, Attitudinal, and Behavioral Self-Control, When Facing Corruption?

According to Aristotle, there is no representation without prior sensations. Having a given representation means developing an opinion about some sensations. There is no belief without prior representations (Aristotle 1993, 215, 218). Aristotle defined three states of the soul: emotion, capacity, and disposition. An emotion is a “state of consciousness which is accompanied by pleasure or pain.” A capacity is “the faculty in virtue of which we can be said to be liable to the emotions.” A disposition is “a formed state of character in virtue of which we are well or ill disposed in respect to the emotions” (Aristotle 1996, 38). Aristotle clearly asserted that virtues and vices are neither emotions nor capacities. Rather, virtues and vices represent a given mode of choice. Both are dispositions of the soul. A given virtue, such as courage, is then a state of the soul through which “we are well or ill disposed in respect of the emotions” (Aristotle 1996, 38). A choice is a voluntary act. Unlike animals, human beings can exercise choice. Animals are rather totally subjected to their passions and instincts. Choosing is identifying the means to reach our end. The end is the object of wish, and not of choice (Aristotle 1996, 57). Aristotle defined a virtue as “a settled disposition of the mind determining the choice of actions and emotions, consisting essentially in the observance of the mean relative to us, this being determined by principle, that is, as the prudent man would determine it” (Aristotle 1996, 41). So, any virtue is intrinsically related to emotions and actions (Aristotle 1996, 53). Human being has “the gift of speech.” Only human language and speech can identify frontiers between good and evil or between just and unjust. Unjust laws stem from “perverted forms of government” (Aristotle 1943, 54, 149). Justice requires lawfulness as well as equality (or fairness). Aristotle believed that justice is the perfect virtue, or “the whole of virtue.” Injustice is not a specific vice but rather “the whole of vice.” Injustice is a lack of lawfulness and the absence of equality (or the absence of fairness). Justice and injustice may be practiced toward all people including ourselves. That is why they are opposite kinds of wholeness (Aristotle 1996, 114–118). Justice is intrinsically linked to the “mean,” while injustice enhances the extremes of excess or deficiency (Aristotle 1996, 125). Being unjust is undertaking unjust actions (Aristotle 1996, 135). Corruption gathers behaviors (bribery, extortion) which produce unjust consequences. Corrupt behaviors are grounded on unfair intent and on the will to transgress laws and regulations (for favoring one’s self-interest). Corruption is a vicious state of mind/heart which creates unjust schemes of thought, speech, and action.

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All things and actions aim at the good, said Aristotle. Nonetheless, good choices and actions may have harmful effects on people: in some situations, “courage has cost men their lives,” argued Aristotle (1996, 3–4, 12). There is no universal notion of good. The sense of good may be differently circumscribed, as regards its substance, quality, quantity, and temporal and spatial actualization. Things could be either good in themselves or good as means for good-in-itself (Aristotle 1996, 8–9). People always choose happiness “for its own sake, and never as a means to something else.” They do not choose happiness as means to get more pleasure, power, or renown. Happiness is then a “final good,” that is, a self-sufficient good: “a thing which merely standing by itself alone renders life desirable and lacking in nothing,” argued Aristotle (1996, 12–14, 22). In some situations, people are unable to behave in conformity with several virtues. Aristotle asserted that individuals should then be “in conformity with the best and most perfect among them” (Aristotle 1996, 13). Happiness requires “a complete goodness and a complete lifetime.” If people have reached supreme happiness, then their whole life always remains happy (Aristotle 1996, 17–20). Aristotle defined happiness as “a certain activity of soul in conformity with perfect goodness” (Aristotle 1996, 22). Happiness is intrinsically linked to the daily practice of virtues (Aristotle 1996, 71, 273, 279). Vices only create unhappiness and suffering. This is particularly the case for corruption since corruption has adverse effects on people (power abuses), organizations (loss of honesty/integrity in the organizational culture), social institutions (such as the business community: reducing competitiveness through illegal and unfair means), and even political authorities (making democratic processes degenerate). Virtuous actions are pleasant because of their own essence (Aristotle 1996, 15). “Things productive of virtues are noble,” said Aristotle. Every virtuous action (such as a courageous action) is noble since it tends toward virtue. Just actions are oriented toward justice. That is why they are virtuous. Virtuous actions are good in themselves, regardless of individual interests, needs, and desires. Altruistic actions are inherently virtuous since they are not egocentric (Aristotle 1954, 57–58). Virtues are noble. They are put in practice because of their intrinsic nobility (Aristotle 1996, 86). Aristotle (1996, 24) distinguished intellectual virtues (wisdom, prudence) and moral virtues (liberality, temperance). Wisdom gives birth to happiness, since it is “a part of virtue as a whole” (Aristotle 1996, 158). Rabbås (2015, 620) rightly distinguished Aristotle’s intellectual virtues and virtues of character. Intellectual virtues are related to “direct activities of reason.” They imply moral deliberation led by wisdom and prudence. Moral virtues are rather connected to indirect activities of the reason since they are related to “how we spontaneously perceive a situation and respond to it.” When analyzing corrupt behaviors, prudent and wise decision-makers know that corruption distorts basic values of individual and community life, such as justice and altruism. Moral virtues deal with pleasures and sufferings, argued Aristotle. Pleasures and pains could corrupt us in various ways: “by pursuing and avoiding the wrong pleasures and pains, or by pursuing and avoiding them at the wrong time, or in the wrong manner, or in one of the other wrong ways under which errors of conduct can be logically classified” (Aristotle 1996, 36–37). Aristotle concluded that moral

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virtues imply acting “in the best way in relation to pleasures and pains.” Pleasure is not the good since every pleasure is not systematically desirable. Some pleasures are superior to others, either because of the intrinsic quality or because of their origin (Aristotle 1996, 265). So, moral vices are then logically the opposite (Aristotle 1996, 36). Moral virtues are produced and eventually altered by habit. Human beings have the natural capacity to put moral virtues into practice. Aristotle believed that “this capacity is brought to maturity by habit.” People acquire moral virtues by practicing them in our daily life: “we become just by doing just acts, temperate by doing temperate acts, brave by doing brave acts.” Our actions are continuously determining the quality and depth of our moral virtues (Aristotle 1996, 33–34, 37–38). Individuals become more temperate “by abstaining from pleasures” and more courageous by “training to despise and endure terrors.” When such decisions become daily habits, then they strengthen the virtues people are practicing. Acting with virtue increases the quality and depth of one’s virtues (Aristotle 1996, 35–37). Habits could be either vicious or virtuous. Some behaviors convey the message that corruption is an integral part of the “business as usual syndrome.” Such syndrome shows how illegal and unfair behaviors could be trivialized. Being “virtue-focused” requires fighting any attempt of trivialization, when facing inherently vicious behaviors. Negative passions (such as anger, hatred, and jealousy) bias and misdirect human judgment. Uncontrolled passions “pervert the minds of rulers, even when they are the best of men” (Aristotle 1943, 160, 163). Aristotle enhanced the “observance of the mean” between the extremes (excess and deficiency). He believed that neither the excess nor the deficiency may convey any kind of perfection. The extremes of excess and deficiency constitute vices and errors which lead to failures and misunderstandings. Avoiding those extremes unveils the “greatness of the soul.” That is why Aristotle enhanced the mean between the (vicious) extremes of excess and deficiency. Moral virtue then becomes the mean itself, between the vice of excess and the vice of deficiency. That is why prudence can never be isolated from moral virtue (Aristotle 1996, 188). Aristotle identified three basic principles for deciding where is the “mean”: (1) avoiding the extremes, (2) being aware of the “errors we are ourselves most prone,” and (3) “being most of all on our guard against what is pleasant and against pleasure, for when pleasure is on her trial, we are not impartial judges” (Aristotle 1996, 35, 40–47). The mean between the vice of excess and the vice of deficiency is a laudable concept. Nonetheless, it cannot always be directly applied to some questionable behaviors. Is corruption a vice of excess or a vice of deficiency? Insofar as corruption implies power abuses, then it could be considered as a vice of excess. But corruption always needs a tragic loss of integrity/honesty, so that it would then be a vice of deficiency. Is that the right way to address the famous “mean between extremes,” when facing corruption? Corruption does not appear on the moral continuum between the vice of excess and the vice of deficiency. If it were the case, then “the mean” would make corrupt behaviors acceptable, in some circumstances. Nonetheless, the virtue of justice is so important for Aristotle, that it would be unreasonable to reach this conclusion.

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Could Deliberation and Prudence Enhance the Golden Mean Between Extremes, When Facing Corruption?

People deliberate about the optimal means to reach a given end, and not about ends themselves. Practical wisdom requires “deliberation of means to chosen ends,” said Mueller (2009, 162). Deliberation deals with “matters which, though subject to rules that generally hold good, are uncertain in their issue; or where the issue is indeterminate, and where, when the matter is important, we take others into our deliberations, distrusting our own capacity to decide” (Aristotle 1996, 59). The object of deliberation cannot be permanent (unchanging) things since deliberation would then be useless. Moreover, people cannot deliberate about “things not within our power to do” since such deliberation would be vain (Aristotle 1996, 149). Prudence may be practiced with “things that can be the object of deliberation” (Aristotle 1996, 152). Deliberation precedes the selection of the object of desire. After having selected this object of desire, decision-makers “fix their desire according to the result of their deliberation.” Actions that are grounded on such fixed desire (such as moral virtues and vices) are voluntary. Any action has two basic (and interrelated) causes: on one hand, the fixed desire (after deliberation) and, on the other hand, the reasoning about a given end (the function of the intellect). Aristotle then argued that virtuous and vicious behaviors depend on one’s choice (Aristotle 1996, 59–62, 65, 146–147). Aristotle argued that voluntary actions are undertaken either by choice (after deliberation) or without choice (without former deliberation) (Aristotle 1996, 128–129). All virtues should be practiced with the observance of the “mean.” For instance, courage must avoid the extreme of excess (confidence) and the extreme of deficiency (fear). The mean positioning requires to endure fears, while keeping self-confidence. However, fear and self-confidence must be related to “the right things and for the right purpose and in the right manner and at the right time.” So, the way the courageous person deals with fears and self-confidence largely depends on the prudent analysis of the context (Aristotle 1996, 65–68). Aristotle believed that prudence determines the “rightness of the means we adopt to gain that end.” The rightness of the means implies that those means are good. Being prudent is choosing the right means and thus being good (and rightly exercising our judgment) (Aristotle 1996, 158–161). The observance of “the mean between extremes” requires courage and prudence. But it cannot neglect the virtue of justice. So, there would be no room for corrupt behaviors. Rejecting/denouncing corrupt behaviors is being courageous and prudent, while focusing on the virtue of justice.

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5 Kantian Ethics and Moral Normativity in the Organizational Culture: Duty-Oriented Strategies for Preventing Bribery According to Paul Ricoeur (1996, 262; 1999, 262–266), Kantian moral normativity refers to the way practical reason universalizes given moral norms. Kantian moral normativity emphasizes the person as an “end-in-itself.” The ultimate ground of Kantian morality is human dignity (as an “end-in-itself”).

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Could Moral Law and Duties Allow Decision-Makers to Avoid Corruption, Regardless of Circumstances?

Kant (1983, 44) asked the following question: “Is it a necessary law for all rational beings that they should always judge their actions by such maxims as they themselves could will to serve as universal laws?” Kant have formulated the moral law in three basic and interrelated ways: First Formulation “Act only in accordance with that maxim through which you can at the same time will that it become a universal law” (Kant 1983, 39, 2002, 38); “I should never act in such a way that I could not also will that my maxim should be a universal law” (Kant 1983, 18); “any action is right if it can coexist with everyone’s freedom in accordance with a universal law, or if on its maxim the freedom of choice of each can coexist with everyone’s freedom in accordance with a universal law” (Kant 1991, 56). Any universal law must be applied to all rational beings (Kant 1983, 57). Any maxim is the subjective principle of action that rational beings define and apply to all rational beings (Kant 1983, 67). Any maxim which strengthens dishonest behaviors could not be universalized, not only because it would not be rationally grounded but also because its universalization would provoke social chaos (Feldmeijer 2009, 233). Second Formulation “Act so that you use humanity, as much in your own person as in the person of every other, always at the same time as end and never merely as means” (Kant 2002, 46–47); “Act so that you treat humanity, whether in your own person or in that of another, always as an end and never as a means only” (Kant 1983, 47). The notion of humanity refers to human being as and end-in-itself, that is, “our rational nature or capacity to set ends” (Calder 2005, 239). Third Formulation “Not to choose otherwise than so that the maxims of one’s choice are at the same time comprehended with it in the same volition as universal law” (Kant 2002, 58). Here, Kant referred to the individual who defines a universal law, while being subjected to this universal law. This is the “principle of autonomy of the will” (Kant 1983, 50–52). Kant even described autonomy as “the basis of the dignity of both human nature and every rational nature” (Kant 1983, 54).

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Kant (2011, 102, 428–429) explained that the concept of freedom is based on the legislative function of reason. Moral law is the rational and formal condition for freedom since it is not subjected to external conditioning factors (Gaziaux 1998, 19). Kant argued that “the legislation of human reason (philosophy) has two objects, nature and freedom, and therefore contains not only the law of nature, but also the moral law.” Kant made a basic distinction between nature and morality: “the philosophy of nature deals with all that is, the philosophy of morals with that which ought to be” (Kant 1965, 658–659). The freedom of the will means a will that is subjected to moral laws (Kant 1983, 65). Moral law makes the concept of freedom possible. Without moral law (the awareness of the “ought”: what people must do), individuals would not become aware of their own freedom (the awareness of one’s capacities: what people “can” do) (Kant 2007, 52–53). This is the basic principle of moral autonomy. The notion of autonomy presupposes the identity between the norms (laws) and the self. It is the law an individual gives himself/ herself. According to Ricoeur, Kant defined the synthesis of law (norms) and freedom (self) as a “fact of reason” (Ricoeur 2019, 138, 144, 316). The awareness of one’s freedom (what someone can do, in the here-and-now) is grounded on the existence of moral laws (what everybody must do). Without moral law, decisionmakers would be unable to get efficient strategies against corruption. Given human finitude (the “can”), moral law imposes its duties (the “ought”) (Stern 2004, 57). Respecting moral law is actualizing the duty to freely comply with moral law (Kant 2007, 107, 121). Freedom is the intrinsic worth of the world (Kant 1997, 233). The knowledge of moral laws presupposes one’s free will. Otherwise, moral laws would be unknowable. Without one’s free will, someone would be unable to know moral laws (what he/she must do). The autonomy of the will is the basic principle of moral laws and duties. Moral law unveils freedom, that is, the autonomy of pure and practical reason, when being confronted to the “causes of the world of sense” (Kant 1983, 71, 73). Kant (1991, 42, 1965, 464–465) provided a negative concept of freedom (“independence from being determined by sensible impulses”) as well as a positive concept of freedom (“the capacity of pure reason to be of itself practical”). Obeying to moral law means that a free will mirrors human capacities for obedience: people can do (obeying to moral law) what they would like to do (expressing the autonomy of their own will) (Kant 2007, 57, 63). Moral law determines human will. Freedom can control inner trends and passions (Kant 2007, 113). A free will is never subjected to inner trends and passion, such as the continuous search for wealth, prestige, and power. A free will does not tolerate corrupt behaviors, even if partners in corrupt behaviors are motivated by the apparently consensual will to increase their wealth, prestige, or power. Human being is the subject of moral law because of the autonomy of his/her will (Kant 2007, 124). Moral law is “the principle of the autonomy of the will” (Kant 1983, 68). Autonomy expresses a good and free will which is not subjected to external conditioning factors (Gaziaux 1998, 15). The consciousness of moral law is not an empirical fact, argued Kant (2007, 55). Rather, pure reason proclaims itself as being an “originating law.” The morality of actions should never be grounded on desires. Desires could eventually change. Desires could strengthen corrupt

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behaviors, because of the continuous search for individual interests (wealth, prestige, power). If moral law were based on desires, then it would be impossible to prevent and fight corrupt behaviors. Embracing moral norms of behavior requires obeying to moral law, regardless of situations and contexts. In doing so, moral constraints will always remain powerful, so that the moral foundations of human deeds will never be strongly shaken (Kant 2007, 120). Moral law requires absolute necessity (moral command). Moral obligations are rooted neither in circumstances (context) nor in human nature. Rather, the ground of moral obligations lies in the (a priori) concepts of pure reason. According to Kant, people need to develop a metaphysics of morals “because of motives to speculate on the source of the a priori practical principles which lie in our reason, but also because morals themselves remain subject to all kinds of corruption so long as the guide and supreme norm for their correct estimation is lacking” (Kant 1983, 5–6). A priori principles do not have any empirical aspect since they are purely rational concepts. Moral concepts are grounded in reason and are thus a priori (Kant 1983, 26, 28). Moral duties presuppose that given actions are objectively in accordance with moral law. However, moral duties require one’s (subjectively driven) respect for moral law. Moral duties should always be described as moral obligations and never as something that meets (present or future) desires and expectations. Desires and expectations may largely vary from one context to another, from one period to another. That is why they can never be the grounds of moral law. Rather, moral duties are obligations which are not related to desires and expectations (Kant 2007, 116–117, 120). According to Kant (1983, 43), “duty is practical unconditional necessity of action; it must, therefore, hold for all rational beings (to which alone an imperative can apply).” Kant defined a duty as “the objective necessity of an action from obligation” (Kant 1983, 58; 1991, 233). The mandatory character of an action stems from a law. Only a law can make a given action “objectively necessary.” The obligation refers to a free and necessary action. This action is mandatory, because of a rationally based categorical imperative (Kant 1991, 46–49). Moral duties are closely linked to a good will. Nonetheless, acting from duty is never being subject to inner inclinations and to the various objects of one’s will (Kant 1983, 13, 17, 1991, 193). Without moral duties, there cannot be any intrinsically good will (Kant 1983, 20). The concept of duty requires a good will (Kant 2002, 13). Morality presupposes the accomplishment of duties (Gaziaux 1998, 69). A moral action is undertaken by duty. Its moral worth depends on “the maxim by which it is determined.” People must fulfill their moral duties in using their free will. Inner inclinations toward a given moral duty do not justify the fulfillment of such duty (Kant 1983, 16). The moral duty to reach perfection is an imperfect duty since it does not include any law guiding specific actions. Rather, it strengthens individual freedom to choose the right means for self-improvement (Kant 1991, 240; Dubbink and Van Liedekerke 2020, 385).

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Are Moral Imperatives Helpful, When Facing Corrupt Behaviors?

Nothing is infinitely good, except a good will, argued Kant: “there is nothing (. . .) that can be held to be good without limitation, except only a good will (. . .) The good will is good not through what it effects or accomplishes, not through its efficacy for attaining any intended end, but only through its willing, i.e. good in itself, and considered for itself, without comparison (. . .)” (Kant 2002, 9–10). Good will is good in-itself, without any limitation (Feldmeijer 2009, 230). Happiness requires a good will. Good will refers to the Kantian ideal of a good person (Thorpe 2006, 463–464). A good will is “good” because “it is good of itself,” and not because of its effects (effectivity) or because of “its adequacy to achieve some proposed end” (end-focused intent). A good will is “good” because the good is willed. A good will is good of itself (Kant 1983, 9–10, 13). An unconditional good will is never wrong. It is rather an absolute good. Categorical imperatives are intrinsically related to an “absolutely good will,” that is, a good will “whose maxim can always include itself as a universal law” (Kant 1983, 55–56, 63, 65). Categorical imperatives mirror intrinsically necessary actions (Gaziaux 1998, 39). In Kantian ethics, moral actions actualize categorical imperatives (Calder 2005, 237). Moral imperatives may be either hypothetical or categorical. Hypothetical imperatives require that “the action is good only as a means to something else”: the action is a means for a given end or purpose, whether it is “possible or actual.” In hypothetical imperatives, there is no moral command (Kant 1983, 62–63). Categorical imperatives refer to “the good in itself, and hence as necessary in a will which of itself conforms to reason as the principle of this will.” They express the good itself. There is no other end or purpose to be enhanced and strengthened. Nonetheless, Kant acknowledged that rational beings are continuously searching for happiness. Hypothetical imperatives put the emphasis on the means to favor one’s happiness. Corrupt behaviors may not be subjected to hypothetical imperatives since the various conditioning factors (whether they are cultural, social, economic, political, and even religious/spiritual) cannot morally justify corrupt behaviors. Those conditioning factors only explain historical processes which have given birth to corruption. A historically based explanation is never a moral justification since it is not related to any moral law. A given action is not categorically mandatory, but rather “a means to another end.” The imperative of morality requires an essentially good intention (Kant 1983, 31–33). According to Kant, the concept of happiness is indefinite: the components of any concept of happiness are driven from life experiences. Such components could then vary from one individual to another, from one country to another, and from one historical period to another. The idea of happiness presupposes “an absolute whole, a maximum, of well-being, in my present and in every future condition.” Kant believed that “happiness is an ideal not of reason but of imagination, depending only on empirical grounds which one would expect in vain to determine an action through the totality of consequences” (Kant 1983, 35–36). Kant asserted that reason

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enhances the interconnectedness of happiness and moral behavior. Without moral conduct, the search for happiness does not have any worthiness and rational justification (Kant 1965, 640–641). According to Kant, only human being (as a rational being) can use his/her will for defining his/her principles of action/decision. Human will is nothing but practical reason. Reason freely identifies the “practically necessary” actions which are then considered as “good.” It is not subjected to inner inclinations and traits of personality. Human will allows people to choose those “practically necessary” and rationally grounded actions. In such situation, rationally grounded actions are simultaneously “subjectively necessary.” The intrinsic connectedness of human will and reason gives birth to moral imperatives. As Kant (1983, 30) said, “imperatives say that it would be good to do or to refrain from doing something, but they say it to a will which does not always do something simply because it is presented as a good thing to do.” A “perfectly good will” requires the connectedness of human will and reason. However, when reason does not “sufficiently determine the will” and “if the will is subjugated to subjective conditions which do not agree with objective conditions,” then human will is disconnected from reason. The rationally grounded actions which are objectively necessary are then “subjectively contingent” (Kant 1983, 29–30). The means of an action “contains the ground of the possibility of the action, whose result is an end” (Kant 1983, 45). Kant (1983, 46–47) believed that human being, as a rational being, only exists “as an end in himself, and not merely as a means to be arbitrarily used by this or that will.” Human subjectivity and rationality make any objectification of human being unjustified. Human (rational) beings have an absolute worth. That is why human beings are ends in themselves. An “end-initself” can never be reduced to simple means. Subjectivity should never be objectified. Kant defined things as nonrational beings which can “have only a relative worth as means.” Human rationality is the decisive factor for attributing an “end-in-itself” to human beings. Human being is an “end-in-itself” since rationality “proposes an end to itself” (Kant 1983, 56, 1991, 195). The end of an action is freely chosen by a rational being, given that a rational being has specific representation of this choice. When an end is also a duty, then this is a “duty of virtue” (Kant 1991, 186–189). An end that is a duty of virtue should never be considered has a duty of right since any right is enforced through heteronomous laws (Mansell 2013, 587). Hence, an end which is a duty of virtue strengthens moral autonomy of the individual. Things do not have any rationality and freedom (Kant 1991, 50). Any free action which denies the “end-in-itself” of humanity is immoral and rationally unjustified. The “end-initself” of humanity is then the “supreme limiting condition of all subjective ends, whatever they may be” (Kant 1983, 49, 56). Only morality can make human being an “end-in-itself.” Any rational being is the “subject of ends.” Morality creates the interconnectedness of specific actions and the autonomous will (Kant 1983, 53, 56, 58). Only rational beings may define and apply moral laws to all rational beings (Kant 1983, 66). Only rational beings are convinced that corrupt behaviors contradict moral laws and duties.

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6 Sustainable Finance and the Axiological Choice Sustainable enterprises have better financial performance, at least for the “shareholder value creation” financial indicator (Gómez-Bezares et al. 2017). When companies integrate ESG criteria, then they reduce their stock volatility. Such phenomenon does not seem to be influenced by industry characteristics (Kumar et al. 2016). According to Schoenmaker (2017, 72), alliances of long-term investors could exert pressure on the companies in which they have invested when sustainable practices are at stake. The integration of ESG criteria depends on their “hoped-for impact on the economic or financial (stock market) value” of a given company (Revelli 2016, 161). Integrating environmental, social, and governance criteria (ESG) in investment strategies shows how a company is deeply dedicated to socially and responsible investments (SRI) (Sciarelli et al. 2021). The integration of ESG criteria in SRI also illustrates the way a company complies with the 2030 Agenda and the Sustainable Development Goals (SDGs), in its financial decision-making processes (Schumacher et al. 2020). SRI presupposes that ESG criteria are taken seriously. However, the influence of shareholder engagement toward ESG criteria is a decisive factor for developing and deepening the SRI strategies (Kölbel et al. 2020, 566). In developing countries, sustainable finance requires to improve the disclosure standards of sustainable through sustainable finance regulations. Moreover, the state, the central bank, and financial regulators should establish incentive and disincentive mechanisms which could allow decision-makers to strengthen their financial decision-making processes (Setyowati 2020, 10). Even in developed countries, the issue of ESG disclosure standards is crucial. SRI depends on the fact that those standards are crystal-clear and trustworthy (Busch et al. 2015). SRI expresses the implementation of ethical values in investment decisions (Pilaj 2017). However, what is the meaning of an “ethical value”? Ethical values are drawn from ethical theories. They do not necessarily have the same meaning in all ethical theories. Petrick (2011) presented a model of sustainable stakeholder capitalism which searches for the right balance between four “parallel ethics emphases” (moral character, moral rules, moral results, and moral context). The author has not described ethical theories which could be intrinsically linked to those “ethics emphases.” According to Soppe (2004), sustainable corporate finance implies an ethics of virtue. Some could rather propose that sustainable finance is grounded on pragmatist philosophy (Dewey, Rorty) or on the ethics of responsibility (Jonas). Investment decisions could be influenced by religiosity, insofar as given religion enhances sustainable criteria of investment. It is particularly true when believers’ decisions and behaviors are considered as having religious effects (Gutsche 2019, 1178). Even the Buddhist notion of mindfulness could allow decision-makers to apply compassion in the investment decisions (Faugère 2016). The axiological choice of decision-makers could favor either a virtue-focused (Aristotle) or a duty-oriented framework (Kant). It may have important consequences for designing and endorsing prevention strategies against corruption. Corrupt behaviors could adversely affect shareholder value creation since it largely

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increases corporate (and even industry) risks, whether they are operational or systemic. Sustainable finance would then strengthen prevention strategies against corrupt behaviors. However, the way the corporate discourse conveys moral/ethical values and principles influences the moral/ethical orientation of those strategies. If the corporate discourse is centered on the search for the ethical aim (Aristotelian ethics), then prevention strategies against corruption will be “virtue-focused.” In the corporate culture, organizational members will have various opportunities and activities to deepen the practice of virtues, to prevent the systemization of corrupt behaviors. Organizational members should then always use their judgment, be prudent, and choose “just” actions. Sustainable finance would express a deep concern for virtuous behavior and a constant orientation toward a more just society. If the corporate discourse is centered on moral normativity (Kantian ethics), then prevention strategies against corruption are “duty-oriented.” In the corporate culture, organizational members should then always remind that they must accomplish moral duties, when facing corrupt behaviors. The analysis of all conditioning factors is irrelevant since moral duties must be accomplished, regardless of circumstances. Sustainable finance would then unveil a basic concern for the accomplishment of moral duties and a constant orientation toward the use of rationality, when facing morally questionable behaviors (such as corruption).

7 Conclusion Axiological strategies against corruption in the corporate culture could be virtuecentered (Aristotle) or duty-oriented (Kant). Prevention strategies against morally questionable behaviors succeed in reducing the frequency of occurrence of vices. This is the a priori principle of any virtue ethics. Prevention strategies against morally questionable behaviors could make moral duties achievable. This is the a priori principle of any deontological ethics. Both kinds of axiological strategies could enhance sustainable finance and prevent corruption in the organizational setting. In both cases, the acid test of the a priori principle is to efficiently cope with various conditioning factors of corruption, in the organizational culture, and thus with the plurality of moral tones (drawn from globalized markets, national culture, or the political/legal environment). The plurality of moral tones about corruption in the corporate culture makes axiological choices much more complex than anticipated. The capacity of virtue ethics and deontological ethics to efficiently prevent corrupt behaviors and to concretely favor sustainable finance is not crystalclear. Any axiological choice should then be made, while clearly analyzing the relative weight of the various moral tones about corrupt behaviors. Future research could look at the applicability of other ethical (philosophical) theories, such as utilitarianism (Mill, Ross), pragmatism (Dewey, Rorty), the ethics of responsibility (Jonas), the ethics of the Otherness (Levinas), and the ethics of moral deliberation (Habermas), to sustainable finance decisions (such as sustainable investments and corporate sustainable growth). Other ethical theories could

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eventually enhance sustainable finance and prevention strategies against financial crime (including fraud, money laundering, tax evasion, and corruption) in a very different way. Comparing various ethical theories could allow researchers to identify multiple modes of axiological choices, when dealing with sustainable finance and the prevention of financial crime in the organizational culture.

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Michel Dion is Adjunct Professor from the École de gestion, Université de Sherbrooke (Québec, Canada), since January 2023 (Retired Professor). He has been Chairholder of the CIBC Research Chair on Financial Integrity (2010-2022) and Chair of the Department of Management and Human Resources Management (2017-2022) at the École de gestion, Université de Sherbrooke (Québec, Canada). His main fields of research include business ethics, ethical leadership, financial crime, corruption, management, spirituality, and organization. His research works have appeared in the Humanistic Management Journal, Leadership & Organization Development Journal, Business Ethics: A European Review, Social Responsibility Journal, Research in Ethical Issues in Organizations, the International Journal of Social Economics, and the International Journal of Organizational Analysis. His latest books include: Worldviews, Ethics, and Organizational Life (Springer, 2021); Financial Crime and Existential Philosophy (Springer, 2014). With David Weisstub and Jean-Loup Richet, he was co-editor of Financial Crimes: Psychological, Technological, and Ethical Issues (Springer, 2016). With Edward Freeman and Sergiy Dmytriyev, he was co-editor of Humanizing Business: What Humanities Can Say to Business (Springer, 2022). With Moses Pava, he was co-editor of The Spirit of Conscious Capitalism: Contributions of World Religions and Spiritualities (Springer, 2022).

Part II

Sustainable Finance, Corporate Governance, and the Challenge of Preventing Financial Crime

Corruption and Transactional Crime: Building up Effective Accountable Inclusive and Transparent Institutions as Ground for Sustainable Finance Mohammad Refakar and Gilberto Cárdenas Cárdenas

1 Introduction Corruption is a scourge that affects most countries in the world. In many of them, corruption is endemic, and its causes are not institutional but cultural. In general, corruption is a stain that covers many aspects of a country’s public and private life. It affects everything from economic growth to the interaction of citizens with the government in the day-to-day procedures of civil life. Therefore, it is difficult to find a univocal concept of corruption that encompasses the public and private spheres that establishes the causes and enumerates the effects. However, the literature suggests that the problem of corruption lies deep in countries’ culture and institutions. Institutions have been identified as a leading determinant of economic development (North 1990; Rodrik et al. 2004). Good institutions enforce contracts and protect citizens against expropriation. They also provide a more stable business environment as regulations are more frequently and effectively enforced. As well as producing and enforcing regulations, institutions perform distributive, representative, and accountability functions. Several previous authors have investigated the effect of institutions and have proposed that corruption is determined by the quality of institutions. In this approach, which has been termed the “hierarchy of institutions hypothesis,” corruption is viewed as an “intermediate product” influenced by institutions and influencing economic outcomes. Aidt et al. (2008) find that the quality of institutions plays an important role on corruption.

M. Refakar (✉) Université de Sherbrooke, Sherbrooke, Canada e-mail: [email protected] G. C. Cárdenas Autonomous University of Madrid, Madrid, Spain e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_9

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On the other hand, attention to sustainability issues has significantly grown in recent years. Stakeholders are increasingly pressure companies to have a more sustainable behavior and lower impacts on society and environment and to provide a more detailed information relating to sustainability through adequate disclosure policies (Eliwa et al. 2019; Manes-Rossi et al. 2018; Vitolla et al. 2021). Thus, environmental, social, and governance (ESG) considerations have become increasingly important by investors. Companies are exploring a more ethically responsible and sustainable way to conduct long-term business, and the integration of environment, society, and governance has become a focus of capital markets. However, there is a debate in the literature over the dimensions of ESG that a business must incorporate particularly in respect of the institutional system of a country. A country’s institutional structure (legal, social, and environmental environment) not only creates a direct transformation toward the business ideologies and practices (Ortas et al. 2015; Baldini et al. 2018) but also indirectly alters the mind set of investors. Thus, informal and formal institutions in a country can stimulate the process of ESG adoption by businesses (Dyck et al. 2019; Clementino and Perkins 2021). In this chapter, we will study the effects of institutions on both corruption and ESG disclosures. We first review the literature on the causes of corruption by emphasizing on the role of institutions and then the country-level variables that can affect the ESG disclosure will be analyzed. We focus on the role of the institutions than can both reduce the corruption in a country and encourage higher ESG disclosure performance. The rest of the chapter is organized as follows: in Sect. 2, the literature on corruption, its causes, and the role of institutions are reviewed, in Sect. 3, the country-level causes of ESG disclosure such as informal and formal institutions will be discussed, and we conclude in Sect. 4.

2 What Is Corruption? Corruption is commonly defined as “the abuse of an entrusted power for private gain” (World Bank 2010; UNDP 1997; Svensson 2005; Bardhan 1997; RoseAckerman and Palifka 2016). The key word in this definition, i.e. “entrusted power” refers to the tasks that should be done based on defined rules. This power can be entrusted by the populace to a government authority or by an employer to an employee. Broken rules followed by the abuse of entrusted power will have harmful results. Corruption is also defined as “the use of illegitimate forms of political influence by public or private parties” (Johnson 1999) and “the abuse of public rules or resources for private benefit” emphasizing that the concepts of “private,” “public,” “abuse,” and “benefit” may have different interpretations within different societies (Zimring and Johnson 2005). While corruption is commonly attributed to the public sector, it also exists in other aspects of governance, such as political parties, the private business sector, and NGOs.

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There are usually two parties that are involved in corruption: a public and a private party: the public party is a corrupt government official who is willing to misuse his power (demand side), and the private party is usually an individual or a corporation that is ready to pay the bribe in order to circumvent public policies and processes for a competitive advantage and profit (supply side). According to Osborne (1997), there are three different types of corruption: 1. Administrative or bureaucratic corruption where public officials abuse their office by demanding bribes. 2. Political corruption where politicians take bribes using their positions of power. 3. Grand corruption where heads of states, ministers, and top officials misuse their power for private profit. In bureaucratic corruption, which is the most common type of corruption, the public officers whose duty is to offer services to the public may ask for bribes to do their main tasks, accelerate service delivery or even provide some services that are not supposed to be available to the public. This type of corruption is usually in the form of paying and receiving bribes, offering government jobs and procurement contracts to friends and relatives (Rose-Ackerman and Palifka 2016). Political corruption which can be explained more by the agency problem refers to politicians who make public policies at their own interests and to the disadvantage of the public through changing the national policies or their implications (Jain 2001). Politicians and public officials may sell decisions in order to collect funds for their election campaign or for their own private wealth (Weyland 1998). Although it is difficult to measure this type of corruption as it benefits at least some small parts of the society, it would be easier to quantify it in its extreme form, when a dictator (and the top officials) applies all the public resources to serve only his own interests (Jain 2001). Grand corruption involves a few numbers of powerful participants seeking large amounts of money through paying legislators and state authorities to enact laws and regulations in their favor and through obtaining concessions connected to government contracts and owning private firms (Rose-Ackerman and Palifka 2016). In general, corruption contains a various types of concepts such as bribery, extortion, cronyism, nepotism, embezzlement, fraud (including judicial, accounting, public service, and electoral frauds), kleptocracy, exchange of favors, conflicts of interest, influence peddling, clientelism, campaign finance abuse, graft, kickbacks, misappropriation, misconduct, pork, patronage, machine politics, rent-seeking, scandal, theft, venality, interest politics, and side payments (Gerring and Thacker 2004; Rose-Ackerman and Palifka 2016). Table 1 explains and defines various types of corruption (Rose-Ackerman and Palifka 2016). Although corruption often implies an illegal action, not all corrupt acts are illegal; some may simply be dishonest or unethical, and it is quite difficult to distinguish the boundary between a corrupt and a non-corrupt behavior. For instance, giving a gift to a public official as an act of appreciation for their services may be overlooked in some cultures. Laws and definitions of corruption, in this regard, become culturally bound.

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Table 1 Various types of corruption Bribery Extortion Exchange of favors Nepotism Cronyism Judicial fraud Accounting fraud Electoral fraud Public service fraud Embezzlement Kleptocracy Influence peddling Conflicts of interest

Exchange of money, gifts, or favors for receiving legally costless services or for rule breaking A type of bribery in which an official asks for a bribe in exchange for doing his or her duty or for breaking a rule The exchange of one broken rule for another Employment priority is based on social ties or family members and not based on qualifications Making job-related decisions in favor of individuals with specific affiliations Unfair judgments due to threats or corruption background International seduction regarding sales or profits to raise stock prices To manipulate election results through threats to the electorate or through buying, destroying, or falsifying votes Any activity that undermines the legal necessities of public service delivery even if there is no bribery Theft from the employer by the employee An autocratic system with the purpose of maximizing the personal wealth of the top leaders To use one’s government-entrusted discretionary power to extract bribes or favors from interested parties To have personal interests in the consequences of made policies

Source: Rose-Ackerman and Palifka (2016)

3 Causes of Corruption There is a vast literature on the causes of corruption. Since there are two parties that engage in a corrupt transaction and their motivations and reasons are different, the authors explain the causes of corruption for the demand side and the supply side separately.

3.1

Demand Side

As shown in Fig. 1, the causes of corruption for the public officials can be broken down into three factors: “incentives,” “institutions,” and “personal ethics.” In other words, corruption takes place where these factors are simultaneously present. Often, the relationship between corruption and these factors is a two-way relationship. For example, corruption and the rule of law are cause and consequence of each other. As another example, corruption causes trafficking in humans, arms, or drugs, and mutually, traffickers corrupt the authorities (Rose-Ackerman and Palifka 2016).

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Fig. 1 Causes and consequences of corruption. Source: Rose-Ackerman and Palifka (2016)

Tanzi (1998), Rose-Ackerman (1999), Jain (2001), Rose-Ackerman and Palifka (2016), and many others have excellently identified the reasons why public officials demand bribes. According to these scholars, there are conditions necessary for corruption in the public sector to arise and persist: – Discretionary power: the public officials (bureaucrats, politicians, etc.) must have the discretionary authority to administer regulations and policies. – Power monopoly: the public officials must have the monopoly on their discretionary power. – Rent-seeking behavior: due to the low salaries of the public officials, they engage in rent-seeking activities. – Personal ethics: the degree of the public officials’ morals. – Weak institutions: in the presence of weak institutions, people cannot hold the accountable for their use of their discretionary power.

3.2

Supply Side

The suppliers of bribes are individuals and more often are companies. There are many reasons why companies bribe. Some of the reasons are derived from the difference of incentive structures of the managers and the owners and also their time horizon and risk attitudes. This inherent differences of incentives are results of the agency problem where there is a separation between ownership and control. In this situation the interests of the principals (shareholders) are usually different than those of agents (top management). The ability to win business through bribery may

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also allow a nonperforming manager to conceal his failure to increase the firm value through strategic planning and hard work. In addition, bribery may actually enable the manager to shirk his duty without facing the consequence of such behavior (Wu 2005). Moreover, controlling shareholders can benefit from bribery and burden the minority shareholders with its costs. Furthermore, even if top management acts ethically, low-level managers can still commit acts of bribery to boost their performance without the knowledge of managers. The company’s desire to operate overseas can also lead to corruption since corrupt behavior can occur in cross-border investments. Because companies do not know the culture before entering the target country, they often bribe more, especially in countries with not so well regulations. According to Aidt (2011), the following necessary conditions provide a perfect breeding ground for firms to bribe: – – – –

The difference in economic and demographic factors in the host country Weak political institutions in the host country Judicial and bureaucratic differences Geographical and cultural factors

In the presence of these factors, companies often opt for bribery. Due to the information asymmetry between the principals (shareholders) and the agents (top management) and the intrinsic secrecy of bribery, it is difficult for the shareholders and the stakeholders to monitor and control bribery behavior by top managers. In another line of study, Wu (2009) identified the characteristics of firms that have a higher probability of bribing: 1. Small firms may have a higher propensity to bribe than large firms. 2. Firms with higher growth rates are more likely to pay bribes. 3. Family-run firms will be more likely to pay bribes than firms under other forms of governance structure. 4. Firms with poor accounting practices are more likely to be engaged in bribery activities than firms with good accounting practices. 5. The less competitive the firms’ market environment, the more likely the firms will pay bribes. 6. Firms are more likely to pay bribes if the legal system is corrupt. 7. Firms will be more likely to pay bribes if they perceive the regulation on licensing as problematic. 8. Firms will be more likely to pay bribes if they perceive that the interpretation of laws and regulations is not transparent. 9. Firms are more likely to pay bribes in an environment where the quality of government services is low. 10. Firms are more likely to pay bribes if they face high taxes.

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4 Consequences of Corruption Corruption is a problem for many countries. It slows economic growth, hinder foreign direct investment, decrease the efficiency in business transactions and public services, and reduce the amount of funding available to important public programs. In addition, corruption has detrimental effects on both investment and growth at the macro-level (Mauro 1995; Meon and Sekkat 2005; Wei 2000; Bardhan 1997). The literature predicts that high corruption levels lead to lower rates of growth in a country. The data also supports this prediction. As exhibited in the Fig. 2, corruption has a strong and negative relation with gross domestic product (GDP) per capita. The countries with less corruption (higher corruption perceptions index (CPI)) have higher GDP per capita which is a proxy for growth and development. The results hold for any development index and any corruption index. However, it is interesting to ask if there is a causality, and if there is, what is its direction? Does development lower corruption, or actually it is corruption that reduces the growth. Both directions of causation are plausible. In an underdeveloped environment, public officials are inclined to create and maintain economic rents. Rents feed corruption, and corruption leads to an inefficient economic environment which in turn reduces the GDP and GDP per capita. Moreover, corruption can be considered as an additional tax on the services provided by the government and thus slows down economic growth. On the other hand, developed markets are more transparent and do not let the economic rents to be created. This transparency will discourage the public officials. Moreover, developed

Fig. 2 GDP Per Capita vs. Corruptions Perceptions Index, 2018. Source: https://ourworldindata. org/grapher/gdp-per-capita-vs-corruption-perception-index?time=latest (based on World Development index and Transparency International)

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markets are more encouraged to fight corruption. Focusing on the theories of corruption based on social interaction, Blackburn et al. (2006) argue that “corruption and economic development may feed off each other, and that simple linear and unidirectional relationships between the two are not expected.” However, empirical studies on the effects of development on corruption are scarce. There are two major hypotheses in the literature on the macroeconomic consequences of corruption: the sand the wheels hypothesis and the grease the wheels hypothesis.

4.1

Grease the Wheels Hypothesis

The grease the wheels hypothesis put forward by Leff (1964) and Huntington (1968) declares that corruption is seen as a is a facilitator of trades by promoting efficiency, and it can be useful when red tape (excessive taxes and regulations) would remain excessive without bribery. For example, allocation efficiency among competing bribers is discussed to be a positive aspect of corruption since it accelerates bureaucratic processes and, thus, increases economic growth (Jain 2001). Huntington (1968) stated that “...in terms of economic growth, the only thing worse than a society with a rigid, over-centralized, dishonest bureaucracy is one with a rigid, over-centralized and honest bureaucracy” (p. 386). Ethical considerations aside, corruption may in fact improve efficiency, particularly in developing countries. This view has been pointed out by both political scientists and some well-known scholars for the past three decades. According to Leff (1964, p. 11), “. . .if the government has erred in its decision, the course made possible by corruption may well be the better one.” Lui (1985) exhibited the efficiency-enhancing role of corruption. Leys (1965) and Bailey (1966) argued that corruption can improve a bureaucracy by improving the quality of its civil servants. Finally, Beck and Maher (1986) and Lien (1986) suggested that corruption may enhance the choice of the right decisions by officials. Nevertheless, research does not support the “grease-thewheels” effect of petty corruption on bureaucratic rigidities (Aidt et al. 2008; Jain 2001). However, there are few articles that support this view, showing that in extreme restrictive regulatory environments, corruption can enhance economic growth by stimulating entrepreneurship and efficiency (De Soto 1990; Egger and Winner, 2005; Levy, 2007).

4.2

Sand the Wheels Hypothesis

Another stream of literature focuses on the negative effects of corruption and argue that corruption is multifaceted and its endogenous with institutions (Aidt et al. 2008; Myrdal 1968). It sands the wheels of the economy. They use many arguments to refuse the grease the wheels hypothesis. Using industrial organization models, Shleifer and Vishny (1993) demonstrate that corruption leads to a misallocation of

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talents and funds, which is very harmful for the economy, even if it facilitates a given process. Kurer (1993) claim that in a corrupt environment, corrupt officials are motivated to create other distortions in the economy to preserve their illegal source of income. Rose-Ackerman (1997) argues that a firm may be able to pay the highest bribe simply because it compromises on the quality of the goods it will produce if it gets a license. Rock and Bonnett (2004) find that corruption decreases investment and development in most developing countries. Many other studies have rejected the grease the wheels hypothesis and actually find the negative effects of corruption on efficiency.

4.3

The Econometric Approach

Apart from the two contradicting hypotheses that try to explain the relationship of corruption and efficiency, many other scholars find the negative effects of corruption on economic development and examine the consequences of corruption, which are reviewed below. . On domestic investment Strong empirical studies support the negative impacts of corruption on the ratio of investment to GDP (Fisman and Gatti 2006; Meon and Sekkat 2005; Wei 2000; Brunetti and Weder 1998; Campos et al. 1999; Ades and Di Tella 1997; Mauro 1995, 1997). In a seminal paper, Mauro (1995) finds that corruption lowers private investments and in turn reduces economic growth. He reported a negative and significant relation between corruption and the domestic investment. Lambsdorff (2003) finds that corruption reduces the ratio of investment to GDP. . On foreign direct investment There is substantial evidence for the adverse impact of corruption on foreign direct investments and capital inflows (Wei 2000; Lambsdorff 2003a). Shleifer and Vishny (1993) observed that foreign investors had to bribe relevant agencies to make an investment. Wei (1997) provides the empirical evidence of Shleifer and Vishny’s (1993) argument, and he found that the effect of corruption on FDI is negative and statistically significant. Wei (2000) suggests that high corruption in China may influence its incoming FDI. Habib and Zurawicki (2002) also report the negative impact of corruption on FDI. They suggest that foreign investors in general are reluctant to invest in a corrupt country. . On economic growth The literature empirically shows that corruption is detrimental to growth (Tanzi 2002; Svensson 2005; Gyimah-Brempong 2002). Empirical evidence shows that countries with higher levels of corruption tend to grow more slowly. Mauro (1995) finds a significant negative association between corruption and investment, as well as growth, both in a statistical and in an economic sense. Mo (2001) finds the adverse impact of corruption on growth. The author observes that a 1% increase in the corruption level of a country reduces the growth rate by about

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0.72 percent. Pellegrini and Gerlaugh (2004) assess the direct and indirect effects of corruption on economic growth and find that one standard deviation increase in the corruption index is related with a decrease of 2.46 percent in investments, which in turn decreases economic growth by 0.34 percent per year. Rock and Bonnett (2004) observe that corruption negatively affects growth through a reduction of investments in small developing countries in general. . On the size and composition of government expenditure Tanzi and Davoodi (1997) analyze the effect of corruption on the government’s public finance and find that: “(A) Corruption increases the size of public investment. (B) Corruption skews the composition of public expenditure away from needed operation and maintenance towards expenditure on new equipment. (C) Corruption skews the composition of public expenditure away from needed health and education funds because these expenditures, relative to other public projects, are less easy for officials to extract rents from. (D) Corruption reduces the productivity of public investment and of a country’s infrastructure. (E) Corruption may reduce tax revenue because it compromises the government’s ability to collect taxes and tariffs, though the net effect depends on how the nominal tax rate and other regulatory burdens were chosen by corruption-prone officials.” Similarly, Mauro (1997) finds that corruption tends to divert public expenditure away from health and education, presumably because they are more difficult to manipulate for bribe purposes than other projects. . Hidden costs of corruption (firm level) Corruption has many hidden costs for suppliers of bribes and for its shareholders. First, firms that are involved in corrupt transaction will bear the risks of legal actions against them if they are caught. Second, their reputation will be at stake. Third, firms that pay more bribes face more, not less, effective red tape because corrupt officials can often customize the nature and amount of harassment on firms in order to maximize their bribe collection. And fourth, firms involved in bribery practices invest less in RandD, so in the long run, they lose their competitive advantages (Wu 2005).

5 Corruption and Institutions Institutions are a fundamental factor in the development of a country’s economic system. Coase (1999a, b) was one of the first to point out the importance of institutions in the economic system: “Economists until recently have never considered the role that institutions play in the functioning of the economic system. In fact, institutions determine the way the economic system operates”. But what should we understand by institutions? There is no univocal definition of institutions. We can find authors who define institutions as rules of the game, while, on the other hand, there are authors who define them as organizations (Van Arkadie 1989). Within the first group, we find North (1991) who defines institutions as “constraints that arise

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from human inventiveness to limit political, economic and social interactions. Consequently, they structure incentives in human exchanges, whether political, social, or economic.” On the other hand, there is Van Rennin and Waisfisz (1988), who define institutions as organizations, such as state enterprises, banks, government departments, the army, and hospitals, among others. North (1991), from the point of view of institutions as rules of the game, proposes a distinction between formal and informal institutions. Formal institutions have a relatively lower degree of openness than informal institutions, provide a framework of incentives (and penalties) recognizable for the set of economic agents, and are much simpler to identify, while informal institutions are those that do not have an explicit definition and are not based on laws or explicit rules but are based on beliefs, traditions, and cultures which, although complicated to identify, are more transparent in nature and have a higher degree of openness (Alonso 2007). Within the first group we find, for example, the political regime, the judicial system, and the rule of law, while in the second group, we have culture, ethics, customs, ideology, and trust. For the purposes of this chapter, we will consider North’s definition of institutions and his proposed classification into formal and informal institutions, with special emphasis on informal institutions and their relationship with corruption. In order to study a relationship between corruption and institutions, we must identify more specific factors that play an important role, such as the quality of institutions, economic growth, state regulation, and political freedom, among others. Several authors have investigated a three-way relationship between institutions, corruption, and economic growth and find that corruption and regulation are jointly determined by the quality of institutions and that these factors, in turn, affect important economic outcomes such as the level of a country’s GDP. In this approach, which is named the “hierarchy of institutions hypothesis,” corruption is viewed as an “intermediate product” influenced by institutions and influencing economic outcomes. For example, Aidt et al. (2008) present a theoretical model that formalizes this logic. In examining the effect of corruption on growth, they find that the quality of political institutions play an important role. In the same vein, Koudelková et al. (2015) point out that indicators of institutional quality, enforcement of investor protection legislation, and political freedom have a significant impact on corrupt behavior. In addition, many studies find that developed and emerging markets have significant differences in their institutional qualities. Krishnamurti et al. (2018) showed that institutional and governance quality and enforcement of legislation are the best means to control corruption. However, the relationship between the corruption and institutions is determined, among other factors, by the environment of the country under study, its culture, traditions, trust in its institutions, and legal regulation. Kaufmann et al. (1998a, b) point out in a study conducted in three European countries that the institutional causes of corruption come from different sectors, considering the characteristics of each of the countries studied. For example, in Albania, the weakness of the judicial system is identified as one of the main causes of corruption, while defects in economic regulation are much less important. The latter problem is more serious in Latvia and Georgia and translates into excessive regulations and discretionary

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regulators. To design anti-corruption policies or legislative reforms against corruption, a country-by-country study is needed. The institutional corruption (the corruption caused by weak institutions) is categorized in several types: public, political, academic, judicial, economic, and police corruption. This shows that there are as many types of corruption as there are social institutions that can be identified as corruptible (Miller 2010). When speaking of the public corruption (so-called bureaucratic corruption), where a public official is corrupt, the advantage provided by the official is not episodic but systematic, regardless of whether or not it is the official himself who provides it. In fact, there are some structural conditions for corruption to occur, and the corrupt motivation for institutional corruption is not necessary to exist. It is the constitutive rules of an institution that can make it corrupt, regardless of whether its members are also corrupt. In other words, institutional corruption does not necessarily require the existence of morally ill-motivated individuals within the institution. This is a much-discussed point, calling into question the very possibility of speaking of corruption (personal or institutional) when the component of individual moral motivation is excluded. Therefore, one can understand the existence of corrupt institutions per se. According to Thompson (2013), the difference between institutional corruption and individual corruption is based on the service given in exchange and the benefit obtained for it, as well as the connection between the two. In institutional corruption, the gain is political, the “service” given in exchange for the gain is systematic, and the connection between the two would be based on what Thompson calls “institutional tendencies.” In contrast, in the case of individual corruption the gain is personal, the service given is episodic, and the connection between the two is based on a personal motive. The underlying idea is that institutional corruption involves the political gain or benefit of a public official under conditions that, in general, tend to promote private interests improperly (Thompson 2013).

6 Corruption and Culture As mentioned before, within the so-called informal institutions of North, we have culture, trust, and ethics. We are interested in highlighting the duality of corruption and culture, and the question to be answered is as follows: is there a relationship between corruption and culture? First of all, and before discussing the relationship between corruption and culture, we must understand the concept of culture. Culture is a set of customs and traditions that a group of people have in common. Culture is an element specific to each country. In fact, a nation is formed by a group of individuals who share a set of common characteristics. Inglehart (2018) argues that “by culture we mean a system of attitudes, values and behaviors widely shared by society and transmitted from generation to generation. While human nature is biologically innate and universal, culture is learned and varies from one society to another.” Culture can help explain

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economic, institutional, social, and scientific differences between countries (Liñán and Fernandez-Serrano 2014). Second, regarding the question of whether there is a relationship between corruption and culture, there are several studies whose results coincide with an affirmative answer. On the one hand, Rose-Ackerman and Palifka (2016) point out that it is culture that is the determinant of corruption. Scholl and Schermuly (2020) show that culture is a very potent factor that explains cross-country variations in corruption if appropriate culture measurement is used instead of percentages of women or of religion members. López and Santos (2014) used Hofstede’s power distance and individualism as predictors of corruption, add different forms of trust as proxies for social capital and an institutional “Global Economic Freedom Index” in an analysis of 60 nations, and they conclude: “Corruption is clearly explained by a sociocultural substrate that we have denominated culture of dependency.” The authors also point out that one of the problems of the culture-corruption relationship lies in the definition of acts considered corrupt. In one country an act may be legally typified as corrupt, while in another country that same act, due to its culture and traditions, may be socially accepted, and it is here where we ask ourselves: should the country where the act is socially accepted, due to its culture and customs, legally define it as corrupt? This leads us to consider that the line of differentiation between various similar acts, such as a gift, a tip, or a bribe, is as thin as prison walls. Assessing the intent or culture of the acts is not always possible, which is why clear regulation is a priority in the fight against corruption, even though we know how complicated it can be to draw that line. Rose-Ackerman and Palifka (2016), point out that one way to differentiate gifts or tips from bribes, culturally adopted, would be the reciprocity that exists in each of them. Reciprocity in gifts or tips is implicit, it is not written in a formal contract, while, in bribes, although reciprocity is clear, its illegality makes it legally void. There are many specific cases, so classifying a gift as corrupt may vary across cultures and legal systems. For example, contributors to a politician’s campaign may say that they are giving gifts, since reciprocity is not clear; however, it may be qualified as a bribe, when the real intention is to obtain public works contracts, once the politician assumes power. To avoid the above blurring between the concepts of gifts and bribes, it is necessary to have a clear and efficient regulation, in this case a Political Campaign Financing Law, which defines the line between a gift and a bribe. Continues Rose-Ackerman and Palifka (2016) by stating that the main difference between bribes and tips lies in the agency relationship: while tips reinforce the principal’s objectives, bribes subvert them. Nevertheless, both tips and gifts can be considered bribes. No one assumes the consideration to be a bribe but rather a gift or tip for a service rendered. For example, tips may lead agents to discriminate among customers in a way that reduces the revenue going to the principal. Imagine waiters offering diners discounts on their meals or serving extra dishes in exchange for bribes (tipping) or the waiter accepting tips (bribery) for reserving a table when the restaurant has no vacancies.

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In conclusion, the distinctions between bribes, gifts, and tips are difficult both to define and to assess normatively and will have to be analyzed country by country on a cultural, customary, and traditional basis.

7 Corruption and Trust Several authors have studied the relationship between trust and corruption. Zak and Knack (1998) postulate that “low trust environments reduce the rate of investment and, therefore, the rate of economic growth” and go on to demonstrate this through statistical analyses of the trust and growth indices of various countries. For his part, Uslaner (2005) points out that the correlation between Transparency International’s Corruption Perceptions Index and the generalized trust measure is 0.724: countries with low corruption index have high trust scores and vice versa. Consequently, we can state that empirically there is a direct relationship between trust and corruption in a country. But what should we understand by trust? Trust can arise from deep-rooted cultural factors, but it can also be a strategy studied and applied to specific situations. In this sense, it is important to distinguish between generalized trust in other people, trust in specific individuals such as family members or friends, and trust in the impartial behavior of institutions and officials. Even though it is institutional trust that we wish to emphasize, we consider it important to point out some aspects of the so-called interpersonal trust, since this type of trust is the basis of any relationship between parties, even when an exchange takes place under anonymity and protected by effective and clear legal regulations. Interpersonal trust makes a relationship between agents honest and impartial or more biased toward corrupt favoritism. Rose-Ackerman and Palifka (2016) argue that interpersonal trust is important among agents involved in bribery. Legal regulations do not protect verbal contracts between the one who promises the payment (bribe) and the one who promises to provide the service in return; therefore, this is where trust between the parties plays a decisive role in making the decision to perform the corrupt act. Interpersonal trust is fundamental for corrupt agents since they have no legal protection for their actions. If there is no such trust between the parties to a bribe, it is almost certain that it will not take place since the provision of a service in exchange for a bribe is only based on the trust of the parties. Institutional trust is the trust that the citizen has in the institutions. Institutional trust depends on the honesty, impartiality, and objectivity with which the institution acts. In an ideal scenario, there should be no affective personal ties between the people who represent the institution and the citizens who relate to it. In this situation, the institution would generate a high degree of confidence in its impartial and objective performance, with no risk of corrupt actions. But this is an ideal situation, since, in real life, institutions are composed of people with affections and feelings, who may favor their relatives or friends and, therefore, encourage corrupt dealings.

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8 Sustainable Finance and ESG Disclosure In recent years, public awareness of the role of companies in society has grown (Reverte 2009). Climate changes, depleting natural resources, poor working conditions, and corporate scandals have “increased society’s expectations in relation to companies’ environmental, social and ethical responsibilities” (Money and Schepers 2007, p. 2). This has led to a growing attention to sustainability. The concrete meaning of sustainability for the financial sector is an issue of controversial debate and continues to be evolving. In early finance literature corporate social responsibility (CSR) was considered as a form of sustainability. Many advocated the importance of CSR, both in the academic literature (e.g., Margolis and Walsh 2003; McWilliams and Siegel 2001; Orlitzky et al. 2003) and in the business world. Thus, companies are encouraged to undertake socially desirable actions to establish congruence between corporate operations and social values (Aerts and Cormier 2009; Chapple and Moon 2005). The sustainability concept in finance includes a longer-term and ethical financial dimension. The sustainable development of the global economy and society calls for the practice of the environmental, social, and governance (ESG) principle. In 2004, the ESG principles have formally proposed and since then, sustainable finance is defined as addressing environmental, social, and governance impacts of companies. Nowadays, since ESG are perceived as critical issues by society (e.g., Ioannou and Serafeim 2012; Kamal and Deegan 2013; Palazzo and Scherer 2006; Tagesson et al. 2009), companies are pressured to disclose their ESG information and investors evaluate their corporate behavior and future financial performances based on this information. In fact, a growing number of regulators and government initiatives call for the alignment of corporate practices with broader societal interests (Ioannou and Serafeim 2011, p. 2) such as working conditions and environmental protection. This call led to producing new reporting policies and regulations on ESG disclosure (Chan et al. 2014; Talbot and Boiral 2015). Moreover, market participants and investors also demand and pressure the companies for ESG disclosure. Prior literature shows that investors now consider firms’ ethical and nonfinancial information in their decision-making process (Berthelot et al. 2003; Gupta and Goldar 2006; Moneva and Cuellar 2009). Solomon and Solomon (2006) find that institutional investors and analysts that were uninterested in environmental disclosure have now turned their attention to such information, creating a demand for sustainability reporting. More recently, Eccles et al. (2011) used data from the Bloomberg database and find a large and growing market interest in the level of a company’s degree of transparency in governance, environmental, and social information. However, despite the pressure from the market and the investors, ESG disclosure practices considerably vary between countries and companies. Prior academic literature investigated country- and firm-level factors determining such variation (e.g., Ioannou and Serafeim 2012; Reverte 2009). In this chapter, we are interested in country-level determinants of ESG disclosure which is explained by institutional and legitimacy theories in the literature.

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The institutional theory focuses on the relationships between the company and its society (Brammer et al. 2012; Campbell 2007; Campbell et al. 1991). This theory posits that organizations and companies are affected by a larger social structure such as public and private regulation and the presence of independent and nongovernmental organizations that monitor corporate behavior (Campbell 2007; Campbell et al. 1991; DiMaggio and Powell 1983). Based on an institutional theory, companies do not make decisions regarding ESG issues purely “on the basis of instrumental decision making, but that such decisions are framed vis a vis a broader social context” (Jackson and Apostolakou 2010, p. 374). Thus, previous studies have utilized this theory to describe the country-level factors that can affect corporate behavior in terms of ESG disclosure (Jackson and Apostolakou 2010; Muthuri and Gilbert 2011; Oliver 1991). The legitimacy theory addresses the importance of social acceptance in a company’s survival (Singh et al. 1986). Legitimacy is defined as “a generalized perception or assumption that the actions of any entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs and definitions” (Suchman 1995, p. 574). Mitchell et al. (1997) implement Suchman’s definition of legitimacy to argue that “legitimacy is a desirable social good, that it is something larger and more shared than mere self-perception, and that it may be defined and negotiated differently at various levels of social organization” (p. 867). The legitimacy theory posits that companies can only survive if the society believes that the entity is operating in accordance with societal expectations (Gray et al. 1996). Therefore, companies disclose ESG only to appear socially aware and to show appropriate behaviors in eyes of stakeholders (Beelitz and Merkl-Davies 2012; Dowling and Pfeffer 1975; Palazzo and Scherer 2006). Therefore, societal and cultural factors affects ESG disclosure levels (Adams et al. 1998; Branco and Rodrigues 2008; Claasen and Roloff 2012). Institutional and legitimacy theories tend to overlap and cannot be considered mutually exclusive. However, these theories both provide a complementary explanation in understanding how firms respond to changing social pressures and expectations from the culture that the company operates in (Deegan 2014). In the literature, there are numerous articles that concentrate on the companylevel characteristic that that could affect the ESG disclosure; however, the literature on the country-level characteristics is not abundant. These articles posit that countrylevel characteristics such as a political system (legal framework and corruption), labor system (labor protection and unemployment rate), and cultural system (social cohesion and equal opportunities) significantly affect firms’ ESG disclosure practices.

8.1

Culture

In any country, there are informal institutions, like culture, norms, traditions, customs, and so on. These informal institutions change very slowly (it may take

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even centuries) and are exogenous (Huntington 1996). Formal institutions are considered to be below the informal institutions. These formal institutions function within the constraints and limits defined by informal institutions. Mathews (1997) highlights that corporate social and environmental behavior is the result of a social contract to gain legitimacy which protects the firm from the loss of reputation (Brammer et al. 2006). Moreover, Hofstede (1980) and Schwartz (1994) exhibit that there is a difference in managerial behavior across countries due to the differences in their national cultural norms, values, beliefs, customs, and traditions (Ho et al. 2012). The national culture is also found to be an influencing factor in shaping the ethical attitude (Budhiraja and Modi 2021) and ethical decision-making (Srnka 2004) of managers. More importantly, Doidge et al. (2007) find that country characteristics play a greater role in managerial decisions than organizational structures. It is thus normal to think that country characteristics affect the ESG disclosure. Roy and Mukherjee (2022) find that culture indeed influences the corporate ESG disclosure. They use difference culture measures and find: . Countries with high power distance are more likely to exhibit poor corporate ESG disclosures. . Individualistic societies prefer higher level of corporate environmental, social, and governance disclosures. . People with long-term orientation prefer responsible ESG behavior and higher disclosures. . Uncertainty avoiding society emphasizes more on corporate environmental and social performance and disclosures. . The overall effects of different cultural dimensions on ESG disclosures are strengthened or weakened by firm size and Tobin’s Q.

8.2

Political System

Political systems, rule of law, and regulations on reporting affect a company’s activity, thus influencing the ESG disclosure practices’ level. There are many articles that highlight the influence of laws and regulations and the legal framework in a country on the social performance of companies in different countries (Adi et al. 2006; De Oliveira 2006; Ioannou and Serafeim 2012; La Porta et al. 2008). The authors hypothesize that a country with tougher formal rules, constitutional constraints, and other political constraints generally produces lower-quality ESG disclosures and there is no need for the companies to produce information beyond the formality required from institutions.

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Corruption

The literature also exhibits that corruption levels of a country are an important factor influencing disclosure. In fact, in countries where the corruption is high, companies are generally assumed to have lower levels of ESG disclosure because such companies use economic rents to survive and “are more likely to engage in unethical practices” and “the resulting benefits of ethical firms may be lower in more corrupt countries” (Ioannou and Serafeim 2012, p. 840).

8.4

Labor System

The labor system of a country could affect the ESG disclosure (Ehnert 2009; Taylor et al. 2012). In the presence of prominent labor unions and strong worker protection, firms expose higher levels of ESG performance (Ioannou and Serafeim 2012; Martinez-del-Rio et al. 2012). Strong labor unions lead to increased benefits for employees, such as health and safety provisions, progressive labor relations policies, and higher workplace benefits. Labor unions can impact firms to be better involved in community and make the firms advocates for environmental and social policies (Matten and Moon 2008). Furthermore, unemployment levels tend to influence the ESG disclosure of companies in different countries, that is, a high unemployment rate creates competition among firms to attract a higher number of skilled employees.

9 Conclusion Corruption is a serious global issue. Governments, policymakers, global institutions, and academics are concerned about the effect of corruption practices on economic development and enabling business environment. The large amount of research published since mid-1990 s and find that corruption, among other things, hampers economic growth, affects productivity, distorts government spending, and in the long run leads to very considerable losses of income and human welfare. Several studies have therefore explored why some countries seem to experience substantially more corrupt behavior than others. The literature summarizes the determinants of corruption as quality of institutions, income, an established democracy, freedom of the press, the rule of law, openness to trade, and an absence of reliance on exports of point resources such as oil or minerals. However, cultural and social factors are also likely to be associated with the incidence of corruption, not least because corruption is, at the end of the day, evidence of unambiguously dishonest behavior. Even if many studies do not discuss this factor, social trust—often taken to be a measure of the strength of honesty norms in a society—has been identified as a

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statistically strong and quantitatively important determinant of corruption in the literature. These variables are dependent of either formal or informal institutions of a country. Institutions of a country, on the other hand, can affect the quality of companies’ information divulgation. In the last two decades, the investors pressured the companies to adhere to the ESG standards and to publish an ESG report. However, the quality of ESG divulgation differs from a country to other (considering the firm-level determinants). The literature finds that formal and informal institutions affect the quality of divulgation.

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Mohammad Refakar is a professor of finance at the École de gestion, Université de Sherbrooke (Canada). His research focuses on corruption, corporate governance, financial crimes, mergers and acquisitions, and foreign direct investment. Professor Refakar is a member of the Association of Certified Fraud Examiners (ACFE). Gilberto Cárdenas Cárdenas is an associate professor at the Department of Public Finance, Faculty of Economics and Business, Autonomous University of Madrid (Spain). He has been a Visiting Professor at the University of Bern (Switzerland), the University of Freiburg (Switzerland), the Autonomous University of Mexico (Mexico), the Autonomous Metropolitan University of Mexico (Mexico), the Misericordia University (USA), and the Catholic University of Táchira (Venezuela).

Rationalization of Corruption: A Discursive Legitimation Approach Shoeb Mohammad and Sofiane Baba

1 Introduction Corruption, the misuse of public power for personal benefit (Rodriguez et al. 2005), is a pervasive and consequential problem in emerging markets. Corruption entails exchanges between public officials and firms in the form of illicit payments for the provisioning of government resources. It is detrimental because it creates added costs for economic activities and raises the uncertainty of doing business in a given context. Corruption is a key inhibitor to economic development, reducing foreign investment and driving away a country’s most promising individuals to countries deemed to be fairer marketplaces (Doh et al. 2003; Kaufmann 1997). Corruption remains as prevalent as ever in the emerging market context with unlawful organizational conduct even accelerating in recent decades (Zheng and Chun 2017). It is estimated to cost the global economy about 5% of GDP on a yearly basis (United Nations 2018). Various theoretical perspectives have connected the pervasiveness of corruption in emerging markets to its justification as a business practice. For example, corruption has been explained as economically rational, a means of reducing administrative blockages that are often artificially imposed by government officials (CuervoCazurra 2016) or obtaining beneficial treatment to get ahead of competitors (Lambsdorff 2002). Corruption is also thought to be normalized, a deeply embedded practice that is second nature because it is the only viable option to maintain the regular operations of the business. For this reason, the lack of moral relevance of

S. Mohammad Ontario Tech University, Oshawa, ON, Canada S. Baba (✉) Université de Sherbrooke, Sherbrooke, QC, Canada e-mail: Sofi[email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_10

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corruption, in spite of its illegality, has also been explored as a reason for why it is so widespread (Mohammad and Husted 2019). However, the literature has not yet explored the discursive legitimation approaches that actors use to justify their involvement in corruption. Despite being commonplace in emerging markets, there is “not a country in the world which does not treat bribery as criminal on its lawbooks” (Noonan Jr. 1984, 702). Corruption is thus considered universally unethical (Husted et al. 1996), such that rationalization strategies are likely required to foster a mindset conducive to perceiving corruption to be a readily available business practice. Discursive legitimation approaches are a window into how an actor rationalizes his or her actions because they unravel an individual’s thought process. Our approach in this chapter is to apply the discursive legitimation model (Vaara et al. 2006; Van Leeuwen 2007) to primary qualitative data collected from Algerian entrepreneurs on the topic of corruption. The resulting contribution to the literature is an exposition of discursive legitimation strategies used by entrepreneurs in emerging markets to justify corruption. Corruption in Algeria is a serious problem. In 2022, Transparency International ranked Algeria as the 117th most corrupt country among 180 countries. Furthermore, corruption is on the rise, with, with Algeria having gone from 88th place to 117th in almost two decades. Corruption in Algeria is systemic and manifests in different forms. It can include minor transgressions such as petty bribes to administrative officials of local governments. When very severe, it encompasses questionable relations between businessmen and senior officials that raise concerns about regulatory capture (Baba and Raufflet 2017; Cheref 2016; Djerbal 2022). The nature of corruption is deeply rooted in the institutional environment, with descriptions dating from 2001 describing very well the reality of corruption in 2022: “The endemic nature of the corruption that undermines Algeria has become an obstacle to the country’s political and economic development. . . it hinders innovation and favors immediately profitable and often unproductive economic activities to the detriment of riskier investments. . . it also weakens the efficiency of the State and the credibility of the economy for investors, especially foreign ones. Politically, it contributes to mixing economic and political interests, making trade-offs difficult and reform efforts unlikely.” (Jolly 2001, 119). With corruption being as serious and crippling as it is for Algeria and emerging markets more broadly, the design of anti-corruption programs is in significant need of improvement and perhaps even novel approaches are required to address the problem. In Algeria, growing discontent has created renewed pressure to alleviate corruption. Shortly after his appointment as President in January 2022, Abdelmadjid Tebboune set up a task force to investigate public officials’ involvement in corruption (Hamdi 2022). Insight into the discursive legitimation approaches underlying corruption can inform the design of policies and programs that directly address these rationalizations, proving them to be false or at least offering information to actors which make them more difficult to accept. Novel theoretical insights that can aid in the fight against corruption are important not solely because of corruption’s economic consequences. Corruption also contributes significantly to broader societal problems such as poverty, inequality, and inadequate social services and

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infrastructure (Kaufmann 1997; Moran 2001). Furthermore, the sensitive nature of corruption makes qualitative data on the topic especially difficult to collect (Stevens and Newenham-Kahindi 2021). Our contribution to the literature is also valuable because it is based on rare, qualitative data on corruption.

2 Literature Review 2.1

Motivations to Engage in Corruption

Despite its illegality, organizational actors in emerging markets believe that corruption is a justified, even necessary, business practice. For example, 1 in 5 employees of Indian companies believe that offering illicit cash payments can be justified, while one in six said that bribery is commonly used to win contracts (Ernst and Young 2018). In Mexico, 40% of entrepreneurs agreed that the most effective way to gain a competitive advantage is through bribes and connections (Instituto Mexicano para la Competitividad A.C. 2015, 23). The wide-spread acceptance of corruption in emerging markets can be traced to their characteristically weak institutional environment. Government officials tend to be granted significant discretionary power in their regulation of firms without sufficient oversight. As a result, officials are able to create excessive bureaucratic obstacles to normal operating that require a firm to make illicit payments. For example, bribes may need to be paid for necessary permits or to courts to ensure the enforcement of contracts. Corruption is a systemic issue in emerging markets because the institutional context provides economic incentives to engage in corruption and fosters business norms that make it acceptable. The institutional environment of emerging markets fosters rational, economically centered justifications for corruption. Corruption is considered an added tax on economic transactions that must be paid to government officials. If bribes are not paid, firms are unable to reduce the transactional uncertainty that makes it difficult to maintain normal business activities (Anokhin and Schulze 2009). Corruption may also be conceived as not simply an operating tax, but an active strategy that allows firms to gain exclusive advantages over their competitors. This is the case when corruption is a symptom of captured institutions, a situation when the state is able to exercise its power to provide preferential treatment to certain firms in the pursuit of its own interest (Dorobantu et al. 2017). Firms in a position to pay bribes obtain contracts, permits, or resources to the exclusion of their competitors, which can produce monopolistic advantages (Kurer 1993). The “source” of corruption, whether it is demanded or supplied (Martin et al. 2007), offers insight into how firms are affected by corruption. The demand-side conceptualization of corruption assumes that bribes are demanded by government officials and is more coherent with the idea that corruption is a type of operating tax. The supply-side conceptualization, on the other hand, assumes that firms actively seek opportunities to offer bribes to government officials, and is more coherent with the notion that corruption offers exclusionary benefits to select firms. No matter its

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source, corruption is considered essential for competing in emerging markets. Empirical evidence in support of the potential benefits of corruption illustrates this idea. For example, corruption is found to increase levels of firm-level product innovation in the context of weak institutional environments (e.g., Krammer 2019; Xie et al. 2019), acting as an “efficient grease” that facilitates economic exchanges that otherwise may be stalled or not occur. The necessity to engage in corruption within the institutional context of emerging markets is also what causes it to be normatively accepted. Faced with the threat of being unable to operate or compete effectively due to predatory government regulation and a weak rule of law, societal rules that enforce law-abiding behavior lose their moral imperative (Martin and Cullen 2006). As a result, corruption becomes normatively acceptable as a means of doing business (Mohammad and Husted 2019; Tonoyan et al. 2010). Corruption becomes further embedded in emerging markets as both the act and its positive benefits are increasingly observed in the business environment without repercussion. Research has found that the likelihood of a firm engaging in corruption increases when it observes its competitors having engaged in corrupt activities (Iriyama et al. 2016).

2.2

A Discursive Legitimation Perspective

Legitimacy and legitimation play a key role in the functioning of institutions and organizations since they determine what constitutes acceptable behaviors and actions (Baba et al. 2021b). In regard to corruption, its legitimacy varies from one socio-cultural context to another. Compared to western societies where corruption is widely considered to be illegitimate, regions of the world with unstable and volatile institutional contexts (i.e., Baba et al. 2022b) give rise to much more convoluted perceptions of corruption. In these contexts, corruption is often seen as inevitable, a necessary evil in light of institutional obstacles (Jauregui 2014; Jolly 2001). Furthermore, weak institutional contexts drive firms to focus on survival. As a result, strategies considered short-term in nature, such as corruption, take precedence over long-term value-adding activities, which some believe to be incompatible with corruption (Xu et al. 2019). Despite acknowledgment of corruption’s contextdependent legitimacy, our understanding of the meaning-making processes through which actors attempt to legitimate corruption is still unexplored. As a step in this direction, this chapter adopts a discursive legitimation approach to unpacking why and how actors justify corruption. A discursive approach posits that attempts at legitimizing corruption are embedded in linguistic resources and discourses (Luyckx and Janssens 2016; Van Leeuwen 2007). Unpacking corruption dynamics by looking at such micro-level discursive strategies “helps us to understand the complexities, ambiguities, and contradictions in legitimation” (Vaara et al. 2006, 790). The discursive approach to understanding the dynamics of legitimization has been applied to th contexts of industrial restructuring (Vaara et al. 2006), mergers and acquisitions (Vaara and Monin 2010), environmental governance

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(Steffek 2009), corporation-related controversies (Luyckx and Janssens 2016; Patriotta et al. 2011), business wrongdoing (Breeze 2012), the construction of the climate change issue (Lefsrud and Meyer 2012), and institutional change (Glynn and Lounsbury 2005; Suddaby and Greenwood 2005). More specifically, we build on Van Leeuwen’s (2007, 91) four “key categories of legitimation.” Authorization refers to the authority of tradition, law and persons of authority. Moral evaluation, or moralization, refers to legitimation that results from a system of values. Rationalization refers to legitimation resulting from a process of rational and cognitive validation. Finally, mythopoesis suggests that legitimation is “conveyed through narratives whose outcomes reward legitimate actions and punish non-legitimate actions” (Van Leeuwen 2007, 91). In our chapter, we rely on a slight adaptation of Van Leeuwen’s model by Vaara et al. (2006, 797) which highlights that in the original model of Van Leeuwen, “legitimation by reference to normal or natural functioning or behavior is not considered a separate category of legitimation.” Building on Vaara et al. (2006), we recognize that constructing an event, a practice of a phenomenon as “normal” is in itself a specific category of legitimation. This “normalization” work “seeks to render something legitimate by exemplarity. . . [which] can involve ‘retrospective’ (similar cases/events/practices in the past) or ‘prospective’ (new cases/events/practices to be expected) references, both of which are important in rendering the case at hand as something ‘normal’.” (Vaara et al. 2006, 798) All in all, we mobilize the discursive legitimation framework by relying on five strategies: moralization, rationalization, authorization, normalization, and mythopoesis. Next, we explain our empirical methodology before presenting our observations of Algerian entrepreneurs relying on the discursive legitimation framework. Finally, in conclusion of this chapter, we offer some reflections on the empirical and conceptual contributions of our article to the current body of knowledge on corruption and sustainable finance.

3 Methods In this section, we detail our research strategy, data collection, and the process of data analysis. Taken together, these details contribute to establishing the trustworthiness of our qualitative study (Lincoln and Guba 1994).

3.1

Research Strategy

The starting point of this research was an inductive immersion in the field between 2016 and 2019. This immersion is part of a larger project to document entrepreneurial successes in Algeria and the challenges of private entrepreneurship, a relatively recent form of entrepreneurship in this country (e.g., Baba et al. 2020, 2021a,

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2022a). One of the authors was involved in the Algerian entrepreneurial ecosystem through that period. The researcher was actively collaborating with several entrepreneurs and various organizations which were supporting them. During this immersion, his focus was on strategic work and competitiveness rather than corruption. However, the researcher was stunned by the prevalence by how often corruption was brought up during interviews, informal conversations, and observations. The terms “corruption” and “bribe” were often discussed in relation to a firm’s survival. While we will get back to the data collection process further in the paper, this deviation regarding the starting point of this research is important to highlight the fact that this study naturally adopts a phenomenon-driven qualitative approach (Patton 2002; Schwarz and Stensaker 2014). Such an approach is best suited for studying complex phenomenon such as corruption, which is best captured through the emotions, perceptions, and opinions of individuals (Patton 2002). Our qualitative endeavor builds on what we label as the Algerian entrepreneurial ecosystem single case-study. We believe that our unique empirical access is precisely what is needed to better understand the multifaceted and complex nature of corruption and unethical behavior, especially in a volatile and dynamic institutional context.

3.2

Data Collection

When immersed in the field for a prolonged period of time and becoming close to interview subjects (Dwyer and Buckle 2009), data triangulation became even more important to ensure the trustworthiness and rigor of a qualitative study (Flick 2018). This study therefore relies on various sources of data to ensure triangulation. The main source of data are semi-structured interviews with entrepreneurs and some local administrators, as well as “conversational interviews.” The latter are various exchanges during which respondents were asked improvised questions (Burgesslimerick and Burgess-limerick 1998). Over the 3-year period, the researcher in the field engaged with 18 different entrepreneurs running different businesses. About 45 different non-entrepreneurs (experts, journalists, academics, managers, and local administrators) were also interviewed over the years. These semi-structured interviews and conversational interviews revealed the severity and multifaceted nature of corruption in the context as well as attempts to justify involvement in corruption. The second source of data is participatory observations. The author who performed the data collection traveled alongside 3 entrepreneurs, spending over 150 hours with them during the field-immersion. During these trips, he was able to listen to various conversations regarding corruption and unethical behavior. While this data is not reflected in the empirical analysis, it was nevertheless crucial in shaping our understanding of the phenomenon. For example, one of the entrepreneurs would share one of his earphones so that the researcher could listen in on his conversation. Some specific conversations revolved around local administrators requesting gifts and money in exchange (indirectly or directly) for the approval of investment projects. Listening to these conversations real-time helped the researcher make sense of how

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corruption manifests and impacts entrepreneurs. Lastly, to triangulate the primary data, various publicly available materials about corruption were also collected and analyzed, including newspapers articles, international rankings of corruption across the world, television debates and talks about corruption, and various interviews (written and video-taped) of Algerian entrepreneurs, some which we had already engaged with.

3.3

Data Analysis

The data collected was analyzed abductively, with the researchers going back-andforth between the data and the literature (Timmermans and Tavory 2012). Three iterative steps were involved in the data analysis. First, we openly coded the various types of unethical behavior and corruption practices. This produced several codes such as “bribes,” “debatable gifts,” and “clientelism.” Second, we then focused our analysis on how these actors explained these behaviors. This allowed us to explore the perceptions of the actors and their justifications. From this step, various codes emerged such as “sense of urgency,” “sense of duty,” and “sense of obligation.” Lastly, we sought to develop a stronger conceptual understanding of the justifications provided by the entrepreneurs. An iterative process between our codes and the literature followed, especially regarding the strategies of discursive legitimation. After this step, it became apparent that the legitimation strategies developed by Van Leeuwen (2007) and enriched by Vaara et al. (2006) are an effective means to conceptualize and integrate the codes that were emerging from our data analysis. Through this process, we identified five discursive legitimization strategies that we now discuss.

4 Empirical Analysis: Discursive Legitimation Strategies of Algerian Entrepreneurs Our empirical analysis focuses on how Algerian entrepreneurs use discourse to legitimize and justify their corrupt actions. We group legitimation strategies according to whether they fall under moralization, rationalization, normalization, mythopoesis, and authorization.

4.1

Moralization

Many entrepreneurs we engaged with rely on the value systems of Islam, the predominant religion in Algeria, to justify their behavior. Two specific discursive

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justifications were observed. First, some entrepreneurs defined corruption in relation to Islamic prescriptions in an attempt to provide a moral justification: “God does not forbid gifts. He never forbade that despite widespread misconception. What God forbids is compulsory gifts imposed to you in exchange of a service that you would not receive otherwise.” This specific entrepreneur is accustomed to giving gifts to senior officials and other administrators to bypass bureaucratic obstacles in order to operate his business smoothly. According to him, this should not be considered corruption: “nobody forces me to do it, and if it allows everyone to be satisfied and to find their account, why not? I am very comfortable with this and with God watching me.” Another entrepreneur rejected this “naïve and dangerous perception” because, according to him, “it is just another way of corruption and hiding it.” He rejects the idea that such gifts are not compulsory. According to him, even those who give gifts “claiming they don’t have to do so know full well that if they didn’t, they wouldn’t be getting services that are supposed to be free.” Second, entrepreneurs rely on religious ideas to justify bribery in specific situations. Much like other religious traditions, the intentions behind an action and their ultimate consequences, rather than solely the act itself, determine morality from the Islamic perspective. For example, an entrepreneur asked rhetorically whether “it was really possible not to play the game [of bribery] even minimally in such a corrupt context, even if one makes sincere attempts of avoiding them as much?” According to him, though his religion unequivocally prohibits corruption, he is convinced that God “understands every situation and he knows that the situation for entrepreneurs here is anything but easy. Do you think I like being in this position?” The intention behind an action is relevant for the entrepreneur and is used as a discursive justification. Likewise, another entrepreneur engaged in discursive legitimation by focusing on the ultimate consequence of his actions: “I just tell myself that if I don’t pay what I’m being asked or encouraged to do, tens or even hundreds of people will be in misery. If I understand my religion correctly, and maybe I am wrong in which case I hope that God will call me to order, giving hundreds of humans a chance is more beneficial than refusing at all costs to pay a bribe, even if it means losing everything, even your business.” In this second justification, it is the ultimate consequence and its value in the eyes of God that is at the heart of the discursive justification. Justifications based on ultimate consequences and intentionality may be interrelated since actors can perceive their intentions to be good if they lead a net positive, utilitarian outcome.

4.2

Rationalization

Many entrepreneurs also relied on rationalization to discursively legitimize their actions. Rationalization entails justifying the social actions based on their rational utility. As various types of rationalization exist, we found that the entrepreneurs we met mostly relied on instrumental rationalization by focusing on the benefits and outcomes of their actions. One specific entrepreneur suggested that paying gifts to

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bureaucrats or taking care of them financially was done in all countries of the world. According to him, “it keeps things rolling while it does not kill anyone.” Another entrepreneur highlighted the detriment of stubbornly ignoring the demands of bureaucrats because “it can cause a company to go completely bankrupt by suffering the damage of administrative blockages.” Interestingly, this same entrepreneur rationalizes his actions through the fate of his own business, but also that of the country. He adds: “anyway, if it allows an economy to be smooth, to function and to contribute to the development of the country, I think there is no point in fighting against it because the bureaucracy is too powerful, and these officials are real raptors.” In a similar vein, another entrepreneur rationalized the corruption that his company engages in by explaining the difficulty of preventing corruption across the organizational hierarchy: “I manage a very large company, anyway I can’t monitor everything, and we have so many executives and operators that corruption is possible at all levels, especially in such a difficult country. My instruction has always been to avoid paying a dime, but I cannot guarantee anything.”

4.3

Normalization

Another discursive legitimation strategy used by many entrepreneurs is normalization, which consists of interpreting one’s actions as being normal in comparison to what is happening more broadly in the environment. At the time of the data collection, Algeria had been embroiled in a series of scandals for the past 20 years. Many senior executives of private and public companies and even of government ministries were implicated and sometimes even imprisoned. In light of this history, one entrepreneur told us: “when high officials whose main duty is to respect and enforce the law end up stealing, I am not sure why people focus on the unfortunate entrepreneurs who pay tiny bribes to have their projects move on. I think we’re barking up the wrong tree.” From the perspective of another entrepreneur, “corruption has always existed in Algeria, and it exists in all countries. But in our country in particular, corruption is omnipresent and the entrepreneurs I know do not pay bribes to get rich but to further their projects which create jobs and added value. For me, we need to go after the big wolves who steal to enrich themselves first, and then the system can be cleaned up.” It is interesting to note that for both these entrepreneurs, there are more and less acceptable forms of corruption depending on the actors’ intentions (to enrich themselves or to contribute to the common good). Small-scale corruption is perceived as normal, necessary means of doing business and the focus is on the contribution of business to society. On the other hand, large-scale corruption is perceived to be illicit, and the focus is on the negative consequences of the act itself. Another entrepreneur pointed to the ultra-bureaucratic system that gives excessive discretionary power to administrative agents. The system makes corruption so commonplace and inevitable that it contributes to its normalization from the perspective of entrepreneurs.: “the main disadvantage of having such a huge bureaucracy, is that you create lots of

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opportunities for individuals—most of them insignificant—to create blockages and encourage these behaviors. So, is corruption good? No of course not, but it is quite normal when you see the Algerian bureaucratic and administrative system. Replicate this system anywhere in the world and you will have as much corruption, if not more.”

4.4

Mythopoesis

Lastly, compelling narratives were also used by several entrepreneurs to discursively legitimize potential corruption actions. One specific entrepreneur argued that one “cannot understand what it is without knowing the whole story and how it happened.” The broader context surrounding acts of corruption, often explained through stories, is imperative from his perspective for understanding the motives behind corruption. Among the stories we were told, two general patterns surfaced. The first relates to the historical prevalence of corruption in Algeria and how it spreads in the country in recent decades. One story told by an entrepreneur attempted to drive home the point that corruption has always been prevalent in Algeria. Illustrative of this story is the following quote: “the contemporary history of the country shows that there has always been corruption, just look at the scandals of the 1970s ... before, senior officials were stealing with teaspoons, timidly, but recently they have been stealing with ladles.” Another entrepreneur explained the roots of corruption and how it spread. According to him, the Algerian administrative apparatus, through an often-incoherent regulatory arsenal, created significant administrative blockages. Dissatisfied with the formal institutional environment, entrepreneurs found ways to circumvent the rules in order to operate their companies efficiently. According to him, these individuals created a set of informal rules they considered fair and reasonable in their dealings with other parties. This resonates with the experience of firms in emerging markets more generally that rely on informal institutions, such as social ties and networks, to facilitate business exchanges (Peng and Luo 2000). The second pattern that emerged was related to what Eero et al. identified as “exemplification,” which refers to relying on particular examples to establish legitimacy. Exemplification is as a form of mythopoesis. Almost all the entrepreneurs we met relied on examples to legitimize their own bribery, or the practice of bribery more generally. These examples usually refer to particular situations where entrepreneurs were either threatened by government officials or faced serious financial repercussions if administrative blockages were to stall their projects. One entrepreneur told the story of a tourism entrepreneur: “this gentleman invested everything he had, or almost everything he had, in the construction of tourist cottages by the sea. His project consisted of affordable prefabricated cottages, a very avant-garde project for us. High-ranking officials forced him to involve them as shareholders and to reserve a certain number of cottages for them, otherwise he would never see his project. . . this example alone says it all.” These examples and the stories

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entrepreneurs tell more generally seem to be vehicles for fostering empathy. By conveying their experience through stories that highlight the threatening institutional environment, entrepreneurs attempt to legitimate their involvement in corruption.

4.5

Authorization

A final discursive legitimation strategy used by entrepreneurs is explaining the role of authority. From the authorization perspective, gifts, bribes, and other monetary payments paid to government are demanded and thus neccessarly inevitable. One entrepreneur conveys this idea particularly effectively: “you really think you can get away with it? A lot of us thought so [laughs].” When entrepreneurs discuss their experience using authorization, they often refer to the threat involving the discretionary power of government actors due to their role and function: “everyone I know who has paid bribes or paid administrative officials in some form or another was afraid of reprisals. These people sometimes have functions that give them great power, even if it is only a signature that blocks an entire industrial project.” In this case, entrepreneurs are asked explicitly or by innuendo to provide compensation in some form: “you may be surprised, sometimes people come up with very explicit requests. One day, a senior executive told me he needed to have an operation and that if I could help him, it would be much appreciated.” Interestingly, even if not explicitly asked, entrepreneurs take for granted that they will have to pay bribes because of the systemic nature of corruption and their experience in the institutional environment. Any level of administrative agent may be perceived as potentially dangerous if not compensated due to the level of discretionary power they hold: “you think that a simple agent in a financial institution can’t do anything, but I’ve seen agents hide files or fake their loss, simply because they want to send you a signal to pay them. These people still have power over you.”

5 Discussion and Conclusion Through an inductive, ethnographic examination of the experience of Algerian entrepreneurs, our chapter uncovers various discursive legitimation approaches used to justify involvement in corruption. The strategies uncovered derived from the discursive legitimation typology (Vaara et al. 2006; Van Leeuwen 2007). While the experiences of the entrepreneurs detailed reflect the unique characteristics of the Algerian context, we feel the discursive legitimation strategies are applicable to emerging markets more broadly where corruption is rife. At their core, they are attempts by entrepreneurs to justify their actions in response to a weak institutional context.

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The five discursive legitimation strategies identified that entrepreneurs used to justify their involvement in corruption are rationalization (cognitive validity), normalization (common behaviors), authorization (authority of persons), moralization (value systems), and mythopoesis (use of narratives and stories). Some of these strategies can be tied to ideas explored in the extant literature on corruption. Corruption is thought of as an economically rational means of uncertainty reduction where its benefits outweigh its costs in weak institutional environments (Nguyen et al. 2016). The normalization of corruption in emerging markets has also been explored. Weak institutional conditions are thought to render corruption a necessity for doing business (Mohammad and Husted 2019). The prevelance of corruption causes it to become taken-for-granted. Firms follow suit and engage in corruption to keep up with their competitors (Venard 2009). Corruption is also most often depicted as being demanded by political actors in positions of authority. Our paper contributes to the literature by uncovering the discursive strategies used by individual actors that give rise to the justifications for corruption previously established in the literature. The micro-level focus of the discursive legitimation approach also allowed us to uncover justifications for corruption not previously explored, moralization and mythopoesis. Future research can expand on our work and examine the use of moralization and mythopoesis rationalizations by individuals and the implications this has for their involvement in corruption. While corruption has received increased scholarly attention in recent years (Krammer 2019; Mohammad and Husted 2021), qualitative examinations that attempt to understand why entrepreneurs engage in corruption are rare (e.g., Stevens and Newenham-Kahindi 2021). The extant quantitative research on corruption has largely established baseline relationships connecting characteristics of the institutional environment or the firm to corrupt behaviors. A drawback of this quantiative research is its limited ability to tap into mindset of the actor. As a result, there is little insight on the process by which institutional and firm-level factors drive entrepreneurs to engage in corruption. Our qualitative, ethnographic approach allowed for capturing entrepreneurs’ motivation and justification for corruption, in their own words. The result is a novel, discourse-based approach to understanding justifications for engaging in corruption that is in-tune with considerations of the actor. A surprising finding allowed for by our approach is that moral precepts of Islam are used to justify acts of corruption. Future research can employ similar qualitative methods to explore how faith and culture justify acts that most would consider contrary to their teachings. Our findings also raise the question of whether the spirit of sustainable finance is compatible with firms in emerging markets that engage in corruption. An immediate and perhaps justifiable reaction might be that firms that engage in corruption are at odds with the ethical standard that are required of firms to be considered targets of sustainable investing. Paying bribes to government officials contributes to the systemic problem of corruption that is not only a detriment to the business environment, but broader societal ills such as poverty and inequality (Kaufmann 1997; Moran 2001). We believe that the legitimacy of the justifications put forth in our paper should be considered in determining whether corrupt firms can be considered

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targets of sustainable investing. For instance, do the rational and moral justifications make a strong case that firms have no choice but make corrupt payments? To the extent that entrepreneurs have their hands tied and truly engage in corruption for the good of their employees and country, a case can be made that firms in emerging markets should not be disqualified as potential targets of sustainable investing. The alternative, reducing the level of foreign investment to firms in such institutional contexts, may exacerbate the problem of corruption by making firms more reliant on their local institutional environment. Corruption and financial crime are often closely associated. The investment of shareholders can be appropriated by government actors through demands for bribes or other impositions placed on a firm by government officials. For example, one entrepreneur in our study explains of a high-ranking government official who demanded ownership of a number of their high-valued products and to be a shareholder of the new venture. Thus, acts of corruption can amount to financial crimes when they result in the misuse of shareholders’ invested funds. An understanding the discursive justifications of entrepreneurs can be used to create anti-corruption efforts to fight against corruption and its associated financial crimes. To foster the belief that corruption is not an economically rational course of action, heavy penalties should be levied against corrupt actors. Our understanding of the authorization justification tells us that firms need to be assured protection if they deny a demand for a bribe or ownership of a firm. From the normalization justification, it can be inferred that repeated examples of firms and political officials being convicted are necessary to fend off the perception that corruption is an accepted part of doing business. Furthermore, anti-corruption campaigns would benefit from broadcasting convictions widely, including those both involving petty corruption by low-ranking officials and more significant corrupt exchanges involving large firms and high-ranking officials. Anti-corruption campaigns should attempt foster stories of firms and businesses being taken down for illegal financial transactions that can displace existing narratives of the enduring nature of corruption. To foster such narratives, anti-corruption campaigns can devote more resources to targeting and making examples of renowned firms and the most public of government officials. To build a moral case against corruption, anti-corruption campaigns may include explanations for why corruption is at odds with religious morals so that faith is not used as a means of false moral justification.

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Shoeb Mohammad is an Assistant Professor of Strategic Management and Entrepreneurship at Ontario Tech University (Canada). Shoeb’s research examines the contextual influences and broad implications of unethical behavior of firms from varying perspectives, with a key focus on emerging markets and innovation. Current topics he is exploring include the implications of the institutional environment of emerging markets on the unethical behavior of firms, how corruption in emerging markets affects firm innovation, and the social evaluations firms receive when involved in scandals. His scholarly works have been published in Journal of Business Research, International Business Review, and Business Ethics: Environment and Responsibility. Sofiane Baba is an Associate Professor of Strategic Management at the École de gestion, University of Sherbrooke (Quebec, Canada). Professor Baba’s research focuses on better understanding the processes, strategies, practices, and projects through which organizations can contribute to making this world more sustainable, just, and inclusive. His empirical research is primarily qualitative and focuses on various contexts, namely SMEs, large complex organizations, and philanthropic organizations, both in Canada and in North Africa. His scholarly works have been published in the Academy of Management Journal, Journal of Cleaner Production, Journal of Management Inquiry, International Journal of Project Management, and Management International.

Financial Crime in OTC Markets Alexis Stenfors and Lilian Muchimba

1 Introduction The UK Financial Services and Markets Act 2000 defines financial crime as “any kind of criminal conduct relating to money or to financial services or markets”, which includes any offence involving (a) fraud or dishonesty; or (b) misconduct in, or misuse of information relating to, a financial market; or (c) handling the proceeds of crime; or (d) the financing of terrorism (FCA 2022). In this chapter, we focus on the first two classifications. To be more precise, we explore various forms of financial market abuse, manipulation, and misconduct in the over-the-counter (OTC) markets. Insider trading and elaborate Ponzi schemes are often put forward as examples of white-collar crime in financial markets. These types tend to be closely linked to exchanges, equity markets, and asset managers. OTC markets, however, are decentralised, relationship-based, and bank-oriented. As we argue in this chapter, these features have a significant impact on the modus operandi of fraudulent behaviour. Until the Great Recession, the largely unregulated OTC markets received little attention from compliance officers, regulators, and lawmakers. Perhaps more important than the lack of regulatory framework as such, the markets were widely perceived to be sufficiently large, liquid, and competitive to withstand manipulative and collusive attempts by traders and banks. However, this status quo was radically altered with the so-called LIBOR scandal in 2013, or the revelation that major international banks had systematically manipulated the world’s most widely used interest rate benchmark. The London Interbank Offered Rate (LIBOR) scandal was quickly followed by the “Forex scandal” and discoveries of grave misconduct in a range of other OTC benchmarks and markets. More lately, regulators in jurisdictions A. Stenfors (✉) · L. Muchimba University of Portsmouth, Portsmouth, UK e-mail: [email protected]; [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_11

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around the world have started to crack down on manipulative tactics such as spoofing that appear to be more associated with algorithmic traders involved in bonds and commodities on electronic trading platforms. In this chapter, particular emphasis is put on the nature of money-related OTC markets, which have a fundamental and inseparable link to the central bank, government, and citizens in general. Through case studies involving money markets and the LIBOR, foreign exchange (FX) and government bonds and bond derivatives futures, we reflect upon the unique characteristics of these markets and why it took so long to reveal that they have always been susceptible to criminal behaviour. The chapter is organised as follows. Section 2 focuses on the LIBOR scandal with a case study on Deutsche Bank. Section 3 addresses fix manipulation in the FX markets with an example from RBS. Section 4 uses a recent case involving JP Morgan to show how spoofing has taken place in the government bond market. Section 5 reflects upon the similarities between the three markets and cases, and why it took so long to discover that OTC markets were highly susceptible to financial crime. Section 6 concludes the chapter.

2 Money Markets and LIBOR Manipulation Traditionally, the LIBOR and equivalent IBORs in other jurisdictions were assumed to be an accurate reflection of competitive conditions in underlying money markets. Since they are linked to the cost and source of funds in the interbank market, the LIBOR was perceived to be an accurate minimum rate to price other financial products (Hou and Skeie 2014). Therefore, interest rate benchmarks contribute to the efficient functioning of the financial markets in various ways. First, as reference rates, they facilitate a standardised way of pricing financial contracts, thereby reducing transaction costs and enhancing liquidity (Federal Reserve Bank of New York 2022). Second, through the pricing of financial products such as student loans, mortgages, and derivatives, reference rates facilitate risk management. To this effect, interest rate benchmarks have a significant role in society as they affect all economic agents (e.g., households, firms, and government). A household with a floating rate product, such as a mortgage linked to an interest rate benchmark is affected by its movements. Likewise, an incorrect interest rate benchmark may understate or overstate the cost and source of funds, thereby resulting in losses or undeserved gains for lenders (e.g. banks). Third, from a monetary policy perspective, interest rate benchmarks are the first step of the monetary transmission mechanism. This is because they represent banks’ borrowing and lending activity in the short-term segment of the money market. According to the monetary transmission mechanism, governments and central banks, particularly inflation-targeting economies, achieve their price and output objectives through their influence on expectations and short-term interest rates. Many inflation-targeting economies have institutionalised the monetary transmission mechanism logic to achieve their output and inflation objectives (Muchima and Stenfors 2021). To this effect, interest rate

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benchmarks are a gauge of the health of financial markets and the effective functioning of the interest rate channel of the monetary transmission mechanism. A flawed rate may give a wrong gauge of financial health and, therefore, inappropriate central bank policy actions. The significance of the LIBOR is evident from its use and liquidity in the financial system. By mid-2018, the LIBOR was underpinning financial contracts estimated at $400 trillion (Schrimpf and Sushko 2019). The size and liquidity of the financial contracts could have masked the incentives and vulnerabilities of the LIBOR to manipulation. The LIBOR was perceived as representative of underlying market conditions. To understand whether the LIBOR is a market, a useful starting point is its link to the central bank or the state. As Stenfors (2013) states, a central bank, as an agent of the state, has the power to influence the LIBOR. The central bank link to the state has evolved at a different pace in different countries. With modern central banks having the independence often backed by law to execute their price and financial stability functions. The first central banks, such as the Swedish Riksbank, Bank of England, the Banque de France, did not perform the modern role of central banks initially. For example, the first central bank, Swedish Riksbank, was created as “the main commercial bank in the country” with a special right of being the monopoly issuer of notes in the capital city. In return, this bank would lend funds to government through government securities and additional loans, and this led to a drain of foreign reserves in some instances. On the other hand, the Bank of England was established as a private entity to finance the war with France (Bank of England 2022). This beneficial role of central banks resulted in the government guarding this relationship (Goodhart 1995). Despite the evolution of central banks as sole issuers of currency, they still have the power to influence the LIBOR benchmark for unsecured short-term interest rates. This is achieved through the central bank’s functions. Through formulation and implementation of monetary policy, lender of last resort and financial stability functions, central banks have the power to influence the LIBOR. To this effect, the LIBOR is highly influenced (susceptible to manipulation) by central bank actions and not by the competitive forces of a market per se. Turning to the calculation methodology, the LIBOR is, and was never a market in the sense that it was not a tradable price or rate (Stenfors and Lindo 2018). Instead, the LIBOR was a benchmark derived from where banks supposedly were able to borrow funds from each other or the interbank market as a whole. There were, and still are, numerous IBORs in different jurisdictions (EURIBOR in the Eurozone, TIBOR in Tokyo, STIBOR in Stockholm, etc.), in different currencies, on different maturities and using somewhat different methodologies. Nonetheless, the fixing process was reasonably similar and could, for instance, look something like this. Just before noon every trading day, 16 banks submit their own LIBOR quotes to a system or platform without being able to see each other’s quotes. An independent third party then audits and checks the quotes for errors and typos. Next, a trimming process takes place, whereby the highest 4 and lowest 4 quotes are omitted. The average of the remaining 8 LIBOR quotes is calculated and becomes referred to as the LIBOR fixing. Soon thereafter,

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Table 1 Examples of LIBOR manipulation by Deutsche Bank Example of improper submission on behalf of Deutsche Bank derivatives traders (EURIBOR) On 29 December 2006, Manager B and Submitter C had the following exchange: Manager B: “. . .COULD I BEG YOU FOR A LOW 3M [EURIBOR] FIXING TODAY PLEASE..THANT WOULD BE THE BEST XMAS PRESENT ;)” Submitter C: “. . .BE A PLEASURE, NO PROBS WE HAVE NOTHING ON THE OTHER SIDE HERE. WILL PUT IN 71 [3.71] AT LEAST MAYBE WE CLD [could] PUT IN 70 [3.70]. . .” Manager B: “LOW AS POSSIBLE AS WE HAVE 2.5 YARDS [2.5 billion] ON IT TODAY, SO WOULD BE VERY HELPFULL” On 29 December 2006, Deutsche Bank’s 3 month EURIBOR submission was 3.70 (a 3 basis point drop from the day before) Example of collusion with other LIBOR panel banks (Japanese yen (JPY) LIBOR) The following Bloomberg exchange took place on 18 September 2008: External Trader B: “you got any ax on 6m fix tonight”? Derivatives Trader C: “absolutely none but i can help” External Trader B: “can you set low as a favour for me”? Derivatives Trader C: “done” Following this request, Derivatives Trader C decreased his 6 month LIBOR submission by six basis points Example of collusion with interdealer brokers (JPY LIBOR) On 10 July 2009, Money Markets Trader A contacted Broker Bank 2 and while discussing 3 month JPY LIBOR asked “any chance to get it lower or some resistance. . .” The Broker responded: “ill try prob Monday can get it lower” Source: FCA (2015)

the LIBOR fixing, as well as the individual quotes by all 16 banks is made public. The process is repeated the next day, and so on (Stenfors 2014). This calculation methodology of the LIBOR and similar IBORs provided a window for banks to submit manipulated rates. Banks had incentives to submit rates to signal their financial strength and benefit from their large derivative positions (Duffie and Stein 2015). Unearthed evidence revealed that various banks and brokers paid penalties worth millions of dollars for rigging the LIBOR and similar benchmarks. There are several ways in which LIBOR could be manipulated. First, the LIBOR submitters working for a particular bank could be pressured or incentivised by traders or managers to submit favourable LIBOR quotes. Second, because of the trimming process, a manipulated LIBOR fixing is more likely to be obtained if several banks work together. In other words, LIBOR panel banks could collude. Third, a considerable proportion of money market transactions are executed through interdealer brokers (IDBs). The IDBs are typically in close communication with all LIBOR panel banks and are, therefore, crucial for information gathering and dissemination. Consequently, IDBs could be pressured or bribed into disseminating false or skewed information to the rest of the market (including other LIBOR panel banks). The intent would ultimately be to deceive them into believing that the market is higher or lower than it actually is. There are more routes to achieve a manipulated LIBOR. As an illustration, though, Table 1 provides examples drawn from the Final Notice issued by the FCA to Deutsche Bank in 2015 (FCA 2015). Note that the

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transcripts are precise and unredacted (hence the spelling mistakes and colloquial language used). In conjunction with the publication of the Final Notice by the UK Financial Conduct Authority (FCA), Deutsche Bank was ordered to pay £227 million for its serious misconduct in relation to LIBOR. The FCA highlighted three key failings— namely Deutsche Bank’s attempted manipulation of IBOR rates, the bank’s systems and controls failings, and the serious deficiencies in the way Deutsche Bank had dealt with the FCA in relation to the IBOR investigation. In addition, the German bank paid $775 million to the US Department of Justice (DOJ), $800 million to the Commodity Futures Trading Commission (CFTC), and $600 million to the New York Department of Financial Services (DFS). Deutsche Bank pleaded guilty to wire fraud in the US, acknowledging that dozens of employees had engaged in illegal activity. However, numerous other banks were also fined for manipulation of IBOR-benchmarks or engaging in cartels—including Barclays, Citigroup, HSBC, JP Morgan, Lloyds Bank, Rabobank, RBS, Société Générale, and UBS. In addition, several IDBs were reprimanded (e.g. ICAP and RP Martins). The LIBOR scandal also resulted in several criminal trials. The most high-profile was undoubtedly that of Tom Hayes, a former trader of Citigroup and UBS, who was sentenced in 2015 to 14 (later reduced to 11) years in prison for manipulation of the Japanese JPY LIBOR. The UK Serious Fraud Office (SFO) also issued criminal proceedings against 11 traders accused of EURIBOR manipulation. Christian Bittar (Deutsche Bank) pleaded guilty in 2018 and was sentenced to 5 years and 4 months in prison. Philippe Moryoussef (Barclays Bank) was found guilty by a jury and sentenced to 8 years imprisonment. Carlo Palombo and Colin Bermingham (both Barclays Bank) were convicted in 2019 and sentenced to 4 and 5 years, respectively (SFO 2022).

3 Foreign Exchange Markets and Fix Manipulation The “Forex scandal”, or the revelation of widespread collusion, manipulation, and misconduct in the global FX markets, followed the LIBOR scandal and attached itself quickly to it. After all, the list of banks involved was almost identical to the LIBOR panel banks involved in the LIBOR fixing process. Moreover, FX and money market trading desks within banks had traditionally been located in close proximity to each other—suggesting that the behaviour could have been closely related to the culture, norms, and market conventions in dealing rooms around the world. However, in contrast to the LIBOR scandal, which involved a non-tradable benchmark, the FX scandal was about actual buying and selling. Overwhelmingly, it involved banks taking advantage of their role as both principal and agent in the global FX market—effectively trading simultaneously on behalf of themselves and their clients. Elaborate strategies were put in place (sometimes in collusion with competing banks) to maximise the profits from orders to the detriment of the clients placing them.

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For instance, clients often leave orders for a bank to execute “at best”. However, if the order is large enough to result in a significant price move, it provides the bank with an incentive to front-run the order. A hypothetical example of the practice of front running (which is illegal in most jurisdictions) looks as follows. Suppose the £/ $ FX spot market is 1.5000–1.5005. Assume that the standard market amount is £10 million. Now assume that a client calls and requests a bank to buy £500 million “at best”. Everyone is fully aware that the execution of the large order will cause the £/$ FX spot price to increase, perhaps even substantially. In other words, the client is willing to accept a higher price than 1.5005. Front running could, however, entail the following. First, the bank buys £50 million for its own account at, say, 1.5010. Second, the bank buys a total of £500 million for the client at an average price of 1.5035. Third, the bank sells the £50 million from its own account at 1.5030. The front running profit is $100,000 (20 pips or 0.0020 of £50 million). The strategy has harmed the client because the rate would have been lower than 1.5035 if the bank had not bought the extra £50 million beforehand. The FX scandal involved the discovery of a number of front running cases similar to the example above (see, for instance, DFS 2017; DOJ 2018; FINMA 2015). In addition, clients often leave “stop-loss orders” to banks. These are instructions to the bank to close out a particular position in case the price for the currency pair reaches a specific and predefined level. Problematically, banks also took advantage of such orders. Rather than waiting on the side lines for the undesirable stop-loss level to be reached, numerous instances were recorded whereby banks actively pushed the market in such a manner that the stop-loss order was triggered. Put differently, rather than treating the stop-loss orders as potential loss-making events for their clients; they were turned into profit-making opportunities for the banks. However, the most frequently cited orders resulting in misconduct were the so-called fix orders. Fix orders are orders submitted by clients that do not have a specific predefined price level. Instead, the focal point is a specific time of the day. There are several different important snapshots throughout the day, but the most widely used at the time was the WM/Reuters 4 p.m. fix—a snapshot or benchmark representing the London market close at 4 p.m. The benchmark, which has since been amended, was based upon actual trading 30 s before and 30 s after the time of the fixing (the “fixing window”). Banks accepting, say, a client fix sell order of £/$ 100 million agree to buy £/$ 100 million from the client at 4 p.m. that day at the fix rate—no matter where the price is before or after that fixing takes place. Problematically, this arrangement also provides banks with an incentive to manipulate the market. Suppose the £/$ FX spot market is trading at 1.5030–1.5035 at 3:50 p.m. and that a client has submitted an order to a bank to sell £200 million at the WM/Reuters 4 p.m. fix. The fix is determined by at what prices actual FX trading takes place within the 60-s “fixing window” before and after 4 p.m. Having accepted the order from the client, the bank guarantees that it will buy £200 million from the client at the fix rate (which is not yet known). An example of fix rate or fix order manipulation would be the following sequence. First, just before the fixing window begins, the bank sells £100 million for its own proprietary account at an average rate of 1.5020. Second, within the fixing window, the bank sells another £100 million for its own account at an average rate of

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Table 2 Manipulation by RBS of the WM/Reuters 4 p.m. fix (conversations) Time 3.22 p.m.

3.45 p.m.

3.46 p.m. 3.48 p.m.

3.51 p.m.

3.54 p.m.

Conversation extract Bank A discloses that it had net sell orders of about £200 million at the WMR fix RBS responds: “blimey . . . judging by liq today. . .” Bank A discloses that another of its offices needs to sell £100 million at the fix RBS discloses that it also has net sell orders of £80 million at the fix Bank B discloses that it needs to sell about £60 million at the fix Bank C discloses that it needs to buy the same amount of £ at the fix as Bank B was selling Bank C and Bank B agree to net off these orders RBS updates the participants in the chat room that it now needs to sell more than the £200 million at the fix that Bank A needed to sell RBS makes a further disclosure of its net sell orders for the fix in a separate chat room involving three further banks and states that “we getting alot betty at fix” Bank A discloses to RBS that it has netted off part of its net sell orders with two other parties outside the chat room, but that Bank A still needs to sell about £140 million at the fix

Authors’ explanation RBS notes that the size of the sell orders is very large when taking into account the liquidity of the market Both RBS and Bank A have obtained sell orders (i.e. will be buying from clients at 4 p.m.). As a result, they will profit if they manage to sell at a higher price in the market than the fix rate Bank B is in a similar position as RBS and Bank A Bank C has the opposite position (and opposite incentive) to Bank B. Bank C and Bank B decide to net their position to avoid a conflict of interest “betty” is a slang term for £/$

Bank A has been “clearing the decks”. This means that it has netted positions with banks having opposite positions and incentives

Source: FCA (2014)

1.5010. Notice that the price has decreased as a result of the heavy selling activity by the bank. Third, let us assume that the average rate traded in the £/$ FX spot market during the fixing window is 1.5010. Consequently, on that day, the £/$ FX spot 4 p.m. fix will settle at 1.5010. The profit to the bank from the manipulation is $100,000. This stems from having sold £100 million to the market at 1.5020 earlier and then having bought them back from the client at 1.5010. However, the client is clearly a victim in this instance. Without the aggressive selling by the bank before the fixing, the price is likely to have been higher than 1.5010. The Forex scandal featured numerous attempts by banks, either alone or in collusion with other banks, to manipulate the WM/Reuters 4 p.m. fix. As an illustration, Table 2 shows a scenario at RBS. The conversations (using exact quotations from transcripts obtained by the regulator) document several forms of misconduct, including manipulation, collusion, and sharing of confidential information (FCA 2014). Table 3 shows RBS’s £/$ FX spot trading activity before and during the fixing window.

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Table 3 Manipulation by RBS of the WM/Reuters 4 p.m. fix (trading activity and FX spot movement) Time 3:50:30 p.m. to 3: 52:10 p.m.

RBS’s £/$ FX spot trading activity RBS sells £93 million

3:50:30 p.m. to 3: 59:30 p.m.

RBS sells a total of £167 million and Bank A sells £26 million. Together they account for 28% of all sales on the Reuters platform during this period RBS sells £182 million, which accounts for more than 32% of the sales in £/$ on the Reuters platform RBS and Bank A together account for 32% during the fix window

Fixing window (i.e. 60 seconds around 4 p. m.)

WM/Reuters 4 p.m. fix

£/$ FX spot £/$ FX spot decreases from 1.6276 to 1.6250 £/$ FX spot decreases from 1.6276 to 1.6233 £/$ FX spot decreases from 1.6233 to 1.6213

The fixing ends up at 1.6218

Source: FCA (2014)

In the real-life example above, RBS generated a profit of $615,000 in a matter of minutes. Afterwards, RBS and the other banks congratulated each other on the collusive and manipulative strategy. In electronic chat rooms, comments such as the following featured: “I don my hat”, “welld one [sic] lads”, “what a job”, “bravo”, and “[RBS] is god”. In relation to the fixing at 1.6218, RBS commented “1.6218. . .nice”, whereas Bank A later on stated that “we fooking killed it right. . . [Bank C], myself and RBS”. RBS was fined £217 million by the FCA in 2014 for its misconduct in the FX markets. Three failings were highlighted by the regulator. First, RBS had attempted to manipulate fix rates (as shown above) both alone and in collusion with other banks. Second, RBS had deliberately triggered clients’ stop-loss orders. The benefit to RBS was to the detriment of their clients and other market participants. Third, RBS had shared confidential information about their clients to other banks. However, RBS was also among a group of 5 banks pleading guilty to felony charges in the US and was fined close to $1 billion by US authorities. The others in the group were Barclays, Citigroup, JP Morgan, and UBS (all LIBOR panel banks). Other large banks, including Bank of America, BNP, Crédit Suisse, and HSBC, have also settled with authorities. Despite more than $10 billion paid fines by banks over the years (plus more in litigation), few traders have been criminally charged or convicted. Nonetheless, in 2020, Akshay Aiyer (JP Morgan) was sentenced to 8 months in prison (DOJ 2020). The most high-profile case has involved HSBC traders Stuart Scott and Mark Johnson accused of front running a large client order. However, similarly to LIBOR-related cases, it has been challenging for a particular jurisdiction to convict an individual sometimes working for a foreign bank, in a foreign country, trading products and instruments denominated in foreign currencies in an environment which has lacked very little regulation and oversight.

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4 Government Bonds, Derivatives, and Spoofing LIBOR manipulation involved rigging a non-tradable benchmark with the purpose of benefiting from the impact the benchmark had on other prices or indicators. The section on the Forex scandal, on the other hand, demonstrated how manipulation could be linked to daily snapshots that are of importance to investors and clients. Although there are significant differences between the two manipulative tactics, there are also two key similarities. First, the banks involved were either LIBOR panel banks or market makers in the relevant FX spot currency pair and could, therefore, exercise significant power and influence over the rate or price. Second, the trader or bank had been put into a specific situation before the manipulative scheme was embarked upon. Whereas client orders such as fix orders were welcomed as such, once they had entered the order book of the bank, their nature changed. Fix orders obtained the form of an “inherited” risk that needed to be dealt with. The same applied to LIBOR. Some LIBOR-indexed interest rate swaps remain on the bank’s books for several decades and give rise to LIBOR fixing risk on a regular quarterly basis. Regardless of whether the contract was entered into by a manipulator or a genuine trader with no harmful intent, the position remained “alive” and could act to rationalise manipulative behaviour until it disappeared from the derivatives book. The case was arguably even stronger when it came to LIBOR manipulation that was linked to perceived creditworthiness (the so-called low-balling). Ultimately, a LIBOR submitter for a bank with 100,000 employees is unlikely to feel culpable if the bank suddenly becomes seen as unsafe and unsound by credit rating agencies, journalists, or other observers. From this perspective, spoofing is a completely different form of manipulation. The intent of a spoof is to cause other traders to react as if genuine price-moving information has entered the market—although the information is fake. It is essentially about profiting from having created a false perception of supply and demand. Put differently; spoofing is less “reactive” than LIBOR and FX manipulation. Rather than involving an inherited risk, it involves the creation of such risk from scratch. The following hypothetical scenario may serve as an illustration. Suppose the market for a bond on a trading venue is made up of buy orders amounting to $20 million at 130.00 and sell orders of $20 million at 130.05. A spoofing strategy consists of a genuine resting order and a spoof order. The resting order is intended to get filled. The spoof order, however, is not intended to be executed. Instead, the purpose of it is to trigger a false perception of the supply or demand in the market— which other market participants will act upon. For instance, the perpetrator may choose to submit a genuine sell order of $10 million at 130.04. After that, however, a $100 million (spoof) buy order is submitted at 129.97. Because the spoof order is very large, other market participants may believe that the price of the bond is likely to go up. Hence, a successful spoofing strategy would entail that the genuine sell order of $10 million at 130.04 is executed. In quick succession, the perpetrator cancels the $100 million spoof buy order at 129.97. Even though spoofing is a form of “quote-driven” rather than “trade-driven” manipulation, it acts to distort the

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Table 4 JP Morgan spoofing example from 3 June 2010 Time 2: 05:55.480 p.m. 2: 05:57.523 p.m.

Activity Trader A at JP Morgan places a genuine order to sell 20 U.S. Treasury bond futures contracts at $122.25000 Trader A places a spoof order to buy 2000 U.S. Treasury bond futures contracts at $122.21875

2: 05:57.582 p.m. 2: 05:58.430 p.m.

Trader A’s genuine resting order is filled

Trader A cancels the spoof order

Authors’ observation The face value of 20 Treasury bond futures contract is $2 million Notably, the spoof order was 100 times larger than the genuine resting order. According to the CFTC (2020), the intent of the spoof order was “to create the illusion of demand, deceive other market participants, and artificially move the market price higher” Notice that the genuine resting order is filled after just 59 milliseconds following the spoof order The spoof order is cancelled within one second of the genuine order being filled

Source: CFTC (2020)

market and can, therefore, be treated as market manipulation (Cumming et al. 2011, 2015). The harmful impact is relatively similar with regard to market integrity, quality, liquidity, and stability (Fox et al. 2021; Mark 2019; Stenfors and Susai 2021). Spoofing was outlawed in the US with the 2010 Dodd-Frank Act. Other jurisdictions have also banned the practice or included it in prevailing definitions of market abuse or fraud. Although human traders are able to spoof the market, machines or algorithms have an edge in the sense that they are faster and able to repeatedly and tirelessly submit and cancel orders. Indeed, the vast majority of spoofing cases brought to light by regulators and lawmakers have involved algorithmic traders (CFTC 2018). In 2017, Citigroup was fined $25 million for spoofing in, inter alia, the US Treasury futures market (CFTC 2017a). The same year, The Bank of Tokyo-Mitsubishi received a penalty of $600,000 for similar misconduct (CFTC 2017b). CFTC filed anti-spoofing actions against other banks (Deutsche Bank, HSBC, and UBS) in 2018, although none of them was bond-related (CFTC 2018). The same year, the Japanese Securities and Exchange Surveillance Commission (SESC) fined Mitsubishi UFJ Morgan Stanley ¥218 million for spoofing in the Japanese Government Bond (JGB) futures market on Osaka Exchange (OSE) (SESC 2018). The following year, Citigroup was fined for a similar offence (SESC 2019). However, in September 2020, CFTC issued the largest ever fine for spoofing when JP Morgan was ordered to pay $920 million. The bank admitted to committing wire fraud in connection with unlawful trading in the markets for precious metals futures contracts and the markets for U.S. Treasury futures contracts and in the secondary (cash) market for U.S. Treasury notes and bonds. The bank’s activity had “involved hundreds of thousands of spoof orders” (CFTC 2020). The following real-life example serves as an illustration (Table 4):

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Table 5 Examples of communications regarding unlawful trading Date 17 January 2008 11 February 2009 1 July 2009 3 December 2009 3 November 2010 6 July 2011

Trade E’s statement i spoof brokertec 2’s OKAY im offering 13’s garban but its spoof. i’m going to spoof down aug 14’s garban im bidding sep 14s up at 16¾ in box as spoof do us want 50 at 16+? there is 16+ bid liberty. . . im just spoofing down jan feb 17 garban just spoofing down the jan 15’s -185m still

Source: CFTC (2020). Note: “brokertec”, “garban”, and “liberty” refer to specific trading platforms and interdealer brokers

Another example published by the CFTC shows discussions about spoofing between Trader E and other traders on JP Morgan’s U.S. Treasuries desk (Table 5): In August 2022, two of the JP Morgan traders involved were convicted of fraud, attempted price manipulation, and spoofing (DOJ 2022). In December 202, NatWest pleaded guilty to fraud and was ordered to pay $35 million. The spoofing had not only involved US Treasury bond futures, but combinations of cash and derivatives (the so-called cross-market manipulation) (DOJ 2021; Stenfors et al. 2022b).

5 The Illusion of Sustainability and Immunity from Financial Crime Financial crime is, of course, not new in the global OTC markets. In fact, the revelations so far have shown that regulators and lawmakers might even only have scratched the surface in some cases. Nonetheless, up until the LIBOR scandal in 2013, the markets in the previous sections were typically seen as immune from successful manipulative and collusive behaviour. That assumption proved to be completely misguided. How could widespread misconduct go unnoticed for such a long time? More importantly, how could the OTC markets be perceived as sustainable from the perspective of outsiders and the wider public? We argue that the reasons fall into five categories (for a detailed insight into FX specifically, see Stenfors 2020). First, it is a widely held belief that large, liquid, and competitive markets are less susceptible to manipulation. LIBOR, FX, and bonds have a history fitted into this category. The OTC FX market is the largest market in the world by a mile, and the major currency pairs are extremely competitive. Indeed, as the FX scandal was about to break, an academic was quoted as having said the following to Bloomberg: “I’m sceptical of the ability of traders to manipulate the major

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currencies in a meaningful way given the massive size of this market [. . .]” (Vaughan et al. 2013). Similarly, LIBOR was sometimes referred to as “the world’s most important number” given how widely it was used in finance and economics (Stenfors and Lindo 2018). The bond market, too, has enjoyed a reputation for having been a gigantic, safe, robust, and even “boringly” stable market—a far cry from anything that would come under attack by fraudsters. As argued by Stenfors (2018), such beliefs have acted to solidify the perception that these markets are virtually immune to manipulative attempts. Second, money, FX, and bond markets are overwhelmingly traded OTC. They are therefore decentralised, relationship-based and, typically, bank-oriented. The liquidity of the market is not upheld by market participants posting bids and offers on a stock exchange. Instead, the liquidity provision process is sustained by a commitment by a group of banks to quote prices to others. In order to be able to do so, they commit to quote each other prices. This kind of arrangement is similar regardless of whether the framework is a group of LIBOR panel banks, a list of primary dealers in government bonds, or market makers in a certain currency or currency pair. The role of banks acting simultaneously as market makers and proprietary traders, as principals and agents, as intermediaries and outright risktakers creates an obvious conflict of interest. The bank’s interests may be priorities ahead of the client’s. Third, the close link to the state undoubtedly makes these markets rather peculiar from a manipulation perspective. For instance, numerous countries have adopted fixed-exchange regimes throughout history. Interventions by central banks in the FX market are rarely controversial from a manipulation perspective unless there are claims of a “currency war”. Likewise, LIBOR is closely correlated with the official central bank policy rate. The policy rate, in turn, is not determined by the market but by a central bank which ultimately is an annexe of the state. It could be argued that government bonds are less influenced by the state because they are traded as securities in the secondary market. However, unconventional monetary policy in the form of quantitative easing and yield curve control has demonstrated that states have significant power and ability to maintain a bond yield that might deviate from the market consensus (Stenfors et al. 2021, 2022a). In sum, the state is actively pursuing policies in these markets that shifts prices away from what could be regarded as a market-determined equilibrium. If the state repeatedly endorses such interventions, some traders might argue that it also provides justification for manipulation. Fourth, compared to stock markets, OTC markets have managed to remain less regulated. Up until the aftermath of the LIBOR and forex scandals, proper governance, trading etiquette, and good behavioural were largely defined by the same group of banks as in the point above. Although some unethical behaviour and undesirable conduct were defined and documented under various umbrella organisations (e.g. ACI 2009), attempts were not made to include words such as “illegal” or “criminal” into the lexicon. Thus, the absence of formal regulation is an important factor in why it took so long to shine a spotlight on the OTC markets. However, an equally significant aspect is the lack of guidance (and

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consequently training) on what might constitute as right and wrong from a legal perspective. Fifth, OTC markets are overwhelmingly banking activities and are, therefore, rooted in secrecy. Information in this market type is bilateral and confidential. Therefore, it is rarely available to the public. When available, it is often aggregated and published with a lag. Consequently, this opacity and limited transparency create challenges in competitive pricing and make the market susceptible to manipulation (Muchimba 2022). Moreover, detecting manipulation becomes hard for regulators. Further, the OTC market is governed by reciprocal bilateral trading relationships. While the mainstream economic view is that interest rates, regardless of the nature of the market, are reflective of competitive market conditions, this may not be the case. In line with the “father of economics”, “People of the same trade seldom meet together even for merriment and diversion, but the conversation ends in a conspiracy against the public or contrivance to raise prices” (Smith 1776 [1991], 145). Reciprocity forces banks to undertake and return favours, making the market susceptible to manipulation and collusion. During the LIBOR and FX scandals, banks and brokers conspired through conversations (internal and external communication) to achieve manipulation and/or collusion.

6 Concluding Remarks In this chapter, we have studied three different OTC markets that have been subject to systematic, significant, and successful attempts of manipulative behaviour. It would, perhaps, be tempting to analyse the events that have unfolded from the classic fraud triangle perspective. Finding incentives, opportunities, and methods of rationalisation is hardly challenging in financial markets that are not only (literally) about money but also have an architecture that has been built upon a lack of transparency, oversight, and regulation. Indeed, subsequent actions taken by regulators, lawmakers, and compliance bear clear footprints of such an approach. However, the discoveries of widespread misconduct, which in many instances have amounted to criminal behaviour, point towards deeper fundamental flaws. The LIBOR scandal revealed that the world’s most important number, in fact, does not represent a market at all. The mechanism had, from its inception, always been susceptible to collusion and manipulative behaviour. However, financial innovation in the form of new LIBOR-indexed derivatives instruments and an exponential increase in risk-taking among banks and other financial institutions help to mask the problem for several decades. The perception of LIBOR as a robust “truth” became rooted in financial and economic activity across society. The discovery of criminal behaviour helped to unmask this misconception. The forex scandal, on the other hand, laid bare the fact that banks always have acted as both principal and agents in the FX and a range of other OTC markets. This would always have been seen as unthinkable in, say, the exchange-traded stock

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market. However, the role of banks as liquidity providers in money and moneylinked OTC instruments meant that such conflicts of interest were natural ingredients in how the markets operated. Further, with the central bank acting as a de facto leader of the “club of banks”, conventions and social norms could evolve outside formal regulation, but nonetheless with implicit backing by the state. Unintentionally, the forex scandal proved to be a reminder of some of the risks in relying too much on self-regulating mechanisms in financial markets that are crucial for society. The recent cases involving government bonds and government bond futures have shown how financial crime in OTC markets has developed in line with technological development. As human traders have gradually lost out to machines and trading venues have become more electronic, classic forms of manipulation such as spoofing have found new avenues to foster. This has led to greater awareness of the pitfalls in the ever-increasing speed and sophistication of markets. The OTC markets and benchmarks outlined in this chapter are vital not only for financial institutions and multinational corporations. They affect governments, small businesses, and households. For decades, the markets had managed to sustain an illusion that they were virtually immune from manipulative, collusive, and other criminal behaviour. Paradoxically, it was financial crimes committed that came to reveal that the OTC market structure had been built on unsustainable foundations right from the start.

References ACI (2009) The model code: The International Code of Conduct and Practice for the Financial Markets, Version April 2009 Bank of England (2022) Our history. Available from https://www.bankofengland.co.uk/about/ history. Accessed 12 Sept 2022 CFTC (2017a) CFTC orders Citigroup Global Markets Inc. to pay $25 million for spoofing in U.S. Treasury futures markets and for related supervision failures. Press release, 19 January. Available from https://www.cftc.gov/PressRoom/PressReleases/7516-17. Accessed 23 Aug 2022 CFTC (2017b) CFTC finds that the Bank of Tokyo-Mitsubishi UFJ, Ltd. engaged in spoofing of treasury futures and Eurodollar futures. Press release, 7 August. Available from https://www. cftc.gov/PressRoom/PressReleases/7598-17. Accessed 23 Aug 2022 CFTC (2018) CFTC files eight anti-spoofing enforcement actions against three banks (Deutsche Bank, HSBC & UBS) & six individuals. Press release, 29 January. Available from http://www. cftc.gov/PressRoom/PressReleases/pr7681-18. Accessed 18 Apr 2022 CFTC (2020) CFTC orders JPMorgan to pay record $920 million for spoofing and manipulation. Press release, 29 September. Available from https://www.cftc.gov/PressRoom/PressReleases/82 60-20. Accessed 18 Apr 2022 Cumming D, Johan S, Li D (2011) Exchange trading rules and stock market liquidity. J Financ Econ 99:651–671 Cumming D, Dannhauser R, Johan S (2015) Financial market misconduct and agency conflicts: A synthesis and future directions. J Corp Finan 34:150–168 DFS (2017) DFS fines Credit Suisse AG $135 million for illegal, unsafe and unsound conduct in its foreign exchange trading business Press release, 13 November. Available at: https://dfs.ny.gov/ reports_and_publications/press_releases/pr1711131. Accessed 20 Aug 2022

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DOJ (2018) Former head of HSBC’s global foreign exchange cash-trading sentenced to prison for multimillion-dollar front-running scheme. Press release, 26 April. Available from https://www. justice.gov/opa/pr/former-head-hsbc-s-global-foreign-exchange-cash-trading-sentenced-prisonmultimillion-dollar. Accessed 20 Aug 2022 DOJ (2020) Former foreign exchange trader sentenced to prison for price fixing and bid rigging. Press release, 17 September. Available from https://www.justice.gov/opa/pr/former-foreignexchange-trader-sentenced-prison-price-fixing-and-bid-rigging. Accessed 23 Aug 2022 DOJ (2021) NatWest markets pleads guilty to fraud in U.S. Treasury markets. Press release, 21 December. Available from https://www.justice.gov/opa/pr/natwest-markets-pleads-guiltyfraud-us-treasury-markets. Accessed 21 Apr 2022 DOJ (2022) Former J.P. Morgan traders convicted of fraud, attempted price manipulation, and spoofing in a multi-year market manipulation scheme. Press release, 10 August. Available from https://www.justice.gov/opa/pr/former-jp-morgan-traders-convicted-fraud-attempted-pricemanipulation-and-spoofing-multi-year#:~:text=In%20September%202020%2C%20JPMorgan %20admitted,U.S.%20Treasury%20notes%20and%20bonds. Accessed 23 Aug 2022 Duffie D, Stein CS (2015) Reforming LIBOR and other financial market benchmarks. J Econ Perspect 29(2):191–212 FCA (2014) Final notice: The Royal Bank of Scotland plc, 11 November. Available from https:// www.fca.org.uk/publication/final-notices/final-notice-rbs.pdf. Accessed 20 Aug 2022 FCA (2015) Final notice: Deutsche Bank AG, 23 April. Available from https://www.fca.org.uk/ publication/final-notices/deutsche-bank-ag-2015.pdf. Accessed 20 Aug 2022 FCA (2022) Financial crime. Available from https://www.handbook.fca.org.uk/handbook/glossary/ G416.html. Accessed 23 Aug 2022 Federal Reserve Bank of New York (2022) Reference rates. Federal Reserve Bank of New York, New York. Available from https://www.newyorkfed.org/markets/reference-rates. Accessed 6 Sept 2022 FINMA (2015) Foreign exchange manipulation: FINMA issues six industry bans, Press release, 17 December. Available from www.finma.ch/en/news/2015/12/20151217-mm-devisenhandel/. Accessed 20 Aug 2022 Fox MB, Glosten LR, Guan SS (2021) Spoofing and its regulation. Columbia Bus Law Rev 3: 1244–1320 Goodhart CAE (1995) The central banking and the financial system. Macmillan, London Hou D, Skeie DR (2014) LIBOR: Origins, economics, crisis, scandal, and reform. Federal Reserve Bank of New York Staff Report, No. 667 Mark G (2019) Spoofing and layering. J Corp Law 45(2):101–169 Muchima L, Stenfors A (2021) Beyond LIBOR: Money Markets and the Illusion of Representativeness. J Econ Issues 55(2):565–573 Muchimba L (2022) Could transaction-based financial benchmarks be susceptible to collusive behavior? J Econ Issues 56(2):362–370 Schrimpf A, Sushko V (2019) Beyond LIBOR: a primer on the new benchmark rates. BIS Q Rev 1–24 SESC (2018) Recommendation for Administrative Monetary Penalty Payment Order for market manipulation of 10-year Japanese Government bond futures by Mitsubishi UFJ Morgan Stanley Securities Co, Ltd, 29 June. Available from https://www.fsa.go.jp/sesc/english/news/reco/201 80629.html. Accessed 18 Apr 2022 SESC (2019) Recommendation for Administrative Monetary Penalty Payment Order for market manipulation of 10-year Japanese Government bond futures by Citigroup Global Markets Limited, 26 March. Available from https://www.fsa.go.jp/sesc/english/news/reco/20190326-1. html. Accessed 23 Aug 2022 SFO (2022) Euribor. Available from https://www.sfo.gov.uk/cases/euribor/. Accessed 23 Aug 2022 Smith A (1776 [1991]) The wealth of nations. Everyman’s Library, London Stenfors A (2013) Determining the LIBOR: a study of power and deception. PhD thesis. SOAS, University of London

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Stenfors A (2014) LIBOR as a Keynesian beauty contest: a process of endogenous deception. Rev Polit Econ 26(3):392–407 Stenfors A (2018) Bid-Ask spread determination in the FX swap market: Competition, collusion, or a convention? J Int Financ Mark Inst Money 54:78–97 Stenfors A (2020) Manipulative and collusive practices in FX markets. In: Cumming D, Alexander C (eds) The handbook of fraud, misconduct and manipulation in financial markets. Wiley, Hoboken, NJ, pp 181–204 Stenfors A, Lindo D (2018) Libor 1986–2021: the making and unmaking of ‘the world’s most important price’. Distinktion J Soc Theory 19(2):172–190 Stenfors A, Susai M (2021) Spoofing and pinging in foreign exchange markets. J Int Financ Mark Inst Money 70:101278 Stenfors A, Chatziantoniou I, Gabauer D (2021) Independent policy, dependent outcomes: a game of cross-country dominoes across European yield curves. Portsmouth Business School, Working papers in economics & finance, 2021-6 Stenfors A, Chatziantoniou I, Gabauer D (2022a) The evolution of monetary policy focal points. J Econ Issues 56(2):348–355 Stenfors A, Doraghi M, Soviany C, Susai M, Vakili K (2022b) Cross-market spoofing. Portsmouth Business School, Working papers in economics & finance, 2022-4 Vaughan L, Finch G, Choudhury A (2013) Traders said to rig currency rates to profit off clients. Bloomberg, 12 June. Available from www.bloomberg.com/news/articles/2013-06-11/traderssaid-to-rig-currency-rates-to-profit-off-clients

Alexis Stenfors is a Reader at the Faculty of Business and Law, University of Portsmouth (UK) and Deputy Director of the Centre for Innovative and Sustainable Finance (CISF). Before returning to academia in 2009, Alexis spent 15 years as a foreign exchange and interest rate derivatives trader at HSBC, Citi, Crédit Agricole, and Merrill Lynch. He has also held academic positions at SOAS, University of Leeds, Washington University in St. Louis, UC Berkeley and Meiji University in Tokyo. His recent research includes manipulation and anti-competitive behavior in money and foreign exchange markets, liquidity issues on electronic trading platforms, and unethical trading practices among human and algorithmic traders. He is the author of Barometer of Fear: An Insider’s Account of Rogue Trading and the Greatest Banking Scandal in History (Bloomsbury, 2017). Lilian Muchimba is a Senior Economist—Reserves Management in the Financial Markets Department at the Bank of Zambia. She is currently pursuing a PhD in Economics and Finance at the University of Portsmouth. As a central banker, Lilian has over nine years of experience in financial market operations and development, surveillance, economic research, and policy analysis. She has participated in financial market development projects, including implementing the Central Securities Depository (CSD) system, the primary dealership system, and the e-bond platform in Zambia. She is also a Graduate Research Fellow of the Macroeconomic and Financial Management Institute for Eastern and Southern Africa (MEFMI), specialising in Financial Sector Management. As a MEFMI Research Fellow, Lilian Muchimba has undertaken capacity-building activities and provided consultancy services for MEFMI member states. Her research interests include financial markets, monetary policy, international macroeconomics, financial benchmarks (anti-competitive behavior, manipulation, and collusion), and financial market development challenges and strategies.

Does Fiscal Pressure Influence Shadow Economy? A Panel Data Analysis for the OECD Countries Monica Violeta Achim, Viorela-Ligia Văidean, Sorin Nicolae Borlea, and Decebal Remus Florescu

1 Introduction The relationship between the level of tax burden and the incentives for tax evasion has been subjects for long debates during our time. These debates are even more intense in the context of analysis of the effects of various fiscal policies on the incentives for tax evasion, which is then a main driver for reducing the sustainable finance. For the relationship between fiscal pressure and shadow economy, there are three categories of specialized studies. The first and the largest category of studies that deals with the analysis of the effects of taxation systems on corporate behaviour, reveals the fact that underground economic activities intensify as the real and perceived fiscal pressure increases (Devereux and De Mooij 2009; Schneider and Klinglmair 2004; Torgler and Schneider 2009; Achim et al. 2018a). Numerous studies have found that individuals find it easier to justify tax evasion when they perceive tax burden to be too high (McGee 2012; Morales 2012). This view has received some support in the religious literature as well (Crowe 1944). A second set of studies contradicts the existence of a causal relationship between fiscal pressure and the volume of the shadow economy (Friedman et al. 2000; Kawano and Slemrod 2016; Achim et al. 2018b; Achim and Borlea 2020, p. 38; Mara 2011; Mara and Sabău-Popa 2013). Thus, Friedman et al. (2000) assess

M. V. Achim (✉) · V.-L. Văidean · D. R. Florescu Babes-Bolyai University, Cluj-Napoca, Romania e-mail: [email protected]; [email protected] S. N. Borlea Babes-Bolyai University, Cluj-Napoca, Romania University of Oradea, Oradea, Romania “Vasile Goldiș” Western University of Arad, Arad, Romania © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_12

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the determinants of shadow activity in 169 countries, using data from the 1990s, and they find that firms operate informally not to avoid taxation but to reduce the burden of regulation and corruption. Corruption, bureaucracy, and a weak legal system are systematically associated with a higher level of the informal sector (Friedman et al. 2000; McGee 2000, 2008; Pashev 2008; Smatrakalev 2012). In the same area, Torgler (2007), in their study on 55 countries in the 1990–1999 timeframe, do not identify a statistically significant correlation between tax burden and the underground economy. Kawano and Slemrod (2016) also identify a weak relationship between business tax rates and tax revenues collected from them, at least on the short run, but it does not rule out a stronger relationship on the long run. A third set of research papers considers the relationship between fiscal pressure and shadow economy to be represented as a curve that relies on the Laffer Curve, which measures the relationship between the rate of fiscal pressure and the revenues received from the state budget (Laffer 2004; Busato and Chiarini 2013; Trabandt and Uhlig 2006; Trandafir and Brezeanu 2010; Achim et al. 2022). The study of Busato and Chiarini (2013) investigates the relationship between fiscal policy, fiscal evasion, and the underground economy in a dynamic general equilibrium model and their results provide solid arguments in favour of a certain parametric Laffer-type curve. Furthermore, the study of Achim et al. (2022), working on a sample for the 2005–2018 timespan on the European Union countries, validates the existence of a U-shaped relationship between tax burden and shadow economy only for the case of direct taxes, while for indirect taxes and social contributions, an inverted U-shaped relationship is validated. For the subsamples of old and new European Union states, the paper obtains different results, showing that old countries have improved regulations and institutional quality. Summing up, we appreciate the fact that there is no unity of the results identified by specialized studies regarding the existence of an influence of fiscal pressure on the underground economy, and this relationship must be analysed in a specific national framework, by using as many variables as possible that moderate the effects. Based on the results identified in the specialized literature, we expect that above a certain threshold, a higher level of tax pressure leads to greater incentives for tax evasion, and thus a higher degree of engagement in underground activities. In conclusion, we aim to test the following research hypothesis: Hypothesis: The relationship between tax burden and shadow economy follows a U-shape. For this purpose, we use a sample that consists of 38 OECD countries (_all) for the period 2005–2020, which is divided into two groups of countries (old countries (_old) and new ones (_new)). Therefore, we are also interested to respond to the following research question: Research question: How do the results of testing our hypothesis differ for the two groups of OECD countries (OECD old and OECD_new)? Our results confirm the existence of the Laffer curve (that of a U-shape) for the majority of our results, with the exception of social and security contributions for the

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entire and old OECD samples, and direct taxes for the new OECD sample. Then, we find that the level of resilience of new OECD countries is below that of old OECD countries. In addition, the form of the relationship differs between old and new countries, while the highest disparities in the form of the relationship regarding shadow economy are found for the case of direct taxes. The remainder of the paper is organized as follows: Section 2 describes the methodology, data, and variables. Section 3 presents the results of our analysis. Section 4 summarizes and discusses the findings. Section 5 provides the conclusions and a brief discussion of policy implications, limitations, and directions for future research.

2 Methodology and Data 2.1

Description of Variables

Dependent variable: shadow economy (SE) The level of the shadow economy is determined as a percentage of GDP, as provided by Medina and Schneider (2019), where the shadow economy is estimated as the volume of tax evasion. Independent variable: tax pressure According with the data available from OECD (2022) we measure the level of tax pressure by several proxies, such as: (a) Total tax revenue as a percentage of a country’s GDP, basically showing the share of a country’s output that is collected by its government through taxes. Tax revenue includes the revenues collected from various categories of taxes, mainly taxes on income and profits, social security contributions, taxes levied on goods and services, payroll taxes, taxes on the ownership and transfer of property, and other taxes. This weight of a country’s total tax revenues within its GDP reveals its tax burden, and it stands for a measurement of the degree to which the government controls an economy’s resources, according to OECD (2022). (b) Taxes on personal income, as a percentage of a country’s GDP. Taxes on personal income are defined by OECD (2022) as the taxes levied on the net income (gross income minus allowable tax reliefs) and capital gains of individuals. (c) Taxes on corporate profits, as a percentage of a country’s GDP. The taxes on corporate profits are defined by OECD (2022) as taxes levied on the net profits (gross income minus allowable tax reliefs) of companies, also covering taxes levied on the capital gains of companies. Our study uses their weight within the country’s GDP. (d) Social security contributions, as a percentage of a country’s GDP. OECD (2022) considers social security contributions to be compulsory payments paid to general government that confer entitlement to receive a (contingent) future

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social benefit. These include: unemployment insurance benefits and supplements, accident, injury and sickness benefits, old-age, disability and survivors’ pensions, family allowances, reimbursements for medical and hospital expenses, or provision of hospital or medical services. These contributions finance social benefits and they are usually levied on both employees and employers. (e) Taxes on payroll as a percentage of a country’s GDP, Taxes on payroll are defined by OECD (2022) as taxes paid by employers, employees, or the selfemployed, either as a proportion of payroll or as a fixed amount per person, and that do not confer entitlement to social benefits. Examples of such taxes, provided by OECD (2022), include: the United Kingdom national insurance surcharge (introduced in 1977), the Swedish payroll tax (1969–1979), and the Austrian Contribution to the Family Burden Equalisation Fund and Community Tax. (f) Taxes on property as a percentage of a country’s GDP. Taxes on property include recurrent and non-recurrent taxes on the use, ownership, or transfer of property. These refer to taxes on immovable property or net wealth, taxes on the change of ownership of property through inheritance or gift, and taxes on financial and capital transactions, according to OECD (2022). (g) Taxes on goods and services as a percentage of a country’s GDP. They are defined by OECD (2022) as all taxes levied on the production, extraction, sale, transfer, leasing or delivery of goods, and the rendering of services, or on the use of goods or permission to use goods or to perform activities. Practically these taxes on goods and services refer to value-added taxes and sales taxes. They consist mainly of value-added and sales taxes, covering: multi-stage cumulative taxes; general sales taxes—whether levied at manufacture/production, wholesale or retail level; value-added taxes; excises; taxes levied on the import and export of goods; taxes levied in respect of the use of goods and taxes on permission to use goods, or perform certain activities; taxes on the extraction, processing, or production of minerals and other products. For our special interest, we intend to analyse the impact of direct and indirect taxes, on the one hand, and social contributions, on the other hand, upon shadow economy. Thus, to proceed with our analysis on direct and indirect taxes and social security contributions, we group the above presented subcategories of total tax revenues according to their transferability or non-transferability character. As such, direct taxes (denoted TDirect) include taxes on personal income, taxes on corporate profits, taxes on payroll, and taxes on property and they are non-transferable taxes paid by taxpayers to the government. Furthermore, indirect taxes (denoted TGoodServ) are taxes for which the liability to pay may be transferred to others. Indirect taxes are taxes on goods and services, as categorized by OECD (2022). Contributions are different than taxes, so social security contributions of OECD countries (denoted TSocSec) are analysed separately.

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Sample Description

Our sample consists of 38 OECD countries, forming our full sample (_all). The 38 OECD countries are further subsampled into old countries (_old) and new ones (_new). The old countries’ subsample includes the official founding members of OECD and the ones that joined it till 2010, mainly the following 30 countries: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, South Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovakia, Spain, Sweden, Switzerland, Turkey, United Kingdom, and United States. Then, the new OECD countries’ subsample includes the eight countries that joined the OECD more recently, from 2010 on: Chile, Estonia, Israel, Slovenia, Latvia, Lithuania, Colombia, and Costa Rica. The time interval covered by our slightly unbalanced panel data covers the 2005–2020 time interval.

2.3

Method

The econometric presentations of the linear approach that models the impact of several taxes upon shadow economy are reflected by Eq. (1), while the parametric approach of a U-shaped or inverted U-shaped impact of taxes upon shadow economy is reflected by Eq. (2): SE = f ðTaxesÞ : SE = f Taxes, Taxes2 :

SEit = β0 þ β1 Taxit þ εit SEit = β0 þ β1 Taxit þ β2 Taxit 2 þ εit

ð1Þ ð 2Þ

where: . SEit—assessment of the shadow economy of OECD country i in year t (according to Schneider (2022)) . β1—linear effect parameter . β2—quadratic effect parameter . Taxit—proxy for the taxes of OECD country i in year t; it includes: – TDirectit—the percentage of direct taxes in GDP of country i in year t (basically taxes on personal income, taxes on corporate profits, taxes on payroll, and taxes on property) – TGoodServit—the percentage of indirect taxes in GDP of country i in year t (taxes on goods and services) and – TSocSecit—social security contributions in GDP in country i in year t . εit—The residual

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Our slightly unbalanced panel data set covers the 2005–2020 timespan, basically the most recent data available at the time of our study. We have used the Pooled OLS method for our panel data, the simple regression modelling approach, in order to estimate Eq. (1). Then, the parametric approach is used in order to estimate the quadratic approach of Eq. (2), for the same unbalanced full dataset, further on subsampled.

3 Results This section is divided into three parts: at first, we present the summary statistics of the variables, then their correlation statistics and last, our empirical results.

3.1

Summary Statistics of the Variables

Our analysis covers in 2005–2020 time interval and the graphical representations include the entire sample (_all) and the two subsamples (_old and _new). Shadow Economy (SE) As such, Fig. 1 shows the evolution of Shadow economy for OECD countries, 2005–2020 for the all sample (OECDall) and separately for old (OECDold) and new countries (OECDnew). The evolution of the Shadow Economy shows a decreasing trend of it, as a result of the measures in place, up to the trigger moment of crisis. As such, although the shadow economy has a decreasing trend till the 2008 financial and economic crisis, it

Shadow Economy, OECD, 2005-2020 30 25 20 15 10 5 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 OECDall

OECDold

OECDnew

Fig. 1 The evolution of shadow economy for OECD countries, 2005–2020. Source: Authors’ processing

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Total Tax Revenues (as % in GDP), OECD, 2005-2020 40 35 30 25 20 15 10 5 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 OECDall

OECDold

OECDnew

Fig. 2 The evolution of total tax revenues (as % in GDP) for OECD countries, 2005–2020. Source: Authors’ processing

goes up again in 2009. Its fluctuating trend in the years to follow starts to decrease in the years before the COVID-19 pandemic (2017, 2018, even 2019), while once the pandemic starts, the shadow economy registers an upwards trend again, in 2020. The minimum and maximum values of shadow economy are 4.8% of the GDP of the United States in 2019 and 33.7% of the GDP of Colombia in 2005. The average values for the entire OECD sample of its shadow economy are of 15.3% of its GDP for the entire time span. On subsamples, as expected, the old OECD countries register lower values of the shadow economy, while the new countries register higher values of the shadow economy. Tax Revenues (as % in GDP) Figure 2 presents the evolution of total tax revenues for the OECD countries, on average, throughout the years, for the all sample (OECDall) and separately for old (OECDold) and new countries (OECDnew). Following a rather stable trend, we may notice a slight decrease of government revenues after the economic and financial crisis of 2008, with an upright tendency up to the present moment. On average, the tax burden is of 32.76% for the whole OECD sample, with a higher average of 34.09% for the old OECD countries’ subsample and a lower collecting average value of 27.79% for the new OECD countries’ subsample. Taxes on Personal Income (as % in GDP) When detailed subcategories of total tax revenues are analysed, we still use their percentage values of the countries’ GDPs. On average, OECD’s taxes on personal income as a percentage of their GDP have evolved between 7 and 8.25% on average, throughout 2005–2020 (see Fig. 3). When analysed separately, on subsamples, the taxes on personal income vary between 2.624 and 26.196% for the old OECD countries, with an average value of 8.82% of their GDP, while for the new OECD countries, their minimum value is of 0.17% of GDP, up to a maximum of 7.66% of

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Taxes on Personal Income (as % in GDP), OECD, 2005-2020 10 9 8 7 6 5 4 3 2 1 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 OECDall

OECDold

OECDnew

Fig. 3 The evolution of taxes on personal income (as % in GDP) for OECD countries, 2005–2020. Source: Authors’ processing in Excel

Taxes on Corporate Profits (% in GDP), OECD, 2005-2020 4

3.5 3 2.5 2 1.5 1 0.5

0 2005

2006

2007

2008

2009

2010

2011

OECDall

2012

2013

OECDold

2014

2015

2016

2017

2018

2019

2020

OECDnew

Fig. 4 The evolution of taxes on corporate profits for OECD countries, 2005–2020. Source: Authors’ processing

GDP, with an average value of 3.619% of GDP throughout the studied time interval. Clearly, their levels differ between the two subsamples of countries. Taxes on Corporate Profits (as % in GDP) According to Fig. 4, this subcategory of taxes on corporate profits has been clearly influenced by the financial and economic crisis of 2008 and the COVID-19 ongoing pandemic, with slightly higher average values for the old OECD countries compared to the new ones. Social Security Contributions (as % in GDP) Figure 5 presents the evolution of social security contributions for OECD countries, on average, throughout the period 2005–2020 for the all sample (OECDall) and separately for old (OECDold) and new countries (OECDnew). As expected, their values in old OECD member states are higher than in the new OECD member states,

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Social Security Contributions (as % in GDP), OECD, 2005-2020 12

10 8 6 4 2 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 OECDall

OECDold

OECDnew

Fig. 5 The evolution of social security contributions (as % in GDP) for OECD countries, 2005–2020. Source: Authors’ processing

Taxes on Payroll (as % in GDP), OECD, 2005-2020 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 2005

2006

2007

2008

2009

2010

2011

OECDall

2012

2013

OECDold

2014

2015

2016

2017

2018

2019

2020

OECDnew

Fig. 6 The evolution of payroll taxes for OECD countries (as % in GDP), 2005–2020. Source: Authors’ processing

the former having more complex and powerful social security systems. On the whole sample and time interval, social security contributions round up, on average, to 8.703% of the GDP of OECD countries. Taxes on Payroll (as % in GDP) In Fig. 6, the evolution of payroll taxes (as % in GDP) is presented, for OECD countries, over the period 2005–2020, for the all sample (OECDall) and separately for old (OECDold) and new countries (OECDnew). According to Fig. 6 on average, for the entire sample and the entire time span, these taxes cover 0.41% of OECD countries’ GDP, basically a small fraction. The downward trend of theirs for new OECD countries is balanced by the upwards trend of theirs for the old OECD member states.

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Taxes on Property, OECD, 2005-2020 3 2.5 2 1.5 1 0.5 0 2005

2006

2007

2008

2009

2010

2011

OECDall

2012

2013

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2014

2015

2016

2017

2018

2019

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Fig. 7 The evolution of property taxes for OECD countries, 2005–2020. Source: Authors’ processing

Taxes on Goods and Services (as % in GDP), OECD, 2005-2020 12 11.5 11 10.5 10 9.5 9 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 OECDall

OECDold

OECDnew

Fig. 8 The evolution of taxes on goods and services for OECD countries, 2005–2020. Source: Authors’ processing

Taxes on Property (as % in GDP) According to Fig. 7, taxes on property (as % in GDP) are rather close to the average value of 1.78%, with the exception of year 2016. The new OECD countries register about half the value of these taxes on property in old OECD countries. Taxes on Goods and Services (as % in GDP) The evolution of taxes on goods and services for OECD countries, 2005–2020 for the entire sample and separately, for old and new countries is presented in Fig. 8. One may found from Fig. 8 that new OECD countries have higher on average taxes on goods and services (average value of 11.34%) than old OECD countries (average value of 10.51%). The summary statistics for the entire OECD sample and its subsamples are presented in Table 1.

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Table 1 Summary statistics Variables Shadow economy for the full OECD sample Shadow economy for the old OECD countries Shadow economy for the new OECD countries Tax revenues for the full OECD sample Tax revenues for the old OECD countries Tax revenues for the new OECD countries Taxes on personal income for the full OECD sample Taxes on personal income for the old OECD countries Taxes on personal income for the new OECD countries Taxes on corporate profits for the full OECD sample Taxes on corporate profits for the old OECD countries Taxes on corporate profits for the new OECD countries Social security contributions for the full OECD sample Social security contributions for the old OECD countries Social security contributions for the new OECD countries Taxes on payroll for the full OECD sample Taxes on payroll for the old OECD countries Taxes on payroll for the new OECD countries Taxes on property for the full OECD sample Taxes on property for the old OECD countries Taxes on property for the new OECD countries Taxes on goods and services for the full OECD sample

Symbols SE_all

Obs 587

Mean 15.3076

Std. dev. 6.4782

Min 4.8

Max 33.7

SE_old

471

13.9124

6.1628

4.8

32.54

SE_new

116

20.9725

4.2759

8.92

33.7

TRevenue_all

606

32.7611

7.6694

11.362

50.286

TRevenues_old

478

34.0905

7.5013

11.362

50.286

TRevenues_new

128

27.7969

6.1134

17.334

39.174

TPIncome_all

606

7.7237

4.4198

0.172

26.196

TPIncome_old

478

8.8228

4.2118

2.624

26.196

TPIncome_new

128

3.619

2.2148

0.172

7.668

TCorpPr_all

606

2.9782

1.4617

0.157

12.588

TCorpPr_old

478

3.046

1.4788

0.869

12.588

TCorpPr_new

128

2.7248

1.3719

0.157

6.675

TSocSec_all

606

8.703

4.7317

0

16.912

TSocSec_old

478

8.9571

4.7456

0

16.912

TSocSec_new

128

7.7539

4.5739

1.266

16.844

TPayroll_all

607

0.4122

0.855

0

5.324

TPayroll_old

479

0.4062

0.9168

0

5.324

TPayroll_new

128

0.4344

0.5695

0

1.79

TProperty_all

607

1.7863

1.2725

0.204

17.219

TProperty_old

479

1.9799

1.2802

0.204

17.219

TProperty_new

128

1.0619

0.9425

0.209

3.322

TGoodServ_all

607

2.7963

4.139

17.102

10.684

(continued)

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Table 1 (continued) Variables Taxes on goods and services for the old OECD countries Taxes on goods and services for the new OECD countries

Symbols TGoodServ_old

Obs 479

Mean 10.5067

Std. dev. 2.9513

Min 4.139

Max 17.102

TGoodServ_new

128

11.3474

1.9915

7.629

14.782

Source: Authors’ processing

3.2

Correlation Statistics

The correlations statistics are realized using the correlation matrix, on the one hand, and various graphical plots of taxes against shadow economy, on the other hand. The correlation matrix for the entire sample (n = 584 observations) is presented in Table 2. It shows, on average, an expected indirect impact of all tax categories upon shadow economy (all direct taxes and social security contributions as well), with the exception of Taxes on goods and services, which are indirect taxes. Basically from Table 2, we may depict that taxes on revenue as a whole exert a positive impact upon shadow economy, when the entire OECD sample is considered. On subcategories of taxes, it seems that taxes on goods and services are the only ones to exert a positive impact on shadow economy. All other subcategories of taxes have negative correlation coefficients between them and the shadow economy, thus exerting a negative impact upon it. Figure 9 contains the graphical representation of total taxes (TRevenue) and their subcategories of direct taxes (TDirect), taxes on goods and services (TGoodServ), and social security taxes (TSocSec) against shadow economy (SE), with a linear approach, for the entire sample of 38 OECD countries (OECD_all, the first column) and the two subsamples of old OECD countries (OECD_old, the second column) and new OECD countries (OECD_new, the third column). Figure 10 contains the graphical representation of total taxes (TRevenue) and their subcategories of direct taxes (TDirect), taxes on goods and services (TGoodServ), and social security taxes (TSocSec) against shadow economy (SE), through a parametric approach, that of a second degree polynomial, for the entire sample of 38 OECD countries (OECD_all, the first column) and the two subsamples of old OECD countries (OECD_old, the second column) and new OECD countries (OECD_new, the third column). More concrete results about the significance of these relationships we find and discuss after running the linear and parametric regressions in the following subsection of empirical results.

Source: Authors’ processing

SE TRevenue TPIncome TCorpPr TSocSec TPayroll TProperty TGoodServ

SE 1 –0.3905 –0.3369 –0.2413 –0.0417 –0.1438 –0.2556 0.1332

Table 2 Correlation matrix

1 0.4817 0.0318 0.5243 0.2431 0.1834 0.633

TRevenue

1 –0.0334 –0.1737 –0.0118 0.2554 0.2055

TPIncome

1 –0.2675 –0.0251 0.138 –0.1754

TCorpPr

1 0.0464 –0.1789 0.3229

TSocSec

1 –0.0544 0.0753

TPayroll

1 –0.242

TProperty

1

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Adj R2 = 0.0883

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Fig. 9 Plots of taxes against SE, linear approach. Source: Authors’ processing

3.3

Empirical Results

To begin with, simple regression models are estimated in order to assess the impact of taxes upon shadow economy, for the entire sample of 38 OECD countries (OECD_all, in the first column of Fig. 9 and Table 3, the Simple regressions OLS) and for the two subsamples of 30 old OECD countries (OECD_old, in the second column of Fig. 9 and Table 4, the Simple regressions OLS) and 8 new OECD countries (OECD_new, in the third column of Fig. 9 and Table 5, the Simple regressions OLS), respectively. The quadratic function approach is further estimated for the entire sample of 38 OECD countries (OECD_all, in the first column of Fig. 10

Does Fiscal Pressure Influence Shadow Economy? A Panel Data Analysis. . . OECD_old SE=f(TRevenue,TRevenue2)

OECD_new SE=f(TRevenue,TRevenue2)

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Adj R2 = 0.1499 Adj R2 = 0.0957

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SE=f(TDirect, TDirect2)

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Adj R2 = 0.2353

Adj R2 = 0.1584

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Fig. 10 Plots of taxes against SE, parametric approach. Source: Authors’ processing

and Table 2, the Parametric regression OLS) and for the two subsamples of 30 old OECD countries (OECD_old, in the second column of Fig. 10 and Table 4, the Parametric regressions OLS) and 8 new OECD countries (OECD_new, in the third column of Fig. 10 and Table 5, the Parametric regressions OLS), respectively. In order to measure the turning points for the maximum or minimum taxation levels, the thresholds are computed as follows: Tax0 = -

β1 2β2

ð3Þ

SE Constant TRevenue TRevenue 2 TDirect TDirect2 TGoodServ TGoodServ2 TSocSec TSocSec 2 Threshold (Tax) R2 Adjusted R2 Observations

0.1513 0.1498 585

n/a

(1) Simple regression OLS 26.3497*** –0.3334***

0.1846 0.1818 585

42.35

Parametric regression OLS 41.9691*** –1.3723*** 0.0162***

0.1962 0.1948 585

n/a

–0.556***

(2) Simple regression OLS 22.506***

Table 3 Shadow economy (SE), OECD_All, as a function of taxes

0.2379 0.2353 585

24.1

–1.4942*** 0.031***

Parametric regression OLS 28.613***

0.0188 0.0171 586

n/a

0.3173***

(3) Simple regression OLS 11.9071***

0.0188 0.0155 586

n/a

0.2907 0.0013

Parametric regression OLS 12.0295***

0.0198 0.0181 554

n/a

–0.2121***

(4) Simple regression OLS 17.6003***

0.0232 0.0199 585

0.6722*** –0.0459*** 7.32

Parametric regression OLS 13.999***

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SE Constant TRevenue TRevenue 2 TDirect TDirect2 TGoodServ TGoodServ2 TSocSec TSocSec 2 Threshold (Tax) R2 Adjusted R2 Observations

(2) Parametric regression OLS 43.0717*** –1.593*** 0.0206***

38.66

0.1535 0.1499 469

(1) Simple regression OLS 22.4808*** –0.2497***

n/a

0.0903 0.0883 469

0.0805 0.0786 469

0.1012 0.0973 469

24.42

–1.1381*** 0.0233***

–0.3637***

n/a

Parametric regression OLS 24.851***

Simple regression OLS 19.087***

Table 4 Shadow economy (SE), OECD_old, as a function of taxes

0.021 0.0189 470

n/a

0.3032***

(3) Simple regression OLS 10.7223***

0.0277 0.0235 470

6.65

–0.6124 0.046*

Parametric regression OLS 14.8645***

0.0085 0.0062 438

n/a

–0.1375*

(4) Simple regression OLS 15.5279***

0.0266 0.0225 469

0.7684***4 –0.0486*** 7.91

Parametric regression OLS 12.0463***

Does Fiscal Pressure Influence Shadow Economy? A Panel Data Analysis. . . 237

SE Constant TRevenue TRevenue 2 TDirect TDirect2 TGoodServ TGoodServ2 TSocSec TSocSec 2 Threshold (Tax) R2 Adjusted R2 Observations

0.0672 0.059 116

n/a

(1) Simple regression OLS 26.1216*** –0.1821***

0.1114 0.0957 116

31.46

Parametric regression OLS 45.4187*** –1.636*** 0.026**

0.1096 0.1018 116

n/a

–0.5517***

(2) Simple regression OLS 25.2206***

Table 5 Shadow economy (SE), OECD_new, as a function of taxes

0.1731 0.1584 116

6.01

1.4853** –0.1237***

Parametric regression OLS 17.6817***

0.1985 0.1915 116

n/a

–0.9819***

(3) Simple regression OLS 32.3031***

0.3292 0.3173 116

12.49

–10.0199*** 0.4009***

Parametric regression OLS 81.7135***

0.0055 0.0032 116

n/a

–0.0695

(4) Simple regression OLS 21.5377***

0.006 0.0011 116

–0.1459 0.0046 15.85

Parametric regression OLS 21.7514***

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Does Fiscal Pressure Influence Shadow Economy? A Panel Data Analysis. . .

SE0 = f ðTax0 Þ =

- β21 þ 4β1 β2 4β2

239

ð4Þ

Basically, the threshold Tax0, computed in each results Table and visible within the graphical representations as well, is called the vertex of the parabolic approach. It is a point of maximum or minimum taxation level for the system, depending on the positive or negative values of β1 and β2. The estimated coefficients of Shadow economy as a linear function of taxes are to be found in our results tables (Tables 3, 4 and 5), while the Adjusted R2s of these simple regressions are also included within Fig. 9. As expected from Table 2 with the correlation matrix, there is a negative impact of direct taxes and social security contributions upon shadow economy, and a positive impact of taxes on goods and services on shadow economy, with the exception of new OECD countries, where the impact of taxes on goods and services upon shadow economy is negative. The estimated coefficients of shadow economy as a parametric function of taxes are to be found in our results tables (Tables 3, 4, and 5), while the Adjusted R2s of these parametric regressions are also included within Fig. 10. With few exceptions (Table 3, model (3) and Table 5, model (4)), the parametric approach comes with improved models, from the linear regression to the parametric regression. From the point of view of a U-shaped versus an inverted U-shaped approach, our second degree polynomial stands strong with the single exception of the estimation of shadow economy as a function of taxes on goods and services, for the entire OECD sample (SE = f(TGoodServ, TGoodServ2)). When analysing the evolution of shadow economy as a function of total tax revenues, the graphical representation is U-shaped, with a more pronounced slope for the old OECD countries’ subsample and a lighter slope for the new OECD countries (see Tables 1, 2, and 3, models (1)). The vertexes of these parabolas are different, the tax burden threshold level for old OECD countries being 38.66 while the same threshold is shifted to the left, of only 31.46% of GDP, for the new OECD countries’ subsample. So, the level of resilience of new OECD countries is below that of old OECD countries. The impact of direct taxes upon shadow economy comes in the shape of a convex second degree polynomial function (U-shaped) for the entire OECD sample and the subsample of old OECD member states (β1 negative and β2 positive, significant at 1%, see Tables 3 and 4, models (2)). The impact of direct taxes upon the shadow economy of new OECD member states is reversed, as a concave second degree polynomial function (inversely U-shaped), with β1 positive and β2 negative (Table 5, model (2), with significant estimated coefficients at 1–5%). It seems that for these newly adhered OECD member states the shadow economy increases as direct taxes increase but only up to the 6.01% taxation level, after which the higher the direct taxes are, the lower the shadow economy becomes. Although the parametric approach on the impact of taxes on goods and services upon shadow economy for the entire sample is not validated, on subsamples of old versus new OECD states we estimate a convex second degree polynomial function.

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Nonetheless, Fig. 10 portraits a concave function for the impact of social security contributions upon the shadow economy (Tables 3 and 4, models (4)), for the entire OECD sample and the subsample of old OECD member states. The estimated coefficients for the simple and parametric regressions from Eqs. (1) and (2) are included in Tables 3, 4, and 5. As such, Table 3 includes the modelling of shadow economy as a function of taxes for the full sample of OECD member states. Table 4 includes the modelling of shadow economy as a function of various taxes for the subsample of old OECD member states and Table 5 includes the modelling of shadow economy as a function of various taxes for the subsample of new OECD member states. Equation (1) is estimated on the simple regression OLS columns of these tables and Eq. (2) is estimated on the parametric regression OLS columns of these tables. Models (1)–(4) included in each results table consider, on turn, total tax revenues as an explanatory variable (TRevenue in models (1)), direct taxes (TDirect in models (2)), taxes on goods and services (TGoodServ in models (3)), and social security contributions (TSocSec in models (4)). According to Fig. 10 and our main results from Tables 3, 4, and 5, our models improve their coefficient of determination when the parametric fit is estimated, basically boosting the explanatory power of the model, with the exceptions of model (3) in Table 3, model (3) from Table 4, and model (4) from Table 5, whose coefficients are not significant. In Table 3, as simple regressions are turned into parametric regressions, the Adjusted R2 of estimating SE as a function of taxes (by total and structure) on turn, is improved from 14.98 to 18.18% in model (1), from 19.48 to 23.53% in model (2), and from 1.81 to 1.99% in model (4).

4 Discussion Checking the type of correlation when estimating shadow economy as a function of taxes (by total and in structure) we may see that a Laffer curve is available (as a U-shape) for the majority of our results, which partially validates our working hypothesis. Similar U-shape relationships between tax pressure and the level of shadow economy are found by Busato and Chiarini (2013), Trabandt and Uhlig (2006), Trandafir and Brezeanu (2010), Achim et al. (2022). Three main exceptions with inverted U-shapes are found, namely social and security contributions for the full and old OECD samples, and direct taxes for the new OECD sample. For the full sample, the estimations of the relationships between shadow economy and tax revenues presented in Table 3 and Figs. 9 and 10 suggest that the parametric regression under the U-shape is more reliable than the linear regression (the value of Adjusted R2 is 0.1818 for parametric regression compared with 0.1498 for the simple regression). In other words, for the entire sample, when the tax revenues increase up to the threshold of 42.35% in GDP, the level of shadow economy decreases. After this point of resilience of 42.35% in GDP, the level of tax burden starts to sting and people look for avoiding tax gaps. Therefore, from this point the level of shadow economy starts to increase.

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The same U-shape is validated for the case of direct taxes, while the resilience threshold becomes 24.1%, when we analyse the entire sample. However, for indirect taxes (taxes on goods and services) the linear relationship against shadow economy fits better. Thus, the results conducted for the full sample show a positive linear relationship between indirect taxes and shadow economy, meaning that a 1 unit increase in direct taxes conducts to an increase of 0.3173 units in shadow economy. Opposed to the rest of the results, the relationship between social security contributions and shadow economy is represented as an inverted U-shape with a maximum threshold of 7.32% in GDP. Beyond this threshold, the level of shadow economy reduces. However, according to Mara (2021) the social protection expenditure results in an increase in the welfare of citizens, which can be considered as an important factor in the decline of the shadow economy. The study of Mara (2021), conducted on a sample consisting of the European Union countries for the 1995–2017 period finds that increasing social protection expenditure are important drivers for the reduction of shadow economy. Further, in order to respond to our Research question “How do the results of testing our hypothesis differ for the two groups of OECD countries (OECD_old and OECD_new)?”, the substantiate conclusions could be drawn after a separate analysis for the two samples (old and new OECD countries). When we separately analyse the two samples, some different results are obtained even from the first analysis (depicted from Table 1 summary statistics). Thus, the average level of shadow economy for the old OECD countries is significantly lower compared to the new OECD countries (13.91% compared to 20.97%, see Table 1), while the general level of tax burden is higher for the old OECD countries compared with the new OECD countries (34.09% compared to 27.79%). When the structure of tax revenues is analysed, some similarities between the level of taxation on the two samples are found for tax on corporate profits (about 3% in GDP), taxes on payroll (about 0.4% in GDP), taxes on goods and services (about 10–11% in GDP) and social security contributions (around 8–9% in GDP). However, quite high disparities between the two samples are found for taxes on personal income (8.82% in GDP for old OECD countries compared with only 3.61% in GDP for the new OECD countries, meaning the average values are 2.44 times higher for the old countries versus the new ones) and for taxes on property (1.97% in GDP for old OECD countries compared to 1.06% in GDP for new OECD countries, meaning about the double value of property taxation for old versus new countries). Going further with the analysis of the relationship between the tax burden and shadow economy on the two samples (old and new OECD countries) we find some similarities but rather important discrepancies. Therefore, the same U-shape is found between tax revenues and shadow economy for the two samples. However, the threshold of resilience is higher for the old than for the new OECD countries (38.66% compared with 31.46%). In other words, the level of shadow economy starts to increase when the tax burden gets over 31.46% in GDP for the new countries, compared to a higher level of this threshold, of 38.66%, for the old countries.

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Going further, the same U-shape is found between taxes on goods and services (indirect taxes) and shadow economy for the two samples. However, it is interesting to find that the threshold of resilience is about two times lower for the old than for the new OECD countries. Among the two samples, the highest disparities in the form of the relationship regarding shadow economy are found for the case of direct taxes. Thus, while a U-shape is found for old OECD countries, an inverted U-shape is found for the new OECD countries. Thus, for the new OECD countries, increasing the level of direct taxes up to a maximum resilience point of 6.01% in GDP conducts to an increase of the level of shadow economy, while for the old OECD countries this resilience level is 3 times higher, after which the level of tax burden starts to sting. Then, when it comes to analysing the impact of social security contributions on the level of shadow economy for the two samples, we may also find some differences. Therefore, while an inverted U-shape is found between social security contributions and shadow economy for the old countries (similar to the results for the full sample), no significant relationship is found for the new OECD countries. In a resembling manner, the study of Achim et al. (2022) conducted for the two samples of European Union old and new countries, finds similar results, that is an inverted U-shape between social security contributions and shadow economy for old European Union countries and no significant results for the new European Union countries. Indeed, the oldest countries that joined either the EU or the OECD have solid social systems in which paying higher levels of social contributions is assimilated with future benefits that would come under the form of public goods (Achim et al. 2022). The results are aligned with those of Chelliah (1971), Torgler (2004), Torgler and Schneider (2009) who find that a higher level of wealth generates a better capacity for tax payments and collections and a higher demand for public goods and services.

5 Conclusion This study analyses the different impact of tax burden structures under different forms upon the shadow economy. For this purpose, we use a panel dataset analysis for the 38 OECD countries, and then we perform the modelling separately for the two samples of old and new joined OECD countries. Our study generally supports the existence of a U-shaped relationship between tax burden and shadow economy, while for social and security contributions, an inverted U-shaped relationship is validated for the full and old sample countries. The results confirm the main policies of assuring the continuous of sustainable finance that should be adopted under the increase the social and security contributions. In addition, direct taxes exert different impacts on the level of shadow economy between the two samples, namely a U-shape for the old countries but an inverted U-shape for the new OECD countries. There are still many gaps between the old and

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new OECD countries, especially due to the levels of development which prints different behavioural patterns of each group. Concluding, the fiscal policies on the direct taxes play important roles on the level of shadow economy especially in the new OECD countries with less solid systems of governance. Then, a special attention has to be paid to the social and insurance policies while the level of social contributions differently impacts the level of shadow economy, compared to the impact exerted by taxes but also compared between the old and new countries. This study has both theoretical and practical implications. From the theoretical point of view, this study comes to cover the gap in literature regarding the way in which the impact of tax burden on shadow economy should be explained by the various types of taxes and by the length of past time from which a country adhered to an international organization (such as OECD is). From the practical point of view the results are useful for policymakers in different countries by helping them find the level of resilience of various nations under different types of tax burden structures. In addition, setting appropriate levels of taxes by typologies needs to be included in the policy of OECD countries for combating the shadow economy in this area. The limits of this study leave avenue for future research in the field of different tax fraud proxies, supplementary control variables, and the use of other multivariate data techniques. Acknowledgement This work was supported by a grant of the Romanian Ministry of Education and Research, CNCS - UEFISCDI, project number PN-III-P4-ID-PCE-2020-2174, within PNCDI III. Declaration of Competing Interest The authors declare that she has no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.

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Monica Violeta Achim is professor of Finance at the Faculty of Economics and Business Administration, Babeş-Bolyai University, Cluj-Napoca (Romania). With over 22 years of experience in academia, she has published as author and co-author over 140 scientific articles and 25 books. Her most recent reference work is the book Economic and Financial Crime: Corruption, Shadow Economy, and Money Laundering, co-authored by Monica Violeta Achim and Sorin Nicolae Borlea (Springer, 2020). In the business environment, she works in liberal professions as accountant expert, tax consultant, and judicial expert, from this perspective being involved in solving many cases of economic and financial crime of the Palace of Justice, Cluj-Napoca. Viorela-Ligia Văidean obtained PhD title in the finance field, in 2010, from “Babeş-Bolyai” University (BBU), Cluj-Napoca, Romania. In 2015, she graduated a postdoctoral study program. She has worked as an expert for different EU financed projects and grants. She has published more than 40 research papers and attended several international conferences. She has been the author or co-author of ten books and international book chapters. Her research interests cover the areas of Health Economics, Corporate Finance, Financial Management, Organized Crime, and Fiscal Policies. Sorin Nicolae Borlea is professor and doctoral supervisor in the field of Finance at the University of Oradea and Vasile Goldiș University, and associate scientific researcher at the European Research Institute of Babeș-Bolyai University, Cluj-Napoca. He has over 16 years of experience in the academic field and 30 years in the business environment. He has published over 90 scientific articles and 20 books. His most recent reference work is the book Economic and Financial Crime: Corruption, Shadow Economy, and Money Laundering, co-authored by Monica Violeta Achim (Springer, 2020). In parallel with the academic field, he works in the business environment as financial auditor, accounting expert, tax consultant, and financial analyst, being strongly anchored in economic and financial crime issues in the files managed by the Court of Cluj-Napoca. Decebal Remus Florescu is a deputy Editor-in-chief of Adevărul newspaper, coordinating its Transylvanian counties. Among the media institutions he worked for there are Ziarul Clujeanului, Clujeanul, Ziarul Financiar, and the Adevărul de Seară network. In 2015, he was elected a president of the Cluj Press Professionals’ Association, a position he has held until today. In 2020, he defended his PhD thesis entitled “Creating viral content in the digital age,” within the Faculty of Political, Administrative and Communication Sciences (FPACS), BBU Cluj-Napoca, becoming a PhD in Communication Sciences. His research interests cover the media, democracy, corruption, and fake news.

A Bidirectional Causality Between Shadow Economy and Economic and Sustainable Development Eugenia Ramona Mara, Monica Violeta Achim, and Sandra Clement

1 Introduction We cannot talk about “really sustainable” finance without developing strong and efficient means to fight shadow economy. However, there are many debates in literature regarding the causal relationship between shadow economy and economic and sustainable development (Kaufman 2010; Ivanyna et al. 2010, Mara 2011a, b; Husted 1999; Paldam 2001, 2002; Kirchler 2007; De Rosa et al. 2010; Mara and Sabău-Popa 2013; Achim et al. 2018, Achim and Borlea 2020). A large strand of studies support negative effects of shadow economy on economic and sustainable development while it reduces the revenues collected by the national budgets (Kaufman 2010; Ivanyna et al. 2010; Mara 2011a, b), the level of investments (Jurj-Tudoran and Șaguna 2016; Stancu and Recea 2009, the increase of social inequalities and poverty (Abed and Gupta 2002; European Parliament 2015), and finally reduce the economic and sustainable development (Borlea et al. 2017; Achim et al. 2021; Hoinaru et al. 2020). On the other hand, the level of economic development of a country represents one of the most important factors identified in the literature and practice as determinant for financial crimes (Husted 1999; Paldam 2001, 2002; Kirchler 2007; De Rosa et al. 2010; Mara and Sabău-Popa 2013; Achim et al. 2018; Achim and Borlea 2020). For instance, the study of Achim and Borlea (2020) conducted on 155 countries over the period 2005–2015 found a negative correlation between GDP per capita and shadow economy of 0.65. In addition, a significant negative influence of the level of the economic development on the level of the shadow economy was found. A high standard of living can lead to better compliance with the law, reducing the incentives to pay bribes and thus reducing shadow activities. Aforementioned studies E. R. Mara · M. V. Achim (✉) · S. Clement Babes-Bolyai University, Cluj-Napoca, Romania e-mail: [email protected]; [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_13

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demonstrate that the highest rates of shadow activities are found in developing and transition countries, and high-income countries have low levels of shadow economy. The well-being of citizens can limit underground activities in the form of informal work (Mara 2021) and the governments of well-developed countries are able to apply different measures such as audits, sanctions, and regulation with an effective impact on diminishing the shadow economy. This effective impact is sustained by a solid institutional capacity to prevent underground activities and moreover to offer high-quality public services to their citizens who are content by their sacrifice in the matter of tax payments. Financial development represents a very complex evolution of the financial system which involves the development of the size, efficiency, and stability of financial markets along with a better access to the financial markets and this can imply a lot of benefits for the entire economy. Financial development has a major impact in the economic system with a significant contribution to the sustainable finance. In this context, the contribution of financial development to the shadow economy evolution is important to be studied and underlined. An important advantage is that the savings are channeled into profitable investments according to Stiglitz and Weiss 1983; Diamond 1984. Regarding the impact of financial development on shadow economy, the literature emphasizes the need to reduce the shadow economy associated with financial development and improve the quality of financial institutions’ capacity. Also, increasing the regulations in the financial sector can have an important contribution in diminishing some activities such as money laundering which comes from shadow economy (Berdiev and Saunoris 2016; Bayar and Ozturk 2016). Combating the shadow economy in European countries should be realized through comprehensive measures based on better governance, improving tax compliance, digitalization and automation of financial procedures, and extending electronic payments according to Kelmanson et al. 2021. Sangirova et al. (2021) confirmed in a study realized for Uzbekistan the fact that implementation of an electronic payments system leads to lower level of shadow economy. Another evidence regarding the impact of financial development in reducing the size of shadow economy is validated by Gharleghi and Jahanshahi (2020) in their research for a sample of 29 developed and developing countries considered between 1975 and 2015. Njangang et al. (2020) demonstrated the importance of financial development in reducing the shadow economy in sub-Saharan Africa. Moreover, there is a U-shaped relationship between financial development and the informal economy. Haruna and Alhassan (2022) sustain the fact that a higher institutional quality can facilitate the access to credit and other financial services, therefore diminishing the shadow economy. Financial development impact on shadow economy and tax evasion was also studied by Blackburn et al. (2012), and the results of this research prove that financial development decreases the shadow economy. In our research we try to test if the financial development is an important way for combating the shadow economy considering the level of development countries. In order to attain our objectives, we split the countries in a few clusters: high-, middle-, and low-income countries and European countries.

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This study intends to cover the gap in literature and investigates if there are a bidirectional causal relationship between shadow economy and economic and financial development and if it is so which are the strongest relationship: From shadow economy to economic and financial development or vice versa? Therefore, the following working hypotheses are stated: Hypothesis 1: Increasing economic development of a country leads to a reduction in the shadow economy, ceteris paribus. Hypothesis 2: Financial development can counteract shadow economy spreading, ceteris paribus. Hypothesis 3: Increasing sustainable development of a country leads to a decrease in the shadow economy, ceteris paribus. For this purpose, a sample of 185 countries over the period 2005–2017 was used and Granger causality test was applied in order to confirm our assumptions. The causality tests confirm the significant impact of shadow economy on the economic development. The rest of the chapter is structured as follows. The next section describes the methodology and data, followed by the results and discussions. The chapter ends with limits and avenues for future research.

2 Methodology and Data For the purpose of our study a sample of 185 countries over the period 2005–2017 is used. Then for capturing the existence of this bidirectional causality the Granger causality test was applied for low-, middle-, and high-income countries. The list with the presentation of the countries is found in Appendix 1.

2.1

Model and Data

For testing our hypotheses, the empirical model can be specified in the following equations: Shadow economyi,t = α þ β1 Economic developmenti,t þ β2 Controlsi,t þ εi,t ð1Þ Shadow economyi,t = α þ β1 Financial developmenti,t þ β2 Controlsi,t þ εi,t ð2Þ

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Shadow economyi,t = α þ β1 Sustainable developmenti,t þ β2 Controlsi,t þ εi,t

ð3Þ

where: . i and t represent country i at year t, respectively; β is the coefficient of the independent variables; εi,t is an error term . Dependent variable: SE: Shadow economy as % of GDP . Independent variables: Loggdpcap: GDP per capita as logarithmic argument; FD: Financial development; HDI: Human development index . Control variables: Internet: Internet use; Urbpopula: The share of urban population in the total population; Industry: Industry value added as % to GDP; Trade: Trade value added as % to GDP; Polstab: Political Stability and Absence of Violence/Terrorism; Incomeinequal: Income inequality (%) – Pre-tax national income; Outoscho: Out of school represents children out of school (% of primary school age); Broadmoney: Broad money (% of GDP); IndexMoney: Risk of money laundering and terrorist financing; Gini: Gini index (0 represents perfect equality, while an index of 100 implies perfect inequality) The dependent variable—shadow economy (SE) is based on the data provided by Medina and Schneider (2019) and is measured as a share of GDP. An important independent variable for the economic development is the GDP per capita. Financial development represents another important coordinate for measuring the degree of development. In this context, we will assume the negative impact of the development of financial sector on the shadow economy. Bayar and Ozturk (2016) confirmed the fact that improvements and developments of financial sector and quality of governing institutions affect negatively shadow economy. The financial development index is defined by the IMF as a relative ranking of countries in terms of the depth, access, and efficiency of their financial institutions and markets. The Human Development index (HDI) represents another independent variable as a proxy for economic development. Here, the UNDP explains that the HDI focuses on the importance of people and their capabilities rather than economic growth alone in assessing a country’s development. The HDI is a conglomerate for average performance on the key dimensions of human development: a long and healthy life, a high level of knowledge, and an adequate standard of living. An exhaustive description of all variables is presented in Appendix 2 while Appendixes 3 and 4 are dedicated to the preliminary analysis of summary statistics and correlation matrix.

2.2

Panel Unit Root and Granger Causality

In order to identify the main determinants of shadow economy in our study we will include all the countries in the world with available data for shadow economy. For

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Table 1 Panel unit root test results First difference Variable ΔSE ΔLOGGDPCAP ΔFD ΔHDI ΔINTERNET ΔUNEMPL ΔURBPOPULA ΔINDUSTRY ΔTRADE ΔINFLA Δ POLSTAB ΔINCOMEINEQUAL ΔOUTOSCHO ΔTAXBUR ΔBROADMONEY ΔINDEXMONEY ΔGINI ΔCPI

LLC –44.74*** –20.08*** –51.02*** –33.89*** –27.24*** –11.03*** –73.08*** –46.76*** –40.35*** –90.82*** –48.27*** –23.53*** –22.84*** –49.31*** –33.21*** 47.91 –58.56*** –45.63***

Breitung –29.95*** 7.60 –29.82*** –21.21*** –10.47*** 10.43 20.40 –28.08*** –14.99*** –20.73*** –18.81*** –16.79*** –0.009* –22.14*** –4.42*** –1.2* –6.7* –22.77***

IPS –36.12*** –17.91*** –47.14*** –29.37*** –25.21*** –16.21*** –15.03*** –32.17*** –29.33*** –67.39*** –39.27*** –30.29*** –13.63*** –36.03*** –31.83*** –3.48*** –15.86*** –28.45***

ADF 1674.65*** 1239.39*** 1506.22*** 150.84*** 1325.02*** 1014.98*** 1138.83*** 1982.84*** 1800.71*** 4426.69*** 1870.70*** 1604.28*** 1101.87*** 2227.71*** 1579.85*** 467.376*** 621.039*** 1802.03***

PP 2853.16*** 1398.29*** 5396.57*** 2160.92*** 1626.97*** 1037.48*** 1086.69*** 3714.9*** 3362.03*** 14429.9*** 2446.44*** 3056.36*** 1618.66*** 3678.18*** 2559.77*** 860.462*** 825.38*** 2907.20***

Note: Newey–West automatic bandwidth selection and Bartlett kernel, Exogenous variables: Individual effects, individual linear trends, *, **, and *** indicate the significance at 10%, 5%, and 1% levels, respectively

obtaining more significant results the world countries will be clustered into a few groups. One cluster will take the level of development of the countries into account. Thus, based on the classification provided by World Bank, low-income countries are considered if their GNI per capita is less than $1085, middle-income countries include two categories from World Bank Atlas1—lower middle-income and upper middle-income—countries having GNI per capita between $1086 and $13,205, and the last category high-income economies are those with a GNI per capita of $13,205 or more. Before proceeding with empirical estimations, it is necessary to check panel cointegration in order to apply the right method. For the panel unit root properties, we will proceed to the following tests developed by Breitung (2000), Levin et al. (2002), Im et al. (2003). In addition to these tests we will use ADF-Fisher Chi-square (Maddala and Wu 1999) and PP-Fisher Chi-square (Choi 2001). The tests results presented in Table 1 (LLC, Breitung, IPS, ADF, and PP) are conducted for individual intercepts and trends, for the first difference. The results demonstrate that our variables imply long-run information because they are

1

https://datahelpdesk.worldbank.org/knowledgebase/articles/906519

252 Table 2 Results for Kao Panel cointegration test

E. R. Mara et al. Equations Eq. (1) Eq. (2) Eq. (3)

t-statistics –1.87** –1.57** 3.76***

Probability 0.034 0.05 0.0001

R-squared 0.10 0.10 0.15

Notes: Probability value for the rejection of null-hypothesis. NullHypothesis = no cointegration, User-specified lag length: 1, Newey–West automatic bandwidth selection and Bartlett kernel

stationary at first difference. As a consequence, a possible cointegration of variables considered in the empirical model has to be verified. For deciding if our variables are cointegrated we perform the Kao’s panel cointegration test following Gutierrez (2003) analysis regarding the efficiency of different panel cointegration test statistics. He proves that in homogeneous panels with a reduced number of time periods, Kao’s tests carry out higher power than Pedroni’s tests, whereas for panels with large T the latter tests perform best. For our model because we have just 23 years we applied Kao’s test. Based on the results provided by Kao’s test the null-hypothesis is rejected, so our variables are cointegrated in each equation, thus we will apply FMOLS procedures (Table 2). Based on the study realized by Breitung and Pesaran (2005), when the cointegration relationship is confirmed, the long-run coefficients can be estimated efficiently using FMOLS procedures. The FMOLS methodology was developed by Phillips and Hansen (1990) for carrying out an optimal co-integrating regression estimation. Pedroni (2001) points out that the most important benefit of the FMOLS estimator for panel cointegration regression is solving the issue of endogeneity bias and serial correlation. Following the advantages of this method of estimation underlined by Hamit-Haggar (2012), FMOLS is the proper technique for our panel methodology including heterogeneous cointegration. Based on cointegration test, the presence of a causal relationship among the variables is detected, at least in one direction. In order to identify the direction of causality among variables, a Granger causality test is carried out. The importance of the Granger causality test is crucial because it validates the real causes of shadow economy, not only the existence of the correlation. In the case of first hypothesis, we try to prove if economic development of countries included in our study can have a significant impact on the shadow economy. Based on the results provided by the Granger causality, a bidirectional causality can be highlighted between the economic development and shadow economy. This bidirectional causality appears due to the fact that both are influencing each other. Our assumption is based on the negative impact of economic development on shadow economy and the positive influence of shadow economy on economic development due to the fact that informal activities are an important source of incomes. The negative influence of economic development on shadow economy is also found in similar previous studies (Husted 1999; Paldam 2001, 2002; Kirchler 2007; De Rosa et al. 2010; Achim et al. 2018; Achim and Borlea 2020; Mara 2021) while a high standard of living conduct to a better compliance with the

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law and limit underground activities in the form of informal work. Then a positive influence of shadow economy on economic development is also found in the previous studies supporting the “grease the wheels” theories, such as Beck and Mahler (1986), Caselli and Michaels (2013), Jiang and Nie (2014), and Zaman and Goschin (2015). These findings support the idea that corruption may help companies circumvent government regulations by providing an important buffer for solving many economic problems. Regarding the assumption from the second hypothesis where the financial development is considered as an important factor for shadow economy, based on the Granger causality a bidirectional causality is proved. The same situation is in the case of shadow economy and the risk of money laundering and the amount of cash payments. Financial development is a potential mean to counteract the underground activities, but in the same time in countries with high level of shadow economy there are some opponents who make an important lobby for maintaining a financial system without too many regulations where the money from informal activities having the possibility of free movement between different accounts. A high level of shadow economy will generate a lot of payments in cash and the risk of money laundering will increase for these countries. For the third hypothesis, we investigated if the sustainable development measured with HDI may have an impact on shadow economy. In the case of HDI, only one direction is confirmed—the negative impact of HDI on shadow economy, because the incomes generated by shadow economy are not enough to have a major contribution to the citizen’s welfare.

3 Results and Discussions 3.1

Main Results

Considering these results presented in Table 3 we can proceed with estimations in order to establish the estimated models of shadow economy and its determinants specified according to each hypothesis. The first hypothesis is confirmed for all our clusters included in the model, thus there is a significant negative impact of economic development on shadow economy (Table 4). The results reported in Table 4 reflect a higher importance of economic development in combating shadow economy in low-income countries. In welldeveloped countries because the level of shadow economy is the lowest, the governments should apply measures for preventing the imported underground activities from less developed countries. For instance, in the case of immigrants who cannot work legally, informal work is the only option for their survival. Our results are in line with previous studies regarding the negative influence of economic development on the spread of shadow economy (Wu and Schneider 2019; Navickas et al. 2019; Ateşağaoğlu et al. 2018; Yalaman and Gumus 2017; Johnson et al. 1999).

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254 Table 3 Results of panel Granger causality tests Null-hypothesis H1: LOGGDPCAP does not Granger Cause SE SE does not Granger Cause LOGGDPCAP H2: FD does not Granger Cause SE SE does not Granger Cause FD H3: HDI does not Granger Cause SE SE does not Granger Cause HDI

F-Statistic

Result

Causality

4.7339*** 7.5073***

Yes Yes

LOGGDPCAP→SE SE →LOGGDPCAP

2.9110** 4.6030***

Yes Yes

FD→SE SE→FD

4.5150*** 1.3964

Yes No

HDI→SE

Note: *, **, and *** indicate the significance at 10%, 5%, and 1% levels, respectively. Lags to include: 4 Table 4 Empirical results based on FMOLS (Eq. 1) FMOLS (1) World Dependent variable SE LOGGDPCAP –25.58*** (0.29) TRADE –0.026*** (0.001) INCOMEINEQUAL 17.34*** (1.14) UNEMPL 0.08*** (0.012) R-squared 0.97 Observations 3076

(2) Low income

(3) Middle income

(4) High income

(5) Europe

–30.67*** (1.46) –0.067* (0.008) 4.52 (2.90) 0.09 (0.10) 0.75 336

–25.33 *** (0.38) –0.03*** (0.002) 19.76*** (1.76) 0.19*** (0.01) 0.95 1719

–22.27*** (0.48) –0.01*** (0.001) 8.86*** (1.49) –0.002 (0.01) 0.97 1021

–10.44*** (0.09) 0.02 (0.001) 132.80*** (0.92) 0.31 (0.015) 0.64 902

Notes: () parenthesis value indicates the std. error; probability significance: *p < 0.1, **p < 0.05, ***p < 0.01. Coefficient covariance computed using default method. Long-run covariance estimates (Bartlett kernel, Newey–West fixed bandwidth) Panel method: Pooled estimation. Significance of clusters: 1 World = 146 countries; 2 Low income = 16 countries; 3 Middle income = 83 countries; 4 High income = 47 countries; 5 Europe = 41 countries

The analysis of the second hypothesis regarding the influence of financial development on the evolution of shadow economy is conducted in Table 5. The findings show that there is a negative correlation and in the low-income countries this influence is even higher (Table 5). In these countries it is necessary to stimulate the financial system development for reducing the shadow economy in the long run. Some measures regarding the electronic payments or requirements for justification of the amounts of money realized can counteract the spread of underground activities. The third hypothesis checks the effect of sustainable development (measured by HDI) on the shadow economy. This hypothesis is confirmed for all the clusters included in our study, therefore an increase of the sustainable development conducts

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Table 5 Empirical results based on FMOLS (Eq. 2) FMOLS (1) World Dependent variable SE FD –12.05*** (0.59) INTERNET –0.05*** (0.001) URBPOPULA –0.34*** (0.009) INDUSTRY –0.24*** (0.006) INFLA 0.005*** (0.0009) R-squared 0.96 Observations 2904

(2) Low income

(3) Middle income

(4) High income

(5) Europe

–37.11*** (5.98) –0.15*** (0.02) –0.46*** (0.04) –0.16*** (0.02) –0.002 (0.014) 0.77 334

–16.25*** (0.97) –0.09*** (0.003) –0.25*** (0.013) –0.24*** (0.009) 0.004*** (0.0009) 0.95 1617

–6.08*** (0.49) –0.05*** (0.001) 0.11*** (0.015) –0.17*** (0.008) 0.05*** (0.01) 0.97 1021

–6.08*** (0.49) –0.06*** (0.001) –0.08*** (0.019) –0.23*** (0.012) 0.003*** (0.0008) 0.97 953

Notes: () parenthesis value indicates the std. error; probability significance: *p < 0.1, **p < 0.05, ***p < 0.01. Coefficient covariance computed using default method. long-run covariance estimates (Bartlett kernel, Newey–West fixed bandwidth) Panel method: Pooled estimation. Significance of clusters: 1 World = 148 countries; 2 Low income = 19 countries; 3 Middle income = 83 countries; 4 High income = 46 countries; 5 Europe = 41 countries

to a decrease of shadow economy. This result is available for all countries and also for the considered clusters (low income, middle income, high income, and Europe) (Table 6).

3.2

Robustness Check

For robustness check we introduce in our equations the risk of money laundering and the broad money which exist in the economy representing the money used outside of the financial system. The relation between using cash and shadow economy was explored by Schneider (2017) and the conclusion was a limited influence of cash on shadow economy. Between shadow economy and the risk of money laundering there is a powerful and positive correlation. In this context, fighting against shadow economy and money laundering should be coordinated and the governments should be aware about the bidirectional causality among SE and risk of money laundering (Table 7).

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Table 6 Empirical results based on FMOLS FMOLS (1) World Dependent variable SE HDI –8.87*** (0.22) POLSTAB –4.44*** (0.05) INCOMEINEQUAL 29.41*** (0.38) OUTOSCHO 0.12*** (0.004) TAXBUR 0.22*** (0.0028 R-squared 0.42 Observations 1250

(2) Low income

(3) Middle income

(4) High income

(5) Europe

–27.21*** (2.04) –1.18*** (0.16) 45.60*** (1.46) 0.16*** (0.009) 0.15*** (0.014) 0.37 116

–15.44 ** (7.50) –3.62*** (0.91) 24.29*** (6.33) 0.17* (0.1) 0.35*** (0.06) 0.09 654

–42.77*** (1.86) –1.06*** (0.14) –4.64*** (1.79) –0.04** (0.02) –0.06*** (0.08) 0.97 473

–9.46*** (0.81) –7.79*** (0.16) 36.52*** (1.59) 0.43*** (0.02) 0.22*** (0.004) 0.65 482

Notes: () parenthesis value indicates the std. error; probability significance: *p < 0.1, **p < 0.05, ***p < 0.01. Coefficient covariance computed using default method. Long-run covariance estimates (Bartlett kernel, Newey–West fixed bandwidth) Panel method: Pooled estimation. In these equations the period included is 2003–2017 and for each cluster is mentioned the number of countries as follows: 1 World = 110 countries; 2 Low income = 11 countries; 3 Middle income = 59 countries, 4 High income = 39 countries; 5 Europe = 37 countries

4 Conclusion The most important finding of this study is to confirm the bidirectional causality between shadow economy and the economic development on one side, and on the other side the bidirectional causality between shadow economy and income inequality. Based on these findings the government policy can be long-term oriented for reducing the inequalities and for increasing the welfare of citizens in order to reduce the shadow economy spread. Another important direction for combating the shadow economy is a better political stability along with corruption control, especially in CEE countries and in low-income countries. The shadow economy has different forms and is in a continuous evolution, in some cases very difficult to be predicted and anticipated. The main concern of the governments should be the adaptation of methods and means for combating the underground activities. The indubitable negative influences of these phenomena on economic growth have been clearly and empirically determined. The main limits of this study could be related to the using of economic and social determinants without accounting for the cultural context of the world countries. Future studies will account on using other control variables such as cultural variables that may impact the behavioral pattern in terms of avoiding taxes.

0.88 318

–0.003 (0.005) 5.13*** (0.08) –0.16*** (0.016) –0.5** (0.01) 0.45 35

High SE countries

0.80 320

–50.85*** (2.61) –1.28*** (0.21) 13.87*** (2.65) 0.09*** (0.01) –0.12*** (0.01)

Middle SE countries

0.05*** (0.001) 2.92*** (0.02) 0.02*** (0.006) –0.02*** (0.002) 0.33 50

Middle SE countries

0.31 456

12.71*** (0.20) –2.87*** (0.05) 8.49*** (0.45) –0.02** (0.01) 0.06*** (0.003)

Low SE countries

–0.02*** (0.002) 2.69*** (0.03) –0.45*** (0.004) 0.04*** (0.003) 0.77 35

Low SE countries

Notes: () parenthesis value indicates the std. error; probability significance: *p < 0.1, **p < 0.05, ***p < 0.01. Coefficient covariance computed using default method. Long-run covariance estimates (Bartlett kernel, Newey–West fixed bandwidth). Panel method: Pooled estimation. High SE countries is the cluster of countries with a level of shadow economy as share of GDP > 25%. Middle SE countries is the cluster of countries with a level of shadow economy as share of GDP between 15 and 25%. Low SE countries is the cluster of countries with a level of shadow economy as share of GDP below 15%

R-squared Observations

CPI

GINI

INDEXMONEY

FMOLS High SE countries Dependent variable SE HDI –1.42** (0.74) POLSTAB –1.67*** (0.16) INCOMEINEQUAL 29.78*** (1.25) OUTOSCHO –0.06 (0.007) TAXBUR 0.31*** (0.008) BROADMONEY

Table 7 Empirical results based on FMOLS

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Acknowledgment This work was supported by a grant of the Romanian Ministry of Education and Research, CNCS - UEFISCDI, project number PN-III-P4-ID-PCE-2020-2174, within PNCDI III. Declaration of Competing Interest The authors declare that she has no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.

Appendix 1. List of Countries High-income countries Andorra Antigua and Barbuda Aruba Australia Austria Bahamas Bahrain Barbados Belgium Bermuda Brunei Darussalam Canada Chile Croatia Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Greenland Hong Kong Hungary Iceland

Middle-income countries Albania Algeria Angola Argentina Armenia Azerbaijan Bangladesh Belarus Belize Benin Bhutan Bolivia Bosnia and Herzegovina Botswana Brazil Bulgaria Cambodia Cameroon Cape Verde China Colombia Comoros Congo Republic Costa Rica Côte d’Ivoire Cuba

Low-income countries Afghanistan Burkina Faso Burundi Central African Republic Chad Congo Democratic Republic Eritrea Ethiopia Gambia Guinea Guinea-Bissau Liberia Madagascar Malawi Mali Mozambique Niger Rwanda Samoa Sierra Leone Somalia South Sudan Sudan Syria Togo Uganda (continued)

A Bidirectional Causality Between Shadow Economy and Economic. . . High-income countries Ireland Israel Italy Japan Korea Kuwait Latvia Liechtenstein Lithuania Luxembourg Macao Malta Monaco Netherlands New Zealand Norway Oman Poland Portugal Puerto Rico Qatar Saudi Arabia Seychelles Singapore Slovakia Slovenia South Korea Spain Sweden Switzerland Taiwan Trinidad and Tobago United Arab Emirates United Kingdom United States of America Uruguay

Middle-income countries Djibouti Dominica Dominican Republic Ecuador Egypt El Salvador Equatorial Guinea Eswatini Fiji Gabon Georgia Ghana Grenada Guatemala Guyana Haiti Honduras India Indonesia Iran Iraq Jamaica Jordan Kazakhstan Kenya Kiribati Kosovo Kyrgyzstan Laos Lebanon Lesotho Libya Macedonia Malaysia Maldives Mauritania Mauritius Mexico Moldova Mongolia Montenegro Morocco Myanmar

259

Low-income countries Yemen

(continued)

260 High-income countries

Source: author composition

E. R. Mara et al. Middle-income countries Namibia Nepal Nicaragua Nigeria Pakistan Panama Papua New Guinea Paraguay Peru Philippines Romania Russia Saint Lucia Saint Vincent and the Grenadines Sao Tome and Principe Senegal Serbia South Africa Sri Lanka Suriname Swaziland Tajikistan Tanzania Thailand Timor-Leste Tonga Tunisia Turkey Turkmenistan Ukraine Uzbekistan Vanuatu Venezuela Vietnam Zambia Zimbabwe

Low-income countries

A Bidirectional Causality Between Shadow Economy and Economic. . .

261

Appendix 2. Description of Variables Variable Dependent variable Shadow economy (SE) Independent variable Economic development (LOGGDPCAP)

Specification

Source

Shadow economy (% GDP)

Medina and Schneider (2019)

LOG GDP per capita (constant 2015 US$)

World Bank 2022 https://data.worldbank.org/ indicator/NY.GDP. PCAP.KD UNDP, 2022 https://hdr.undp.org/data-cen ter/human-developmentindex#/indicies/HDI Financial Development – IMF, 2022, https://data.imf.org/?sk= f8032e80-b36c-43b1-ac26-4 93c5b1cd33b

Sustainable development (HDI)

Human development index varies between 0 and 1.

Financial development (FD)

Financial development index

Control variables Urban population (URBPOP)

Urban population (% of total population)

Industry (INDUSTRY)

Industry value added (% GDP)

Trade(TRADE)

Trade (% of GDP)

Broad money (BROADMONEY)

Broad money (% of GDP)

Index of Money laundering (INDEXMONEY)

Risk of money laundering and terrorist financing (AML)

Worldbank, 2022: United Nations Population Division. World Urbanization Prospects: 2018 Revision. https://data.worldbank.org/ indicator/SP.URB.TOTL. IN.ZS Worldbank, 2022: https://data.worldbank.org/ indicator/NV.IND.TOTL.ZS Worldbank: World Bank national accounts data, and OECD National Accounts data files (2022), https://data.worldbank.org/ indicator/NE.TRD.GNFS.ZS Worldbank, 2022, https://data.worldbank.org/ indicator/FM.LBL.BMNY. GD.ZS Basel Institute on Governance, 2022: https://baselgovernance.org/ basel-aml-index

Expected sign

–

–

–

–

– –

+

+

(continued)

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Variable POLSTAB

Specification Political Stability and Absence of Violence/Terrorism: Estimate

Corruption (CPI)

Corruption Perception Index (CPI – ranges from 0 (highly corrupt) to 100 (very clean)) Gini index (0 represents perfect equality, while an index of 100 implies perfect inequality) Income inequality (%) – Pre-tax national income Gini coefficient Children out of school (% of primary school age)

Inequality (GINI)

INCOMEINEQUAL

Out of school

INTERNET

Individuals using the Internet (% of population)

TAXBUR

Tax burden

UNEMPL

Unemployment, total (% of total labor force) (modeled ILO estimate) Inflation, consumer prices (annual %)

INFLA

Source Worldbank, 2022: https://databank.worldbank. org/metadataglossary/1181/ series/PV.EST Transparency International, 2022: https://www.transpar ency.org/en/cpi/2020/index/ nzl Worldbank, 2022: https://data.worldbank.org/ indicator/SI.POV.GINI World inequality database, 2022: https://wid.world/data/ Worldbank, 2022: https://data.worldbank.org/ indicator/SE.PRM.UNER.ZS Worldbank, 2022: https://data.worldbank.org/ indicator/IT.NET.USER.ZS Heritage Foundation, 2022: https://www.heritage.org/ index/explore Worldbank, 2022: https://data.worldbank.org/ indicator/SL.UEM.TOTL.ZS Worldbank, 2022: https:// data.worldbank.org/indicator/ FP.CPI.TOTL.ZG

Expected sign –

–

–

+

–

+

+

+

Source: Own composition

Appendix 3. Summary Statistics

SE LOGGDPCAP FD INTERNET UNEMPL URBPOPULA INDUSTRY TRADE

Observations 3618 4727 4171 4288 4627 4888 4330 4346

Mean 30.40 3.70 0.31 26.93 8.24 56.30 26.79 86.22

Median 30.50 3.67 0.23 13.98 6.42 55.98 25.14 76.19

Maximum 70.50 5.26 1.00 99.70 68.56 100.00 87.80 442.62

Minimum 5.10 2.32 0.02 0.00 0.11 7.21 0.96 0.02

Std. dev. 12.66 0.65 0.22 29.40 7.05 23.75 12.15 53.22 (continued)

A Bidirectional Causality Between Shadow Economy and Economic. . . Observations 4306 4316 4145 4498 2786 3929 3919 1298 1587 3665

INFLA HDI POLSTAB INCOMEINEQUAL OUTOSCHO TAXBUR BROADMONEY INDEXMONEY GINI CPI

Mean 9.98 0.67 –0.06 0.57 8.47 73.23 55.18 5.67 37.89 43.27

Median 3.60 0.70 0.04 0.59 3.03 75.10 44.88 5.61 35.90 36.00

263

Maximum 4145.11 0.96 1.97 0.84 78.05 100.00 452.55 8.61 65.80 100.00

Minimum –18.11 0.23 –3.31 0.34 0.00 10.00 2.86 1.78 23.00 4.00

Std. dev. 81.34 0.17 1.00 0.08 13.09 14.51 43.46 1.23 8.81 21.33

Appendix 4. Matrix Correlations LOG INCOME GDPCAP TRADE INEQUAL UNEMPL FD

SE SE

URB INTERNET POPULA INDUSTRY INFLA HDI

OUT POLSTAB OSCHO

BROAD INDEX TAXBUR MONEY MONEY GINI CPI

1

LOGGDPCAP

-0.7

1

TRADE

-0.1

0.0

1

INCOMEINEQUAL

0.4

-0.4

-0.5

UNEMPL

0.2

-0.2

0.1

0.1

1

FD

-0.7

0.8

-0.1

-0.3

-0.2

1

INTERNET

-0.6

0.9

0.1

-0.6

-0.1

0.7

1

URBPOPULA

-0.4

0.8

-0.1

-0.2

-0.1

0.6

0.7

1

INDUSTRY

0.1

-0.2

0.1

0.0

-0.2

-0.2

-0.2

-0.2

1

INFLA

0.2

-0.2

-0.1

0.1

0.0

-0.3

-0.2

-0.1

0.3

1

HDI

-0.6

0.9

0.1

-0.6

-0.1

0.7

0.9

0.7

-0.1

-0.2

1

POLSTAB

-0.3

0.6

1

-0.5

0.6

0.3

-0.5

-0.1

0.4

0.6

0.4

-0.2

OUTOSCHO

0.4

-0.5

0.0

0.3

-0.1

-0.4

-0.5

-0.4

0.0

-0.1 -0.7

-0.3

1

TAXBUR

0.6

-0.7

0.1

0.3

0.1

-0.7

-0.6

-0.5

0.3

0.2 -0.5

-0.4

0.3

1

BROADMONEY

-0.5

0.5

0.1

-0.2

-0.1

0.7

0.5

0.4

-0.2

0.5

0.3

-0.2

-0.3

1

INDEXMONEY

0.4

-0.6

-0.3

0.6

0.0

-0.5

-0.7

-0.4

0.2

0.3 -0.7

-0.5

0.4

0.4

-0.2

1

GINI

0.4

-0.3

-0.4

0.9

0.0

-0.2

-0.5

-0.1

-0.1

0.0 -0.5

-0.3

0.3

0.1

-0.1

0.5

1

CPI

-0.6

0.8

0.1

-0.4

-0.1

0.7

0.7

0.6

-0.4

0.7

-0.4

-0.7

0.5

-0.6

-0.3

-0.2

-0.3

0.7

1

1

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Eugenia Ramona Mara is associate professor of Public Finance at the Faculty of Economic Sciences and Business Administration, Babeş-Bolyai University, Cluj-Napoca (Romania). She has published many articles and books in such topics as Public Finance, Fiscal Policy, Financial Economics, Tax Competition and Tax Havens. She has also been involved as an expert consultant in several projects financed by the European Commission in the field of taxation. Monica Violeta Achim is professor of Finance at the Faculty of Economic Sciences and Business Administration, Babeş-Bolyai University, Cluj-Napoca (Romania). With over 22 years of experience in academia, she has published as author and co-author over 140 scientific articles and 25 books. Her most recent reference work is the book Economic and Financial Crime: Corruption, Shadow Economy, and Money Laundering, co-authored by Monica Violeta Achim and Sorin Nicolae Borlea (Springer, 2020). In the business environment, she works in liberal professions as accountant expert, tax consultant, and judicial expert, from this perspective being involved in solving many cases of economic and financial crime of the Palace of Justice, Cluj-Napoca. Sandra Clement is a PhD candidate at the Doctoral School in the field of finance at the Faculty of Economics and Business Administration, Babeş-Bolyai University, Cluj-Napoca (Romania). Her research focuses on financial crime, with a particular interest on the shadow economy.

Sustainable Finance and the Role of Corporate Governance in Preventing Economic Crimes Etienne Develay and Stephanie Giamporcaro

1 Introduction Modern corporations need to be able to attract investor capital in order to grow and prosper. While investors traditionally decided to invest in well-managed and profitable corporations, they increasingly consider environmental, social, and governance (ESG) factors when making investment decisions. Their confidence in the corporation is paramount to ensure its growth, prosperity, and sustainability. However, several high-profile corporate governance failures have eroded investors’ trust in corporations and financial markets worldwide these last two decades. There is a growing recognition that these failures result from systematic shortcomings in the governance structures of corporations and that no sustainable finance can be implemented without developing appropriate corporate governance measures to combat economic crimes. The PWC’s global economic crime and fraud survey of 2022 found that 46% of companies interviewed experienced fraud, corruption, or other economic crime over the last 24 months (PWC 2022). Based on 1296 respondents from 53 countries, this survey gives a good overview of the weight of economic crimes and misconducts affecting corporations worldwide. Various corporate actors have called for more accountability and transparency from corporations through better corporate governance to prevent economic crimes and restore investors’ confidence. Nestor (2004, 347) sees corporate governance as a “toolbox for addressing these dysfunctionalities which are often linked to criminal behavior within a corporation.” There is no unique definition of corporate governance. However, for this chapter, we see corporate governance as “a collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of E. Develay · S. Giamporcaro (✉) Nottingham Trent University, Nottingham, UK e-mail: [email protected]; [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_14

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shareholders and other stakeholders” (Larcker and Tayan 2011, 8). Corporate governance can be considered a system of policies, practices, and processes aimed at controlling and directing corporations. Through various mechanisms, such as the board of directors or executive compensation, it translates the overall corporate direction and ensures business integrity with the aim of protecting investors. In criminology, researchers mainly explained the occurrence of economic crimes through poor corporate governance (Hansen 2009; Nestor 2004; Yeoh 2016). For them, the dysfunctions in corporate governance systems are exceptional and mainly caused by personal values or opportunism. The current stream of research on economic crimes mainly omits that the nature of the corporation may be the cause of these crimes (Alcadipani and de Oliveira Medeiros 2020). Today, the dominant business model is rooted in the agency theory and sees the primary objectives of a corporation as purely economic with the research of profit maximization for shareholders (Bebchuk and Tallarita 2020; Friedman 1970; Jensen 2001). This shareholder primacy approach has contributed to the development of a corporate governance aimed at ensuring financial returns to shareholders by aligning their interests with the ones of managers (Shleifer and Vishny 1997). Thus, the dominant corporate governance systems in place are designed to ensure minimal interferences with the maximization of shareholder value. However, this approach has been widely criticized over the last two decades because there are suspicions that it encourages opportunism and risk-taking of executives without punishing them for failure (Tomasic 2011). Moreover, for some researchers, the shareholder value maximization view locks the company in the short term, narrowing executives’ attention and preventing them from seeing ESG issues in different time frames, which might be detrimental to the corporation and its stakeholders (Flammer and Bansal 2017). The construction of a corporate governance whose sole focus is shareholder value maximization might not be sufficient to prevent or deter economic crimes because the right mechanisms of checks and balances are not in place to ensure that managers will make decisions in the interests of the corporation and all its stakeholders (Dion 2016). Considering that all other stakeholders are essential for a corporation as it increases its ability to grow and survive (Edmans 2011; Freeman et al. 2017). However, while corporations mainly focus on the contractual relationship between shareholders and managers, they overlook other, more implicit, contractual relationships with stakeholders. This reduces the accountability of managers toward other groups of stakeholders. Thus, there is a need to make executives accountable to all stakeholders. In this way, the stakeholder-agency theory (Hill and Jones 1992) combines the agency and the stakeholder theories by extending the contractual relationships between executives and shareholders to executives and all legitimate stakeholders. This theory sees executives as the agents of all stakeholders and adopts a socioeconomic perspective on the purpose of corporations where the interests of all legitimate stakeholders of the corporation are considered. This approach induces the development of corporate governance systems designed to protect the interests of all these stakeholders. Thus, this more sustainable corporate governance aligning the

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corporate governance systems of a corporation with sustainable development should promote accountability for all stakeholders. Furthermore, through a long-term orientation and the consideration of ESG issues important to stakeholders, sustainable corporate governance might be helpful in combating economic crimes, ranging from corporate theft and fraud to crimes against consumers, workers, and the environment. By studying two recent high-profile corporate governance failures that have led to economic crimes, this chapter examines the extent to which the lack of accountability, ethics, and corporate governance is detrimental to corporations and all their stakeholders, and whether a corporate governance more aligned with sustainable development may help prevent and deter economic crimes. The remainder of this chapter is organized as follows. First, the next section presents the conceptual background. Then, the second section introduces the two cases. Finally, the last section provides a discussion of the two cases, introduces the concept of sustainable corporate governance, and presents two incentive alignment mechanisms, CSR committees and CSR contracting, to foster the implementation of sustainable corporate governance.

2 Conceptual Background: Corporate Governance and Economic Crime The first distinction between conventional or street crimes and white-collar crimes has been made by Sutherland (1949, 9), who defines a white-collar crime as “a crime committed by a person of respectability and high social status in the course of his [sic] occupation.” Although conventional crimes are seen as more important by the general public because they are more visible and generate fear among the general public, white-collar crimes still generate significant economic and social losses (Hansen 2009). White-collar crimes can also be called economic crimes, which are “crimes of profit which take place within the framework of commercial activity” (Korsell 2002, 201 in Croall 2007). In this chapter, the term economic crime is preferred because the monetary nature of this crime is emphasized, which avoids confusion with other types of crimes that could happen in corporations (i.e., harassment). However, the concept of economic crime is broad, and there must be a distinction between crimes committed by individuals for their interests (occupational crime) and crimes committed for the sake of the corporation (corporate crime) (Holtfreter 2014). Additionally, the categorization of crimes committed for the sake of the corporation (corporate crime) is subject to debate, and most researchers in criminology distinguish between financial crimes, which cause harm against financial actors, and social crimes, which cause harm against customers, employees, the environment, and the general public (Snider 2000). The motives for committing economic crimes can be numerous (Croall 2007). Nevertheless, the criminology literature suggests that it might result from a combination of different factors. Building on the pioneering study of Cressey (1953), three

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main conditions are conducive to economic crimes, such as fraud. These three conditions involve (1) pressure, where individuals conceive themselves as having non-sharable financial problems, (2) opportunity, where individuals are in the position of committing the crime, and (3) rationalization, where individuals are finding a justification for their crime (Cressey 1953, 30). This three-step process, also known as the “fraud triangle,” is extensively used in research on criminology to explain the motives behind economic crimes (Holtfreter 2014). Although knowing the motives leading to economic crimes can help in their prevention ex ante, it is often ex post that a need for more corporate governance starts to emerge to promote accountability (Said et al. 2014). In its very succinct definition, corporate governance consists of “the systems by which companies are directed and controlled” (Cadbury 1992, 15). Corporate governance originates from the recognition that the separation of ownership and control of the corporation can create information asymmetries between a principal and an agent (Berle and Means 1933). The principal, who hired the agent, must mitigate these information asymmetries due to the agent’s self-interested and opportunistic behavior that might not be in his or her best interests (Jensen and Meckling 1976). The principal expects the same level of duty and care (fiduciary duty) that he or she would naturally have if the principal represented his or her interests. As a result, the principal implements various corrective corporate governance mechanisms to align his or her interests with those of the agent. This approach to corporate governance relies on the agency theory and is mainly studied in the context of shareholders (principal) and executives (agent), although agency relationships might occur in numerous other contexts. Let us focus first on corporate governance systems established to align the interests of shareholders with those of managers. This type of corporate governance system is referred to as shareholder-centric and “deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment” (Shleifer and Vishny 1997, 737). The shareholder-centric corporate governance, based on Friedman’s (1970) doctrine and the Chicago School of Economics thoughts, posits that the responsibility of a corporation is to make profits and maximize returns to shareholders. It implies that all the systems by which a corporation is directed and controlled should espouse the sole economic objective of the corporation. Thus, the absence or malfunction of shareholder-centric corporate governance systems is seen as detrimental to shareholders because executives may not act in their best interests, which may harm their profits. The shareholder-centric corporate governance model is not without limitations because the governance systems in place might not be appropriate to prevent or deter economic crimes. For Dion (2016), these governance systems are only designed to limit managerial opportunism and ensure minimal interferences with the maximization of shareholder value. However, the agency theory framework does not restrict the principal to only shareholders, other stakeholders are legitimate to be considered as principals (Hill and Jones 1992). Moreover, the common belief that shareholder interests should be met first has no legal foundation and constitutes a misleading conception of directors’ fiduciary duty (Eccles and Youmans 2016; Supiot 2017;

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Stout 2012). Investigations of the legal framework in a large variety of jurisdictions by law experts have shown that the consideration of ESG issues and other stakeholders’ interests by board members are part of directors’ fiduciary duty and failing to integrate them constitutes a breach of this duty (PRI and UNEP Finance Initiatives 2016). The shareholder value maximization approach is also challenged by researchers as it is suspected to produce unintended consequences affecting the corporation and all its stakeholders. For Yeoh (2016), the rise of corporate governance failures these last decades could be attributed to the euphoria surrounding financial markets and the research of economic return for shareholders that have encouraged corporate misconduct. The corporate governance literature also questions the role of shareholder-oriented governance mechanisms. For example, the role of executive compensation contracts as a trigger of the global financial crisis of 2008 is debated by academics as their compensation contracts may have encouraged opportunism and excessive risk-taking without punishing them for failure (Tomasic 2011). This shareholder value maximization approach is also responsible for other corporate governance flaws, such as poor risk management, the absence or ineffectiveness of the board of directors, and the lack of internal control systems, among many others. There is a plethora of cases where this approach has shown its limits. Notable examples include the Ford Pinto scandal in the 1970s, the Lehman Brothers scandal in 2008, and, more recently, the Volkswagen scandal in 2015. A shift to a more stakeholder-centric type of corporate governance seems therefore needed. The stakeholder theory (Donaldson and Preston 1995; Freeman 1984; Jones 1995) posits that other groups of constituents impacted by the corporation’s activities, called stakeholders, have legitimate claims about the way corporations are directed and controlled (Mallin 2019, 80). From this perspective, corporate governance is seen as “a collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and other stakeholders” (Larcker and Tayan 2011, 8). This view of corporate governance encompasses the primary economic objective of shareholder value maximization to a more socio-economic one promoting accountability and responsibility toward a broader range of stakeholders. This stakeholder-centric approach to corporate governance implies that the interests of other groups of stakeholders, such as customers, employees, suppliers, the environment, and the broader community, should be considered. Nevertheless, it also suggests that stakeholders can be the victims of potential economic crimes and that corporations should orient their corporate governance systems to protect all stakeholders, not only shareholders, and promote sustainable development. The next section examines the extent to which the lack of accountability, ethics, and corporate governance is detrimental to corporations and all their stakeholders through two recent high-profile cases. To do so, we separate economic crimes into two categories, governance-related and governance-impacted crimes. Building on the work of Nestor (2004, 347–348), we define governance-related crimes as “economic crimes having a direct bearing on the way a corporation manages its resource and distributes economic returns among its different constituencies” and

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governance-impacted crimes as “economic crimes perpetrated within a corporate framework but whose direct results are primarily felt outside the corporate sphere and are not per se a primary concern of governance design.” This distinction between governance-related and governance-impacted crimes is important to understand the effects of corporate governance efficiency and orientation in preventing economic crimes.

3 Case Study Analyses 3.1

Case 1: The Abraaj Scandal

The Abraaj Group was a financial service company based in Dubai, United Arab Emirates. Founded in 2002 by Arif Naqvi with $3 million, Abraaj Capital merged with Aureos Capital in 2012 to form the Abraaj Group. The corporation was a leader in the private equity market in emerging countries and reached a peak of about $13.6 bn of assets under management (AUM) in 2018. For almost two decades, Abraaj invested in growth markets with the vision of realizing “investments in foresight” to establish sustainable and virtuous partnerships with corporations and communities (Vittee et al. 2021). The Group’s investment strategies consisted of private equity, impact investing, and real estate with a focus on southern regions such as South America, Africa, the Middle East, and Asia to develop the south-south corridor. In addition, Abraaj initiated numerous philanthropic projects, including the Abraaj RCA Innovation Scholarship, in partnership with the Royal College of Art in London, and the Abraaj Growth Markets Grant to support the development of socially responsible projects in emerging countries. The Group joined the UN Global Compact initiative in 2012, and its CEO, Arif Naqvi, became one of its board members the same year. Through its impact investing funds centered around healthcare and clean energy in emerging countries, its philanthropic initiatives, and the charisma of its leader, Abraaj attracted famous investors such as the Bill and Melinda Gates Foundation, the International Finance Corporation (IFC), a member of the World Bank Group, and the UK’s CDC Group.

3.1.1

What Happened?

The story begins in September 2017, when a fund manager working in the Bill and Melinda Gates Foundation, Andrew Farnum, became suspicious about the management of Abraaj after being asked by the company to invest more money. Fanum sent an email asking the group how they used their funds, where the funds were currently located, and a detailed schedule of spending investments (Afanasieva 2021). The Abraaj Group answered by sending assurance and dated bank statements which failed to dispel suspicion of Fanum (Afanasieva 2021). Additionally, about a week after, the Bill and Melinda Gates Foundation received an anonymous email from an

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employee of Abraaj urging the investor to perform their duty by conducting thorough research and asking appropriate inquiries (Afanasieva 2021). A few months later, at the beginning of 2018, the Wall Street Journal published an article about the potential misuse of funds by the Abraaj Group. This article explained that four investors (the Bill and Melinda Gates Foundation, the World Bank’s IFC, the UK’s Development Finance Institutions CDC, and the French Proparco Group) were hiring a forensic accountant, Ankura Consulting Group LLC, to audit the fund and trace their money (Louch et al. 2018). It was not the first time Abraaj faced difficulties. In 2014, Abraaj and the European Bank for Reconstruction and Development (ERBD) co-invested and acquired the majority stake in Yörsan, a Turkish producer and retailer of dairy products (Pyrkalo 2014). However, the Turkish political context made this investment risky as the anti-government protests forced the Turkish government to buy milk directly from farmers to gain their support, making companies like Yörsan obsolete. The company went bankrupt a few years later, and Abraaj faced problems repaying its investors (Clark and Louch 2021). In 2017, Abraaj tried to sell its shares of Pakistan K-Electric to Shanghai Electric Power, a Chinese energy company. The deal consisted of selling 66% of the company shares for about $1.8 nb, leading to a profit of $450 m for Abraaj, but it has been postponed due to regulatory approvals (Kerr and Sender 2018). These two issues weakened Abraaj and raised suspicions about the fund’s management practices. Nevertheless, the public relations of Abraaj and the charisma of its leader helped the corporation to keep up appearances. It is only with the wave of allegations of funds misuse at the beginning of 2018 that Abraaj started to face serious issues in reimbursing its investors. Although Abraaj denied any wrongdoing in the first instance, the allegations of funds misuse were enough to show that the private equity company could not reimburse its lenders. In the subsequent months, the Chief Executive Officer (CEO) Arif Naqvi and other top executives resigned from their positions (Parasie and Louch 2018). In early May 2018, Kuwait’s Public Institution for Social Security, an investor of Abraaj, filed a petition to put Abraaj under liquidation and share its assets (Parasie 2018). The claim was made to the Cayman Island Court System as Abraaj was incorporated in this country. Knowing they could not repay the Kuwaiti fund, Abraaj applied for provisional liquidation in the Cayman Islands, which was accepted in mid-June, to protect itself against individual creditors’ actions allowing liquidators time to sell the assets (Kerr 2018). A few weeks later, Abraaj defaulted on Kuwait’s Public Institution for Social Security’s loan of $100 m (Clark et al. 2018a). Finally, end of June, the first legal actions against Naqvi were taken. The Sharjah Court in the United Arab Emirates emitted a warrant against Naqvi for issuing a $300 m cheque without sufficient funds (Carvalho et al. 2018). Following these allegations and the imminent collapse of Abraaj, some journalists revealed in early July 2018 that KPMG had close ties with Abraaj’s executive team, which has raised more suspicions about conflicts of interests and the credibility of its financial statements to reflect a true and fair view (Clark et al. 2018b). This article exposed three main conflicts of interest. First, the son of Vijay Malhotra, the chairman and chief executive of KPMG Lower Gulf Ltd., was working at Abraaj.

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Second, Ashish Dave alternates between KPMG and the Chief Financial Officer (CFO) role at Abraaj. Finally, other members of the Abraaj group seemed to have worked previously at KPMG. In April 2019, Naqvi was arrested in the United Kingdom for the fraud charges emitted by the United States concerning the misappropriation of $230 m from its healthcare fund (Lewis 2019). However, 1 month later, Naqvi paid £15 m bails to be put under house arrest and confined in his residence in London (Kerr 2019). Next, in July 2019, the Dubai Financial Services Authority (DFSA) gave a $315 m fine to Abraaj Investment Management Limited and Abraaj Capital Limited, two entities of the Abraaj group (DFSA 2019). Finally, in January 2022, the DFSA sentenced Naqvi to a $135.6 m fine and 3 years of imprisonment for his role in the collapse of the Abraaj group (Nair and Narayanan 2022).

3.1.2

What Went Wrong?

The Abraaj scandal occurs in a context where governments and financial institutions search for new approaches to mitigate rising activism and public defiance toward financial markets. The emergence of impact investing appeared after the global financial crisis of 2008 as a promising response to solve socio-political issues through the promotion of an investment approach combining the creation of profits while addressing environmental and social issues such as reducing carbon emission, ending extreme poverty, and improving healthcare systems (Hehenberger et al. 2019). In this context, Abraaj had momentum because the company presented itself as an impact investor financing socially responsible projects in emerging countries. The philosophy of the Abraaj Group, and in particular those of its CEO Arif Naqvi, attracted numerous investors who were seduced by the simultaneous achievement of profitability and sustainability objectives. As a result, Abraaj quickly became one of the major private equity companies in emerging countries, and its founder was highly visible during world-leading meetings on sustainable development and impact investing. For example, Naqvi was a board member of the United Nations Global Compact initiative that helps businesses to create sustainable capital markets and was regularly invited to the World Economic Forum to discuss the tenets of stakeholder capitalism. However, behind these commendable initiatives, the promises of Abraaj were a smokescreen hiding criminal activities. The Abraaj Group was a classic Ponzi scheme, but investors failed to identify the red flags linked to its corporate governance. First, investors overlooked the lack of independence between Abraaj executives and its audit company. An audit company is an independent examiner that provides a true and fair view of the financial statements of a corporation. It ensures that the financial statements are free from errors, misstatements, or fraud. In the case of Abraaj, this independence was questioned as few top executives, and their relatives worked at KPMG, the auditor of Abraaj. Additionally, the corporation was tracking its funds’ performance with in-house tools, which should have also raised questions about the corporation’s independence as the opportunity to

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manipulate numbers is facilitated. In the investment fund and private equity industries, fund performance tracking is usually given to a third party to ensure the independence and reliability of the figures. Second, investors should have looked at the board of directors’ structure. They would have noticed that the power was concentrated in the hands of a key individual, Arif Naqvi. The separation of duties in a corporation through the appropriate systems of checks and balances is necessary to prevent individuals from being too powerful in the company and committing economic crimes. Moreover, a careful examination of board members’ backgrounds and previous professional experiences would have revealed that most individuals came from the same business network and went to the same elite schools. This may affect the judgment of directors as they might be too accommodating and blindly trust each other. Third, an extensive examination of the Abraaj group would have revealed that the company was incorporated in the Cayman Islands. Although the argument can be made that investing in such a country allows the Group to benefit from a favorable corporate tax policy that can be reinvested in socially responsible investment, the banking secrecy laws of this country favor criminal activities and money laundering. This should constitute a red flag for impact investors with ethical standards.

3.1.3

What Lessons Can Be Drawn?

The Abraaj scandal is a case of occupational crime with fraud and misappropriation of funds. The Group was gathering funds from new investors to repay the existing ones and finance the extravagant lifestyle of its founder, Arif Naqvi, and some of its top executives. What differentiates the case of Abraaj from other Ponzi scheme cases is that the narrative used to attract investors was uncommon. While deviant fund managers operating a Ponzi scheme traditionally promote their fund’s high return for investors, Naqvi promoted the simultaneous achievement of financial and sustainable objectives for the greater good. This narrative attracted numerous high-profile investors concerned about mitigating environmental, social, and governance (ESG) issues in a tense socio-political context. However, these investors failed in their duty by not identifying flaws in the Group’s corporate governance. Therefore, the Abraaj case can be considered as a governance-related crime because the fraudulent activities of its CEO and other top executives have contributed to the collapse of the private equity company and have significantly affected its lenders. To finish, the corporate governance at Abraaj was ineffective in promoting sufficient accountability and encouraging responsible behavior for its executive team.

3.2

Case 2: The Boohoo Scandal

The Boohoo Group is an online fashion retailer based in Manchester, United Kingdom. Launched in 2006 by Mahmud Kamani and Carol Kane, the corporation

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grew significantly over the last decade and counted 3042 employees in 2021. Before building Boohoo, Kamani and Kane supplied prominent fashion companies such as Primark or New Look. The two co-founders were pioneers in the fast-fashion retail industry when they decided, in 2006, to sell online clothes to customers aged 16–30. The business model of Boohoo is to produce fast and cheap trendy clothes online for a young public. The Group sells its own clothes, which gives them more flexibility and control over the products. This approach led the company to considerably increase its margins by avoiding the costs of a middleman. As a result, Boohoo grew rapidly, and the Group now possesses an important number of brands, including MissPap, Karen Millen, Coast, and Nastygal, and has plans to acquire more. The fashion group went public in March 2014 after completing its initial public offering with 600 million shares sold at 50 p, raising £300 million from investors. Despite the economic downturn generated by the COVID-19 pandemic, the Group generated £1.745 billion in revenues in 2021.

3.2.1

What Happened?

The story begins in June 2020 with the publication of a report from a UK-based notfor-profit organization called Labour Behind the Label, which promotes fair working conditions in the fashion industry. The report was alerting to illegal workplace practices in the factories supplying Boohoo that were putting their workers at risk (Labour Behind the Label 2020). It notably mentioned the continuity of operations of these factories during the national lockdown, the lack of health and safety measures to protect their workers against COVID-19, and illegal remuneration practices (Labour Behind the Label 2020). A month later, on the 5th of July 2020, the Sunday Times published an article about an undercover investigation corroborating the allegations made by Labour behind the label (Wheeler et al. 2020). The article revealed that factories supplying Boohoo were still operating during the national lockdown with no health and safety measures to protect its workers. It also exposed a minimum wage of £3.50 an hour, while the national minimum is £8.72. These allegations of modern slavery in the supply chain were not new, and numerous NGOs, journalists, and scholars had already tried to attract attention to sweatshops and illegal working conditions among Boohoo’s suppliers in the city of Leicester in the United Kingdom. For example, in January 2017, Channel 4 released “Dispatch,” a documentary reporting illegal compensation practices, and in May 2018, the Financial Times reported the conclusions of an investigation describing modern slavery cases (O’Connor 2018). The Sunday Times article had an immediate reaction among the general public and on the financial market due to the salience of the newspaper and the sociopolitical context of that time. While the COVID-19 restrictions eased on the 4th of July 2020 for most cities in the United Kingdom, a new lockdown was imposed in Leicester due to a high number of COVID-19 cases (Reuters 2020). Leicester is the largest sourcing hub of the fashion industry in Europe, and about 70–80% of Boohoo’s products come from this city (Metcalf 2020). There were suspicions that

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the COVID-19 cases originated from its garment factories due to poor working conditions and lack of health and safety measures to protect their workers, although this has not been proven (Nilsson 2020a). As a result, when the stock market opened on Monday 6th of July, Boohoo’s share price dropped by 18% after these allegations of modern slavery in its supply chain (Butler 2020). In addition, the financial broker Liberum issued a “hold” notice to warn investors from buying Boohoo shares (Duke 2020). In response, Boohoo declared that the factory concerned (Jaswal Fashions) was a minor supplier and that they will hire Alison Levitt QC, a senior barrister specialized in business crimes, to conduct an independent review of the supplier (Onita 2020). Despite the quick response of Boohoo, three major online retailers (Next, Asos, and Zalando) dropped Boohoo’s products from their websites on the 7th of July (Nilsson 2020b). As a result, its share price decreased by another 12%, and in just 2 days, the company lost one-third of its value (Nilsson 2020b). On the 10th of July, one of Boohoo’s most significant shareholders (Standard Life Aberdeen) sold most of its shares (Mooney 2020). Standard Life Aberdeen is an asset management company that invested in Boohoo through three funds (ethical equity, responsible equity, and impact employment opportunities equity funds). These three funds were supposed to follow an investment strategy called ESG investing, which seeks to promote the simultaneous achievement of financial profits and broader sustainability objectives. However, the fund managers of Standard Life Aberdeen did not correctly appreciate the investment risks that Boohoo represented, and they had to divest as the accusations of modern slavery among Boohoo’s suppliers were threatening the funds’ profitability and credibility. A few months after the accusations of modern slavery in the supply chain of Boohoo, the independent review of Alison Levitt QC reported no evidence of criminal offenses (Bland and Makortoff 2020). Nevertheless, her report suggests that the company knew about the poor working conditions, capitalized on the pandemic to increase its sales, and had not the right corporate governance tools to appropriately monitor the supply chain (Bland and Makortoff 2020). Following the results of this independent review, Boohoo promised to take substantive actions on sustainability (Boohoo 2021). For example, the company planned to improve its relationships with its suppliers to ensure that they were complying with its standards, build governance systems that will prevent such problems from occurring again, build a new factory to demonstrate best practices, and establish relationships with NGOs and local communities (Boohoo 2021). Nevertheless, at the beginning of 2021, the NGO Liberty Shared sent a petition to the United States Customs and Border Protection to ban Boohoo and other fast-fashion companies operating in Leicester from selling their products in the United States (BBC 2021). This market represents one-fifth of Boohoo’s sales which could result in substantial losses for the company.

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What Went Wrong?

The Boohoo scandal takes place in a tense socio-political context with, on the one side, the COVID-19 pandemic and the lockdown that has challenged the individual perceptions of freedom, and on the other side, the newly Modern Slavery Act of 2015 aimed at combating modern slavery in the United Kingdom. This Act has changed the British regulatory landscape by consolidating previous human trafficking and slavery regulations and introducing preventive measures. The garment industry has been particularly affected by the Modern Slavery Act of 2015 because it has pushed corporations to take action to fight modern slavery in their supply chain. For example, the transparency in supply chain provision requires companies with a turnover of more than £36 million to publish an annual statement that declares having taken all steps to ensure that no issues of modern slavery or human trafficking existed in their supply chain. Boohoo complied with this regulation and went even further in 2018 by becoming a member of NGOs Hope4Justice and Slave-Free Alliance to fight modern slavery in the fashion industry. However, the Boohoo scandal reached the UK parliament, and some adjustments have been made to the Modern Slavery Act of 2015 to prevent modern slavery in the supply chain (UK Parliament 2021). The Boohoo scandal is primarily a corporate governance scandal. Although the actions of Boohoo are commendable at first sight, the substantiveness of these initiatives can be questioned. The right governance mechanisms were not present, preventing the company from seeing the risks of poor working conditions among its suppliers. First, the company’s strategy appears purely financially oriented, and there was no strategy toward other stakeholders or related to environmental, social, and governance (ESG) issues. For example, among the six key performance indicators (KPI) of Boohoo in its annual report of 2019, no one focused on ESG-related issues (Boohoo 2019, 16). Instead, the metrics were related to the number of customers, the number of orders, the order frequency, the conversion rate to sale, the average order value, and the number of items per basket. KPIs metrics translate the corporate strategy by measuring the corporation’s performance with respect to the corporate objective. In the case of Boohoo, we can see that ESG, particularly supply chain management, was not the primary concern of the top management. Second, the corporate governance structure and effectiveness are also questionable. Indeed, in 2019, the board of directors had eight directors, six males and two females (Boohoo 2019, 28–29). The board included the two co-founders, the CEO and the CFO, and four other directors with practical business expertise (Boohoo 2019, 28–29). The corporate governance literature finds that a board of directors with greater business expertise and gender diversity can bring significant benefits to the corporation, including improved performance, better decision-making, and enhanced reputation (Adams and Ferreira 2009; Crifo et al. 2019; Dass et al. 2014; Velte 2016). Third, the risk management plan identified ESG risks linked to other stakeholders is controversial, but no concrete actions were taken. For example, the only actions taken consisted of knowing their supplier base and switching

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suppliers in case of problems (Boohoo 2019, 21). However, no actions around product quality, safety, or ethical standards were made. Furthermore, the corporations also overlooked the education of employees about supply risks and internal or external audits, which is crucial to raise awareness and ensure adherence to the corporate objectives. Overall, the combination of these three factors (lack of strategy, governance, and risk management) enabled the presence of modern slavery in Boohoo’s supply chain.

3.2.3

What Lessons Can Be Drawn?

The Boohoo case provides a good understanding of how allegations of a potential social crime can undermine a profitable corporation. Although the term “crime” can be contentious in this case because the harmful activities committed by the business have not been explicitly punished by criminal law and sanctioned, the Boohoo scandal can still be considered as a governance-impacted crime case due to its harmful impact on various stakeholders such as suppliers’ workers and local communities. The company’s lack of accountability and responsibility at its top level has been conducive to poor working conditions among its suppliers. The negligence of Boohoo’s board of directors and its lack of corporate governance orientation to all stakeholders are to be blamed because the risk of modern slavery among its suppliers was known. Nevertheless, the appropriate detection, control, and monitoring mechanisms were not in place to mitigate this risk. Although Boohoo presented decent corporate social responsibility (CSR) credentials and promoted its consideration of all stakeholders, the existing corporate governance systems were mainly shareholder-oriented with no real consideration of other stakeholders. This has caused a governance-impacted crime as the governance mechanisms guaranteeing corporate accountability were not present to protect other stakeholders.

4 Discussion and Conclusion These two recent economic crimes demonstrate that a lack of accountability, ethics, and corporate governance is detrimental to all stakeholders, particularly those supporting sustainable finance. The alignment of finance with sustainable development raises new challenges for business actors. Thus, the box-ticking exercise consisting of checking if the right governance mechanisms are in place is no longer enough, and business actors should now consider their effectiveness and orientation to ensure that risks are adequately managed and to promote sound corporate practices with respect to all stakeholders. In this chapter, we distinguish between governance-related and governance-impacted crimes, following Nestor (2004), to emphasize the need for effectiveness and orientation in the design of corporate governance systems.

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Table 1 Summary of the two cases Case What?

Abraaj Fraud and misappropriation of funds

Why?

Lack of effectiveness of corporate governance systems Ponzi scheme with an innovative narrative (dual achievement of profit and sustainable development) The CEO, Arif Naqvi, and his top executives accomplices Global Governance-related crime

How?

Who? Where? Consequence

Boohoo Allegations of modern slavery in its supply chain Lack of orientation of corporate governance systems Negligence of supply chain management risks Boohoo’s top management team United Kingdom Governance-impacted crime

In the Abraaj case, we demonstrated that the effectiveness of governance systems is paramount to ensure corporate accountability and prevent executives from committing economic crimes. Naqvi and his accomplices would not have been able to misuse the funds of their investors and commit fraud if effective corporate governance mechanisms had been implemented. In this case, it is mainly the independence of its auditor, its board members, its performance tracking system, and the corporation’s state of incorporation that should have served as red flags for investors. This case is particularly relevant in the context of sustainable finance because, even if investors might be seduced by the promises of solving the world’s most urgent environmental and social issues while making profits, it does not prevent them from doing a due diligence and verifying all the information provided by the fund. In the Boohoo case, we showed that the orientation of the governance systems is critical to protect all corporate stakeholders. The fast-fashion business model of Boohoo centered around shareholder value creation led the corporation to be an accomplice of modern slavery as it neglected its supply chain management risks. This case is also relevant in the context of sustainable finance because it demonstrates that investors should not only rely on the previous CSR credential of a corporation, but they should conduct thorough investigations to ensure that actions are taken. In sum, the case study analyses reveal that Abraaj’s governance-related crimes might be caused by the lack of effectiveness of corporate governance mechanisms. In contrast, Boohoo’s governance-impacted crimes might be caused by the lack of orientation of corporate governance systems toward different stakeholders. The case study results show that both the effectiveness and orientation of governance systems seem necessary to prevent economic crimes. Table 1 recap our findings. In addition, the case studies results can be helpful to investors, board members, and analysts in assessing the likelihood of an economic crime based on the quality of its corporate governance. Figure 1 provides a matrix for the prevention of economic crime through the evaluation of the effectiveness and orientation of its corporate governance mechanisms. Users of this matrix could estimate the risks of a company being subject to governance-related or -impacted crimes based on their consideration

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High

Concern for the presence and effectiveness of governance mechanisms

Medium likelihood

Low likelihood

High likelihood

Medium likelihood

Low

High

Concern for all stakeholders’ interests Fig. 1 Matrix for economic crime prevention through governance effectiveness and orientation

of the presence and effectiveness of corporate governance mechanisms and the consideration of all stakeholders’ interests.

4.1

The Need for a Sustainable Corporate Governance

The two case studies have highlighted the need for a paradigm shift in corporate governance to consider sustainable development and promote a more sustainable finance. We saw that a shareholder-centric governance model promotes the effectiveness of governance mechanisms, but it could also fail to consider the needs of other stakeholders, which has detrimental consequences for corporations and all stakeholders. Indeed, aligning governance mechanisms with the sole research of shareholder value maximization is pernicious because it does not prevent or deter economic crimes. It might even be a vector of economic crimes. Additionally, we saw that a stakeholder-centric governance model seems more appropriate due to its ability to orient governance mechanisms on all legitimate stakeholders, guaranteeing accountability and protection. However, such a model must be closely monitored to ensure that the promises made by corporations are kept. In sum, a corporate governance model aligned with sustainable development could combine effectiveness and orientation to promote accountability to all stakeholders. In this way, the stakeholder-agency theory (Hill and Jones 1992) combines the two shareholder-centric (agency theory) and stakeholder-centric (stakeholder theory) models of governance to build a new paradigm where executives (the agent) should act in the best interests of all legitimate stakeholders (the principals). This approach is particularly relevant in today’s context, where society expects corporations to take serious actions on sustainability.

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From the stakeholder-agency theory perspective, the legitimacy of stakeholders is established through an exchange relationship. Stakeholders who bring resources to the corporation have a legitimate claim over its activities as they are in the position of expecting something in return. For example, shareholders who brought financial capital to the corporation expect profit in return. Workers who brought time to the corporation expect decent wages and working conditions. And the same logic applies to all other stakeholders who brought resources to the corporation. This theory extends the contractual relationships between shareholders and executives to a series of explicit and implicit contractual relationships between different groups of stakeholders and executives (Coombs and Gilley 2005). The stakeholder-agency theory requires corporations to shift their corporate governance models from a narrow shareholder value creation in the short term to a stakeholder value creation that is more sustainable for all. Thus, the governance systems of a corporation can be aligned with sustainability. The Brundtland Commission (1987, 41) defined sustainability as the “development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” Sustainability consists of three central tenets: environmental integrity, social equity, and economic prosperity (Bansal 2005). Its application to governance would push corporations to focus on more long-term sustainable value creation instead of short-term value creation and better manage sustainability-related matters (EY 2020). In this way, sustainable corporate governance1 is key to ensure the preservation and enhancement of corporations’ environmental, social, and economic ecosystems, guaranteeing their growth and survival in the long run (Goergen 2022). Furthermore, sustainable corporate governance would make corporations more accountable and protect all legitimate stakeholders’ interests, not only those of shareholders. For Tombs and Whyte (2020), it may be the appropriate answer to combat all sorts of economic crimes, ranging from occupational crimes with fraud and misappropriation of funds, as seen in the Abraaj case, to social crimes with modern slavery issues, as seen in the Boohoo case.

4.2

Promoting Sustainable Corporate Governance

The main challenge of sustainable corporate governance is establishing control and monitoring mechanisms that incentivize executives to act on sustainability-related matters with a long-term orientation. The corporate governance literature distinguishes two main types of incentive alignment mechanisms, executive compensation and board supervision (Edmans et al. 2017). While the former constitutes an ex ante mechanism that motivates executives to reach precise objectives specified in their

For Malecki (2018, 218), even though the term ‘socially responsible’ corporate governance could be used in this context, the term ‘sustainable corporate governance’ is preferred as it is more accurate and neutral.

1

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compensation contracts, the latter constitutes an ex post mechanism that assesses and supervises executives’ behaviors (Wiseman and Gomez-Mejia 1998). Traditionally, the incentives alignment mechanisms have been used to align the interests of executives with those of shareholders. However, under the stakeholder-agency theory, these incentive alignment mechanisms should be designed to align the interests of executives with those of all stakeholders. The first incentive alignment mechanism is CSR contracting, and corporations could implement it in order to align corporate governance with sustainable development and promote sustainable corporate governance. It consists of tying ESG performance targets to executive compensation (e.g., targets related to GHG emissions, safety measures, employee engagement, and other ESG-related issues). This corporate initiative aims to attract executives’ attention to extra-financial objectives in the interests of different stakeholders to benefit the corporation in the long run (Hong et al. 2016; Maas 2018). Unlike the “pay for financial performance” dominant since the 1970s, CSR contracting could be considered as a “pay for ESG performance” (Flammer et al. 2019, 1098). An increasing number of firms are taking the plunge as corporate leaders start to appreciate the benefits of this approach to their corporations (Maas and Rosendaal 2016). A notable example in the United States is Apple Inc. which implemented CSR contracting following shareholders’ pressures (Apple 2021, 66). Since the beginning of 2021, the technology company has applied a 10% annual bonus modifier based on ESG targets related to labor practices in its supply chain and employee diversity (Rosenbaum 2021). Other examples of highprofile companies having implemented CSR contracting include Bank of America, Deutsche Bank, and Volkswagen. The second incentive alignment mechanism is the CSR committee. Since the board of directors has an increasing role in the governance of CSR (Elkington 2006; Ayuso and Argandoña 2007), companies have started to delegate CSR-related tasks to an expert committee. A CSR committee is in charge of monitoring, guiding, and rewarding CSR-related activities (Berrone and Gomez-Mejia 2009; Al-Shaer and Zaman 2019). In addition, it centralizes and coordinates various isolated sustainable governance initiatives, such as the commitment of a CEO or the creation of a Chief Sustainability Officer (CSO) position, within one structure to guarantee the successful enforcement of the CSR strategy within the corporation’s processes, policies, and practices (Elmaghrabi 2021). For some researchers, a CSR committee can also be implemented to improve a corporation’s relationship with its stakeholders by promoting sustainability practices (Chen and Roberts 2010; Mallin and Michelon 2011). Nevertheless, regardless of the motives behind its implementation, the CSR committee’s essential functions are to make recommendations and assist board members in their CSR-related functions (Dixon-Fowler et al. 2017; Orazalin 2020). These two incentive alignment mechanisms are promising, but there are still controversial in the corporate governance literature due to the dearth of empirical research on their ability to deliver sustainability. Some researchers are particularly concerned that these initiatives may have unintended consequences, such as focusing on specific ESG dimensions while neglecting others, increasing the insulation of executives to market pressures, and delaying stakeholder-oriented reforms (Bebchuk

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and Tallarita 2020). Furthermore, the criminology literature is muted on the ability of these sustainable corporate governance mechanisms to reduce economic crimes. Although some papers have highlighted the necessity of a corporate governance aligned with sustainable development to combat economic crimes (Tombs and Whyte 2020), empirical evidence is scarce. Future research should address this issue by empirically testing the effects of CSR contracting and CSR committees on the prevention and deterrence of different economic crimes, such as occupational, financial, or social crimes. Meeting the challenges of sustainable development requires actions at the corporate level and sustainable corporate governance represents a substantial move in this direction.

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Etienne Develay is a doctoral candidate at Nottingham Business School, Nottingham Trent University (UK). Prior to this, he worked as a financial auditor in Mazars Luxembourg. His research interests include corporate governance, business ethics, and corporate social responsibility. Stephanie Giamporcaro is an associate professor of sustainable and responsible finance at Nottingham Business School, Nottingham Trent University (UK), and a visiting associate professor at the University of Cape Town Graduate School of Business (South Africa). Her research is theoretically rooted in sociology of markets, social studies of finance and organization, and management theory. Her main empirical focus is to investigate sustainable and innovative finance both in Europe and Africa.

Part III

Sustainable Finance and the Challenge of Combating Financial Crime

The Financial Fraud of the German Fintech Company WireCard: Structural Causes and Failures of the Supervisory Authorities Michael S. Aßländer and Eckhard Burkatzki

1 Introduction Financial scandals run like a red thread through the history of trade (Peemöller et al. 2020, 29–39). However, after the bribery scandal of the German technology corporation Siemens the intensive discussions about compliance and several legislative reforms gave the impression that corporate scandals in the financial world are gradually declining in Germany. The WireCard case obviously contradicts such vain hopes and opens up previously unknown dimensions. The insolvency of the FinTech company not only left behind a loss of 23 billion euros, but it also threatens the reputation of Germany as a financial centre. It was the first time that a DAX listed company had to file insolvency (Weiguny and Meck 2021, 9). Although WireCard has been criticized for non-transparent accounting practices since 2008, the company was able to flourish on the German financial market until 2020 before its accounting fraud was publicly exposed. Despite all this critique during that time, WireCard developed to one of the most beloved shares of the biggest German investment funds. Thus, for instance, between end of 2019 and beginning of 2020, WireCard became the biggest single stock in the ‘DWS Deutschland’ fund (Kirchner 2019a, b, 2020a) with between 9.2 and 9.6% of the total investment volume. Similarly, at the same time ‘DWS Investment German Equities’ invested between 9.0 and 9.8% of its investment volume in WireCard shares (ibid.). At this time DWS asset management—an affiliate of Deutsche Bank—presented itself as a frontrunner in terms of sustainable and responsible investment stating that 75% of their assets were managed under ecological, social and governance (ESG) criteria (Honegger 2022). According to their own ESG standards, DWS listed WireCard as ‘B’ for their exemplary ethical conduct and immaculate governance structures—notwithstanding M. S. Aßländer (✉) · E. Burkatzki Technical University Dresden, Dresden, Germany e-mail: [email protected]; [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_15

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the obviously opaque business practices of the company and its involvement in the porno and online gambling business (Barth 2021). However, even other financial institutes invested in WireCard. Thus, for instance, the rather conservative German private bank Metzler invested 6.1% of its ‘Metzler Aktien Deutschland’ fund in the German FinTech company by end of 2019 (Kirchner 2019a). For private investors, prominent analysts, like Heike Pauls from the Commerzbank, issued buy recommendations for WireCard shares until shortly before the company filed for insolvency. While optimists tripled their WireCard investments in the funds they managed, pessimists speculated against WireCard. Insiders estimated that at the same time about 20% of all WireCard shares have been sold short (Kirchner 2020a). This and the fact that newspapers like the London Financial Times have issued critical reports about irregularities and poor governance at WireCard should have raised red flags at least for professional investors. Especially for funds like ‘UniGlobal Vorsorge’, managing private pension plans of the so-called Riesterrente (Kirchner 2020b), the disproportionate investment in WireCard shares not only became a financial disaster but also did raise questions of due diligence and responsibility since the fund management affects the retirement provision of significant parts of the German population. When WireCard collapsed on June 25th 2020, the wrong assessment of WireCard as a healthy and financially sound company became obvious. It turned out that the astronomical growth of WireCard has been a fake and that the company has cooked its books over years. First investigations showed that about the half of WireCard’s clients did not exist and that about a quarter of its earnings have been fictional (Holtermann 2022). This raises the question of how a company can engage in fraudulent behaviour for so many years without intervention of supervising authorities. In this vein, mainly the German financial supervisory authority BaFin has been criticized for not taking action. But also the lacking oversight of WireCard’s supervisory board became a point of critique in the analysis of the WireCard debacle. Again, other observers mainly blamed the role of the auditing company EY, having approved the financial statements of WireCard over years without complaints. Finally, also the role of leading politicians was questioned, especially the role of the German Chancellor Angela Merkel who has advertised the company as the leading German FinTech company on several occasions on international travels (Behringer 2022, 174). In fact, the scandal was caused by a complex interplay of different factors ranging from a too optimistic view of financial analysts over the lacking oversight of supervisory authorities and accountants ignoring the weak governance structures and incomplete reporting at WireCard to political interventions curbing the speculation of short sellers. Furthermore, the biased media reporting in Germany aimed at shielding the seemingly FinTech-star WireCard from negative reporting from abroad, namely the allegations of the Financial Times, and was promoted by a kind of ‘wishful thinking’ that WireCard should become the German flagship on the international market for financial service providers. In this vein, governance aspects and unclear financial statements at WireCard have been ignored

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systematically by supervising authorities and monitoring agencies, since ‘it cannot be what may not be’. But why ‘the watchdogs didn’t bark’? Given the prominence of financial supervision for sustainable development of the financial markets, the question arises how structural reforms of the supervising authorities emphasizing the control of governance structures at the DAX listed companies may help to prevent the reiteration of similar financial scandals. Furthermore, we want to ask whether the strengthening of sustainability aspects in the fund management might help to protect investors against financial losses. To answer these questions the remainder of the article is structured as follows: In the following paragraph, we will provide a brief sketch of the rise of WireCard as a German FinTech company that has received much attention especially in Germany. In a next step, we briefly will outline the history of the so-called WireCard scandal and then analyse the failures of the supervising authorities. In this vein, we try to explain why they did react only lately to the obviously wrong financial statements of the company and have turned a blind eye on the inconsistencies in the financial statements over years. We will conclude with a short outlook with regard to the efficiency of recommended preventive measures for avoiding similar financial scandals in the future and for securing sustainable financial investments.

2 The Rise and Fall of a German FinTech-Star WireCard was founded in 1999 as a payment processor enabling credit card payments via Internet and in less than 20 years developed from a small start-up enterprise to a great and globally acting corporation that was admitted in 2018 to the German share index DAX 30. After a first crisis in 2001, the company merged with its former rival Electronic Business Systems in 2002 and was consolidated in the following years under the leadership of CEO Markus Braun, a former KPMG consultant (Weiguny and Meck 2021, 40–49). While at the beginning, online payments were mainly a niche-product for pornographic pay sites and online gambling, steadily growing numbers of online shopping platforms enabled the company to extend its business also to serious clients and thus profiting from the overall boom of the E-commerce (Haaker and Thamm 2022, 159). Although payment processing in the so-called adult-entertainment business remained a business line for WireCard likewise in the following years, the company steadily expanded its business to other market areas of online trading and developed to a global player of Internet-based financial technologies and financial services. In 2005, WireCard went public by taking over a stock exchange listed call centre group. This merger allowed WireCard to avoid the otherwise obligatory legal and economic examination of its readiness for the stock exchange in the course of a regular initial public offering (Löw and Kunzweiler 2021, 13). In September 2006, WireCard was included in the German technology index Tec-DAX. From this point onwards, WireCard was nominally one of the 30 most important technology companies in Germany (Bergermann and ter Haseborg 2021, 61–62).

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In its early years, the core business of WireCard was only the processing of electronic payment transactions in online trading. Till 2006, WireCard provided only technical services for online payment processing between merchants and buyers charging a commission for the transactions. When a customer paid online with his credit card using WireCard’s online payment system ‘Wirecard Gateway’ the company transmitted the payment data to the acquiring bank of the online trader, which then charged the credit card of the customer. This fundamentally changed in 2006 when WireCard acquired the XCOM Bank AG, renamed then WireCard bank, and thus received its own bank licence. Now the company was able to function also as acquiring bank, which transmitted payments from buyers to vendors. When a client now bought in the Internet, his payment was first received by WireCard bank and was then forwarded to the vendor’s bank. Since the buyer was able to reclaim his money when she was dissatisfied with the product, WireCard bank had to hold securities for paying back the purchasing price to the buyer. This money was hold at escrow accounts to buffer the risk. For this service, WireCard charged its customers with a commission rate of about 2.5% of the revenues (Karami 2022, 3–9). Due to its comparatively high commission rate up to nearly ten per cent, online gambling at this time was one of the cash cows of the company. When online gambling became more strictly regulated by the US government in 2006, WireCard circumvented the new regulations with the help of its subsidiary Click2Pay. With the help of Click2Pay the company could process payments for credit card providers like Mastercard in such a way that it looked for the providers as if the cards were charged for payments at regular shops, like for example flower shops. With this so-called flower shop business WireCard enabled US citizens to continue gambling on the Internet beyond 2006 and carried out transaction worth of more than one billion euros in 2009 (Bergermann and ter Haseborg 2021, 81–82). However, the US government reacted and closed this loophole. On the so-called Black Friday in April 2011, the US Department of Justice seized the assets of the three major gambling companies ‘virtually overnight’ and closed their websites. At that time, according to the Bundestag investigative committee’s hearing, the profits from gambling in the US had accounted for at least 90% of WireCard’s profitability (Deutscher Bundestag 2021a, 143). Against the background of this situation, Jan Marsalek, who has joined the board as new COO in 2010, implemented a new business strategy of WireCard. The strategy aimed at staging an impressive story of international growth and success and communicating this to the company’s shareholders, capital providers and auditors to attract new investors. Correspondingly, he was engaged in expanding the company’s broking business by buying several payment service providers in Singapore and the Philippines but also in India and Dubai (Karami 2022, 3–9). Since WireCard had no bank licence for the Asian countries its affiliates functioned as third-party acquirers which acted as broker between the seller’s and the buyer’s bank earning a service commission which was paid to escrow accounts in Singapore and the Philippines to buffer the financial risks of the third-party acquirers (Karami 2022, 3–9). This new business strategy turned out to be very successful, and WireCard was able to present ever-increasing numbers. Between 2012 and 2018, company’s

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revenues increased from 364 million euro to over two billion euro and profits raised from 109 to 560 million euro (Karami 2022, 9). In the public WireCard was perceived as rising star of the German FinTech industry, and correspondingly experienced benevolence both from established politics and from the public media. While the market value of WireCard shares at the year-end closing price was 10.19 euro in 2010, in September 2018 its market value reached a maximum of 195.75 euro per share (Wirecard 2019, 25). Although the Financial Times started to issue several critical reports questioning the rapid growth of WireCard and mentioned several inconsistencies in the group’s accounts in 2015, WireCard became one of the most beloved shares of Germany’s biggest equity funds and was recommended for buy by prominent analysts. To underpin its credibility WireCard argued that the allegations are part of a complot and that short sellers, speculating against the company, have paid for the reports. In the following BaFin, the German financial supervisory authority, started investigations for alleged market manipulation against several groups of short sellers and issued a short selling ban to protect the company against short selling practices in 2019. To refuse allegations of balance sheet manipulation, WireCard referred to the positive audit results of the accountant firm EY that have emphasized the credibility of the company’s business practices by clean audits since 2008. When EY issued its positive audit of 2017, WireCard shares reached a new peak at the stock market and were included in the DAX 30 list in the following. However, due to critical reporting the pressure on the company steadily increased. While the company continued to announce successful business deals as, for instance, a 900 million euros investment from the Japanese SoftBank in 2019, first investigations against the company’s affiliates were initiated in Singapore at the same time. To underpin its credibility anew the company now was forced to take action and hired the accounting firm KPMG for conducting a forensic audit aiming at clarifying the allegations of financial manipulations. The results were published on 27th of April 2020 and became a disaster for WireCard. The allegations of KPMG included among others phony business relations, forged bank accounts and balance sheet manipulations (Karami 2022, 12–14). As a consequence of the KPMG report WireCard’s market value dropped by 61% in 1 day. In between 3 days, WireCard shares lost 85% of its market values representing nine billions euros (Lehrbass et al. 2022, 90). On 18th of June 2020, Markus Braun as the CEO of WireCard admitted publicly that a sum of about 1.9 billion euro that has been reported as company asset in the annual financial statement of the corporation in 2019 is fictitious and factually does not exist. On 25th of June 2020, WireCard declared insolvency due to overindebtedness. The collapse of one of the biggest stock values of the DAX 30 index shocked the financial world in Germany. However, the collapse not only was a financial disaster for private investors and investment funds alike; it also was the first time that a DAX 30 company went bankrupt. Especially, fund managers of the allegedly under ESG criteria managed funds like ‘DWS Deutschland’ or ‘DWS Investment German Equities’ came under pressure to explain their investment decisions. Equally, the recommendations of professional market analysts, issuing buy recommendations until shortly before the collapse turned out to be less ‘professional’ than private

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investors following these advices might have expected. Given the public criticism of WireCard’s business practices and its opaque business structures the question arises how the company could reassure even professional fund managers over years and create the appearance of solvency and financial stability. To explain this, we want to show how this critique was downplayed in the German business world, how red flags have been systematically ignored and how due diligence has been neglected in the following section.

3 From Initial Doubts to Massive Suspicion Initial doubts concerning the questionable accounting practices at WireCard have been formulated already in 2008 when the Schutzgemeinschaft der Kapitalanleger e.V. (SdK), a German shareholder association, criticized dubious mergers and acquisitions of the company (Magenheim-Hörmann 2020). The shareholder association criticized the deeply non-transparent style of reporting and balancing of WireCard and put in question the seemingly high profitability of the company’s operations. However, WireCard silenced its critics by threatening SdK with legal actions. The case became even more delicate when it turned out that some of the board members of SdK have speculated on falling courses of WireCard shares. This enabled WireCard to downplay this criticism as an endeavour of some adventurers trying to manipulate courses for personal gains (ibid.; Romeike 2020). In the same year, WireCard appointed EY to check its books and thus profited from the reputation of an apparent serious and honest auditing company in the following years. In 2015, anew allegations were made against the company. A series of articles published within the Financial Times, entitled ‘House of WireCard’, pointed out discrepancies in the WireCard balance sheets and questioned the astronomic growth of the company. In February 2016, a report on possible incidents of corruption, fraud, money laundering at WireCard and even involvement in illegal gambling was published online by an anonymous group named ‘Zatarra Research’. Following this publication, the WireCard share price fell by around 25% (Bundesministerium der Finanzen 2020). Again, WireCard succeeded with stopping the criticisms under criminal law. The story presented by WireCard was nearly the same as in 2008: Even the Financial Times’ reports are part of a conspiracy aiming at market manipulations and paid by a group of short sellers. Interestingly also in this case, with ‘Zatarra’ WireCard could present a group of short sellers speculating against the company. WireCard thus successfully created the picture of being a victim denigrated by a bought press and attacked by a hostile group of short sellers. Instead of investigating the business practices at WireCard, German legal authorities and the financial supervision therefore focused on the allegation of market manipulation and thus created unwillingly a protection screen for further dubious practises at WireCard. While WireCard proceeded with publishing ‘good news’, especially from its Asia affiliates, about its business success, the impression solidified that the German FinTech star is under attack of malicious foreign villains and should be

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protected by policy and legal authorities. This helps, at least partially, to understand why the German financial supervisory authorities resorted to unusual means in 2019 and issued its short selling ban to protect the company against speculation. On 15th of October 2019, just 9 months before the insolvency, the Financial Times again raised allegations of financial manipulation. Internal documents, thus the report of Financial Times, would suggest that WireCard had overstated sales and profits at subsidiaries. WireCard likewise denied these accusations and again presented its ‘we-are-the-victim’ story. However, in this case, Financial Times with the help of a whistle-blower from a WireCard subsidiary in Singapore presented evidences that customers listed by WireCard do not exist and that the company’s profits are faked. Due to the pressure of alarmed investors the supervisory board decided to hire the auditing firm KPMG to check the correctness of the financial statement and thus to refute the allegations on 31st of October 2019. The result of the KPMG investigation was published in April 2020. Therein KPMG stated that it was not possible to analyse all data completely, and that hence it was not possible to completely dispel all allegations. Although the result of the KPMG audit was completely different from what might have been expected by WireCard, WireCard-CEO Markus Braun nevertheless claimed that his corporation is exonerated by the published report. However, WireCard further had to postpone the publication of its annual financial statement of 2019 and the audit report of EY to June, allegedly due to the Corona crisis. Publicly Braun let investors know that EY will have no problems with approving the financial report and will issue a positive audit certificate—as usual. However, in this case he was mistaken. At the beginning of June 2020, the German Federal Financial Supervisory Authority filed charges against Markus Braun and two other members of WireCard’s board of managers on suspicion of market manipulation. On 18th of June 2020, WireCard admitted that the auditing firm EY was unable to identify sufficient evidence of the existence of bank balances in escrow accounts amounting to 1.9 billion euro for the year 2019. On 22nd of June 2020, WireCard announced in an ad hoc disclosure that credit balances in escrow accounts in excess of 1.9 billion euro in all probability do not exist. The next day the long-serving CEO, Markus Braun resigned and was arrested shortly afterwards on charges of falsifying income and market manipulation. In this context, a warrant was also obtained for the arrest of the long-serving COO Jan Marsalek. Marsalek, who was considered Markus Braun’s confidant and ‘right-hand man’, did not turn himself in to the police, but fled abroad. After starting further investigations of the accounting practice of WireCard public prosecutors currently assume that the financial statements have been falsified since at least 2015. Now the brilliant story of success turned out to be a classic case of financial crime. In a widely used definition, financial crime is defined as ‘any kind of criminal conduct relating to money or to financial services or markets, including [amongst others] any offence involving: (a) fraud or dishonesty; or (b) misconduct in, or misuse of information relating to, a financial market’ (Financial Conduct Authority 2023, 59)—and this exactly describes what WireCard has done. Simply put, WireCard’s business policy aimed at communicating an impressive story of corporate success to its investors, capital providers and auditors that did not correspond to

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the facts and was simply a lie. Although the case is not yet fully cleared in all its details, the comprehensive report of the WireCard Investigation Committee of the German Bundestag (Deutscher Bundestag 2021a) in conjunction with the partial confessions of two former WireCard senior managers, already gives a sufficient impression of the deceptive and, in this sense, fraudulent actions carried out within the WireCard Group. Thus, the allegation of financial crime encompasses at least five issues: (1) The first issue concerns the allegation of money laundering related to WireCard’s the so-called flower shop business that enabled US citizens to continue gambling on the Internet beyond 2006; (2) The second issue concerns balance sheet manipulations to conceal the fact of stagnating or declining sales and profit rates of the company from capital providers and investors (Deutscher Bundestag 2021a, 137–138; Steinmann 2022); (3) A third issue concerns the overpriced acquisitions of companies in Asia that mainly served the purpose to disguise of the true financial situation. Additionally, the Asian subsidiaries were used for round tripping transactions via bogus orders enabling the company to record the incoming payments as new revenues (Deutscher Bundestag 2021b); (4) The fourth issue concerns the artificial over-complexity of the company structure being a network of 58 companies. This created the possibility to manipulate annual consolidated financial statements in a way that was not readily comprehensible to third parties (Karami 2022, 3–6; Deutscher Bundestag 2021a, 172); (5) The last issue concerns the third-party acquirers—namely Al Alam Solutions based in Dubai, Senjo Group based in Singapore and PayEasy Solutions based in Manila—that served as vehicles systematically to forge revenues from bogus commission rates. Oliver Bellenhaus, former managing director of the WireCard subsidiary Card Systems Middle East in Dubai, has summed up the WireCard system in a nutshell: ‘We built a company that was real. Except for the sales’ (Verfürden et al. 2022, 44, own translation). Given the wide range of offences listed above, carried out systematically and over years, it is obvious that German legal authorities reacted too late and that financial supervision was insufficient at best. Neither did EY critically examine the financial statements of WireCard nor did supervising authorities react when first suspicions arose. But what could be seen as simple negligence of due diligence and insufficient oversight might also be explained by the wishful thinking of the involved parties. WireCard was hyped for long years as the new star on the firmament of the FinTech market—and it has been a German company. WireCard has been seen as the ‘made in Germany’ answer to PayPal or Amazon and was a subject of ‘national pride’ since WireCard gave the impression of a global player mainly engaged in the evolving Asian markets. This might explain why WireCard not only was protected by German supervising authorities but also received positive media echo of the German press over years and the support of politicians like Angela Merkel. Thus, we want to analyse the motivation of the involved parties in the following section.

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4 National Pride and Failures of the Supervisory Authorities It should be outlined that for creating the impression of growth and expansion WireCard even in its early days needed more money than company sales and profits made available annually. At the latest from the time when online gambling was prohibited on the US market in 2011, the generated profits have not been able to cover WireCard’s expenses. Hence, the company tried to attract additional shareholders and finance providers. To make payment flows more opaque WireCard developed through worldwide company acquisitions a company mesh where for outstanding observers it was very difficult to identify the origin and storage of firm deposits. However, this engagement in emerging markets was not seen as dubious activities but as regular business of an alleged global player. As Stefan Behringer (2022, 175–180) points out, mergers and acquisitions draw attention to the strategic implications and new business opportunities of a company and detract from possible irregularities in the accounting practices. This opens up the pathway to several dubious practices like overpriced acquisitions, phony consultancy contracts or money laundering. Especially acquisitions in remote countries create a specific challenge for accountants and the supervisory board since the prospects of the new affiliates are often difficult to assess. Cultural differences, different accounting practices and country-specific legal regulations complicate a correct valuation. Since in most cases supervisory authorities are not able to visit the new affiliates on site, they are forced to trust the information of the company board about the value and the future prospects of the merger. This not only creates some leeway in the assessment of the acquisition price but also allows a company to hide debts and to fake profits. According to the so-called crime-pattern theory, illegal practices typically occur in the periphery of the company group since it is difficult to observe business activities in remote areas (Benson et al. 2009, 181–182). Seen from this perspective, the engagement of WireCard in India, Singapore, the Philippines and Dubai was a perfect strategy to distract from the fraudulent intentions of this engagement. Hence, among analysts, professional investors and even the interested public, this strategy was praised as a clever business strategy of a successful global player. Since WireCard year by year presented growing revenues and profit margins, mainly from its Asia-Pacific business, nobody really wanted to question this allegedly successful investment strategy. Investors, analysts, supervising authorities as well as the broader public let themselves blind by the beautiful image of the new rising star and were proud about the fact that this was ‘made in Germany’. To show how this erroneous assessment with its disastrous consequences could happen we briefly want to shed some light on the role of some of the supervising authorities whose ignorance enabled WireCard to proceed with its dubious practices over years.

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The Role of Financial Oversight

Financial oversight in Germany is complicated—and inefficient. The control of financial statements involves three institutions with different responsibilities. In the first step the German Financial Reporting Enforcement Panel (Deutsche Prüfstelle für Rechnungslegung, DPR) reviews the correctness of the financial report of capital-market oriented companies and the Auditor Oversight Commission (Abschlussprüferaufsichtsstelle, APAS) controls the correctness of the auditing procedures. In addition, the Federal Agency for Financial Services Supervision (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) monitors financial markets and financial services. This means that DPR and APAS were responsible for the financial statement while BaFin was responsible only for the financial institute of WireCard, the WireCard bank. Furthermore, not financial market activities are monitored by the respective district courts and not by a central governmental agency. Thus, this ‘organized irresponsibility’ of competencies caused a situation where nobody really felt competent to take the first step to investigate WireCard’s business practices seriously. Even in the aftermath of the scandal, the respective authorities denied their responsibilities since they were responsible only for one part of the company and could not see the whole picture (Mayer-Kuckuk 2021). However, it might also be assumed that critical examinations of a German champion like WireCard would have caused turbulences at the markets and hence were not politically desirable (Karami 2022, 47–48). In the case of WireCard this system of financial oversight pitifully failed (Karami 2022, 18). Instead of critically examining the business practices at WireCard, BaFin believed the stories about a ‘foreign attack’ against the German FinTech champion, led by the Financial Times and some groups of short sellers, and initiated criminal proceedings against two journalists of the newspaper, Dan McCrum and Stefania Palma, being responsible for the critical reports about WireCard (Karami 2022, 27–28). However, BaFin went even one step further in its attempt to shield the German FinTech star against its ‘enemies’. On February 18th 2019, BaFin issued a short selling ban to protect the company against short selling practices. In the aftermath of the scandal, this appears like complicity and might be explained only by a political interest to protect a ‘German company’ against international attacks and unfair practices. Without further investigations, BaFin wanted to believe the story and did not ask any critical question. It, therefore, is no coincidence that the European Securities and Markets Authority (ESMA) speaks about a lack of professional scepticism among the German supervising authorities. Such scepticism would have necessitated a more questioning approach when collecting and considering information and driving a conclusion (Lehrbass et al. 2022, 99). Meanwhile, the German legislator has reacted and in 2021 passed a law for fostering financial market integrity (Finanzmarktintegritätsstärkungsgesetz, FISG) which, among others regulates the rotation of the auditing firms after 5 years—for companies of public interest—and 10 years—for other companies. Furthermore, the former two-step process of the financial control is now reduced to a one-step process being the

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responsibility of BaFin alone. Finally, the civil liability of auditing firms has been extended (FISG 2021).

4.2

The Role of the Accountants

In the public discussion after the collapse of WireCard public accusations were made especially against the accounting firm EY which served as accounting firm for WireCard since 2008 and which has approved the financial statements of the company over years without complaints. To investigate which role the accountancy firm played in the collapse of WireCard Martin Wambach, board member of the Institute of Auditors in Germany (Institut der Wirtschaftsprüfer) was nominated as special investigator by the inquiring committee of the German Bundestag. In his report, Wambach outlines that EY lacked a critical examination of the third-party acquirers business in Asia. This is especially critical since the revenues and profits from this business segment dominated the consolidated balance sheet of WireCard since 2014. Furthermore, EY certified transactions that were not backed by traceable business activities. Similar allegations concern the non-existence of the alleged business partners and the question why EY did not verify their existence although they have contributed to the economic success of WireCard in such a disproportionate manner. Finally, the report criticizes the personal linkages between former WireCard employees and the phony Asian companies; thus, for example, the former WireCard employee Christopher Bauer was the founder of PayEasy, a third-party acquirer of WireCard in Manila. These facts should have been obvious to EY and should have led to a more critical attitude in the auditing process (Deutscher Bundestag 2021a, 1757–1760). It is worth noting at this point that the original report has been classified as security matter and first was made publicly available by the German Newspaper Handelsblatt (Karabasz et al. 2022). This sheds some strange light on the transparency endeavours of the WireCard inquiry committee. It can be assumed that the lacking critical distance of EY in the auditing process might have been a result of long-standing business relations with WireCard. Nonetheless, the lax review of the accounting procedures and business practices of the company led to the disastrous misrepresentation of WireCard in the finance world as a sound and healthy company. Given the reputation of EY as one of the ‘Big Four’ accounting firms, the positive certificates made WireCard unimpeachable.

4.3

The Role of Fund Managers and Market Analysts

Due to its positive certificates from EY and its seemingly ever-increasing market value WireCard became one of the most beloved stocks for investment funds and due to the buy recommendations of market analysts also for private investors. As already mentioned above, short before the collapse of the company, WireCard

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became the biggest single stock in the ‘DWS Deutschland’ fund and of ‘DWS Investment German Equities’ (Kirchner 2019a, b, 2020a). When Tim Albrecht, the fund manager at DWS, was asked why he invested disproportionately in WireCard, he referred to the superiority of the FinTech company and the fact that there are little other Tech shares in the DAX listing (Kirchner 2020a). But also other fund managers, like Andreas Mark from Union Investment, were full of praise for the German Fintech star. In an interview in 2019 with the German newspaper Handelsblatt, Mark stated that an end of the growth of WireCard is yet not in sight (Olk 2019). Although he admits that Union Investment observes critically the allegations of money laundering and corporate fraud at WireCard, the fund invested in WireCard on large scale (Kirchner 2020b). With similarly optimistic expectations, analysts like Heike Pauls from Commerzbank issued buy recommendations until just before the collapse of the Fintech giant and discredited critical reports as ‘fake news’ (Zdrzalek 2022). However, this simple ‘best-in-class’ argument of Tim Albrecht and the overoptimistic view of other analysts were quite naïve. Especially in the case of DWS the management had established clear criteria for sustainable finance, which, among others, also included guidelines for assessing the quality of governance structures of the rated firms. Hence, the weak governance structures at WireCard should have attracted the fund managers’ attention at least (Kirchner 2020c). Thus, for instance, the supervisory board at WireCard consisted only of three and since 2016 of five people, most of them not qualified for this job. This is far away from the general precepts of good governance and completely unusual for a DAX 30 company. Furthermore, WireCard did not comply with the standards of the German Governance Codex in many points, which should have caused also deeper investigations of the fund managers and of professional market analysts before issuing buy recommendations. In fact, the ESG policy of the fund management at DWS turned out as greenwashing. When in 2020 Desiree Fixler entered DWS as ESG specialist, she realized quickly that the criteria were simply a public relations gimmick; and when she started to criticize these practices internally, she was dismissed (Landert and Hofer 2021). None of the market analysts really did examine WireCard carefully. This not only sheds some unfavourable light on their professionalism but also questions the credibility of using ESG criteria for a sustainable fund management. Apparently, it was the—obviously wrong—impression that WireCard as a German global player can keep up with international giants like PayPal and Amazon (Lehrbass et al. 2022, 107) and the narrative of the steadily growing FinTech star (Haaker and Thamm 2022, 155) which caused the fund managers to invest overproportionally in WireCard. This impression was backed by political decisions which aimed at protecting WireCard against speculations and which bestowed the company with the special aura of infallibility. Much more could be said, for instance, about the role of the German media neglecting their duty to investigate more critically, about German politicians becoming supporters of the criminal activities of the company, and about public prosecutors ignoring the true facts behind the allegations against WireCard. However, this would not add something new to our analysis. WireCard could happen because so many people were blinded by the glamour of a FinTech star ‘made in Germany’, and

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because so many of them wanted to believe the story of success of the German start up that rose to a global player and an international champion. As Mayer-Kuckuk (2021) has put it: The responsible actors have been mesmerized by this aura of success and by the promises of an ever-increasing growth. This might partially explain the arrogance and hubris among WireCard managers who were aware about the prominent role of their company in the corporate world of Germany and widely used this to shield the fraudulent activities form allegations. Fahmi Quadir, invited as an expert in the investigation commission of the German Bundestag, quoted former COO Jan Marsalek with the words: ‘We have so much money that we can get away with anything. We are so important for the German government that every time when a disaster strikes, the next day it looks like as if it never has happened. I have never experienced anything like this’ (Deutscher Bundestag 2021a, 165, own translation).

5 Conclusion: The Sustainability of Sustainable Finance The story of WireCard is simply told. Like in many such cases, it is a story of hubris, self-enrichment and greed. It is a story of manipulations, phony accounts and falsification. However, what makes the case unique is that so many people wanted to believe what obviously was a fake. In our opinion, WireCard could proceed with its practices for at least three reasons. Firstly, WireCard was very successful in aggressively tackling and muzzling its critics. Surprisingly, it repeatedly succeeded with addressing accusations of market manipulation to its critics in a way that motivated supervising and political agencies to give shelter to the uprising and promising German FinTech star. WireCard created the picture of a German hero fighting against foreign enemies. Thus, it became a ‘national task’ to defend WireCard from malevolent attacks from foreign countries. Such partiality of the supervising authorities led to wrong judgements and biased valuations. In this vein, even more elaborated supervisory rules are insufficient since this might not hinder the partiality of the supervisors, and this leads to the age-old question: quis custodiet ipsos custodes? Thus, even the demand for more professional distance and critical attitude, as made, for example, by ESMA, will be of little use when actors are prejudiced and act in the supposed interest of a ‘higher cause’, i.e. the national interest. Secondly, the famous auditing firm EY being employed to review the financial statements of WireCard repeatedly did a bad job with view to its task. Also vis-à-vis the auditing firm WireCard’s board of managers was able to set both the auditors and its own supervisory board under pressure not to question the financial integrity of foreign business transactions of the firm. Irrespective of whether EY acted credulous or negligent, the long-standing business-relation between EY and WireCard limited the professional distance one should expect from an external auditor. Given the fact that supervisory board and external auditors are base lines in the defence against fraudulent practices in a company, in the case of WireCard this system has failed. In

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this vein, it has been proposed that a rotation system of external auditors would help to maintain their critical distance vis-à-vis the audited company. However, as long as auditors are paid by companies, and as long as companies are free to choose their auditors, such rotation might not help too much since competition forces auditing firms, at least to some extent, to review in favour of the audited company. Last not least, professional investors and market analysts played a significant role in the rise of WireCard and this is often neglected in the analysis of the case. Especially in the last years of the company, analysts hyped WireCard shares on the market. Irrespective of whether this was due to pure speculation or whether analysts really believed in the fairy tale of the infallible company presenting everincreasing numbers every year, the question arises which role professional investors should play on the markets. Given the fact that especially DWS had publicly stated to have about 75% of its investment volumes managed under ESG criteria this turned out to be a deception of the investors. It therefore is somehow unintelligible why the legal reforms, enacted after the scandal, remained comparatively opaque with regard to stricter rules for fund management. If investment companies are allowed to define for themselves what they call ‘sustainable’, such lax regulations enable fund managers to label sustainable what is not sustainable. In this vein, uniform regulations concerning ESG criteria and a monitoring system for controlling the compliance with such established rules seem to be overdue. Whether the legal reforms in Germany aiming at monitoring financial markets more efficiently will be successful, will turn out in the future. However, several observers, like Behzad Karami who has extensively analysed the case and the concomitant new regulations in German law, doubt that such new legislation will prevent criminals from wrongdoing (Karami 2022, 72). In fact, criminals will always find new loopholes and develop innovative strategies for conducting criminal activities.

References Barth U (2021) Ex-Nachhaltigkeitschefin erneuert ihre Vorwürfe gegen die DWS. Finanzbusiness. https://finanzbusiness.de/nachrichten/banken/article13244219.ece (2022-08-14) Behringer S (2022) Mergers and Acquisitions als Ausgangspunkt und Verschleierungsinstrument illegaler Transaktionen. In: Karami B (ed) Skandalfall Wirecard: Eine wissenschaftlich fundierte interdisziplinäre Analyse. Gabler, Wiesbaden, pp 173–200 Benson ML, Madenson T, Tamara D, Eck JE (2009) White-collar crime from an opportunity perspective. In: Simpson S, Weisburd D (eds) The criminology of white-collar crime. Springer, New York, pp 175–194 Bergermann M, ter Haseborg V (2021) Die Wirecard Story - Die Geschichte einer Milliardenlüge. Finanzbuchverlag, München Bundesministerium der Finanzen (2020) Sachstandsbericht und Chronologie WireCard. https:// www.bundesfinanzministerium.de/Content/DE/Standardartikel/Themen/Internationales_ Finanzmarkt/Finanzmarktpolitik/2020-07-17-Sachstandsbericht-Wirecard.pdf? __blob= publicationFile&v=3 (2022-08-22)

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Mayer-Kuckuk F (2021) Wenn der Staat an Märchen glaubt. taz. https://taz.de/Ausschuss-zuWirecard-Skandal/!5762355/ (2022-08-18) Olk J (2019) Ein Ende des Wachstums bei Wirecard ist nicht in Sicht. Handelsblatt. https://www. handelsblatt.com/finanzen/banken-versicherungen/banken/fondsmanager-mark-im-interviewein-ende-des-wachstums-bei-wirecard-ist-nicht-in-sicht/24465452.html (2022-08-17) Peemöller V, Krehl H, Hofmann S, Lack J (2020) Bilanzskandale: Delikte und Gegenmaßnahmen. ES-Verlag, Berlin Romeike F (2020) Die Wirecard-Story. RiskNet—The Risk Management Network. https://www. risknet.de/themen/risknews/die-wirecard-story/ (2020-08-18) Steinmann T (2022) Betrugsskandal—Was die Ermittler über den WireCard-Betrug wissen. Capital. https://www.capital.de/wirtschaft-politik/was-die-ermittler-ueber-den-wirecard-betrugwissen-31703714.html (2022-09-02) Verfürden M, Bender R, Holtermann F, Iwersen S, Nagel L-M, Votsmeier V (2022) Inside WireCard—“Es war ein supergeiles Leben”. Handelsblatt print: No. 65/2022 from 01.04.2022, pp 44–51 Weiguny B, Meck G (2021) Wirecard. Das Psychogramm eines Jahrhundertskandals. Goldmann, München WireCard (2019) Transition to tomorrow—Geschäftsbericht 2018. https://www.wirecard.com/wpcontent/uploads/2020/11/Jahresfinanzbericht-2018.pdf (2022-09-01) Zdrzalek L (2022) Nun doch: Wirecard-Analystin Pauls verlässt Commerzbank. WirtschaftsWoche. https://www.wiwo.de/unternehmen/banken/insolventerzahlungsdienstleister-nun-doch-wirecard-analystin-pauls-verlaesst-commerzbank/28487870. html (2022-08-18)

Michael S. Aßländer is professor for business ethics at the International Institute of the Technical University Dresden (Germany). From 2005 to 2010, he held the Plansecur Endowed Chair for business ethics at the University of Kassel (Germany). His research encompasses business ethics, corporate citizenship, corporate social responsibility, history of political economy, and social history of labor. He was co-editor (with Sarah Hudson) of The Handbook of Business and Corruption: Cross-Sectoral Experiences (Emerald, 2017). Eckhard Burkatzki is adjunct professor at the Chair of Social Sciences at the TU Dresden— International Institute Zittau (Germany). His current research interests are: sociology of economic crime, sociology of economic rationality, and triangulation of qualitative and quantitative research methods. He has published Kriminalität im Marktkontext—Eine institutionentheoretische Untersuchung zu sozialen Ursachenwirtschaftskriminellen Handelns. Rothenburg: Schriftenreihe der Sächsischen Polizeihochschule (2015).

Reducing Financial Crime Convenience for Sustainable Finance. A Case Study of Danske Bank in Estonia Petter Gottschalk

1 Introduction Corruption payments from the Icelandic fishing corporation Samherji traveled via the Norwegian bank DNB to state officials in Namibia to obtain fishing rights off the coast of Namibia (Kleinfeld 2019, 2020: Seljan et al. 2019). According to Reuters (2019), Samherji transferred more than $70 million through a shell company in the tax haven Marshall Islands from 2011 to 2018. Samherji transferred the money through bank accounts in DNB. The bank’s largest shareholder is the Norwegian state, which holds 34% stake in the bank (Kibar 2020). The Panama Papers consisted of 11.5 million leaked documents that detailed financial transactions and attorney-client information for more than 214,000 entities in tax havens. Law firm Mannheimer Swartling (2016) was hired by the Swedish bank Nordea to investigate allegations of tax evasion. They found illegal backdating of contracts by Nordea wealth management in Luxembourg. Non-resident Russian bank clients had the opportunity to launder money in branch offices of Scandinavian banks Swedbank and Danske Bank in Estonia, Latvia, and Lithuania. While law firm Bruun Hjejle (2018) conducted an internal investigation at Danske Banik, law firm Clifford Chance (2020) conducted an internal investigation at Swedbank. One outcome of the investigations was that chief executives had to leave their positions. Corruption, tax evasion, and money laundering as presented here are just three examples of financial crime involving financial institutions. This chapter presents a case study of Danske Bank activities in Estonia by application of convenience theory. Reducing financial crime convenience is a matter of financial motives, organizational opportunities, and willingness for deviant P. Gottschalk (✉) BI Norwegian Business School, Oslo, Norway e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_16

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behavior. Reduction in crime convenience is thus a matter of reduction in motives, reduction in opportunities, as well as reduction in willingness (Braaten and Vaughn 2019; Dearden and Gottschalk 2020; Stadler and Gottschalk 2021; Vasiu 2021; Vasiu and Podgor 2019). Reduction in crime convenience contributes to sustainable finance, where sustainable finance represents “the assimilation of sustainability aspects into standard risk and return calculus associated with investment decision making” (Ionescu 2021: 95), while “sustainability as a way to improve environmental and social conditions is neither an easy task nor a subject to debate on” (Paun and Pinzaru 2021: 280). While “research on sustainable finance is traditionally considered to be the domain of economists” (Kuhn 2020: 1), the case study in this chapter is in the domain of criminologists with the organization rather than the individual or the society as the main unit of analysis.

2 Danske Bank Wealth management is a profitable service for most global banks where they take care of money values for affluent individuals, families, and firms. It is a banking service which incorporates structuring and placement of wealth to assist in preserving and protecting owner fortunes. Often, wealth management involves secrecy by placement in tax havens. Therefore, suspicions of tax evasion and money laundering are often associated with wealth management. Recent scandals involving Danske Bank in Denmark (Bruun Hjejle 2018), Swedbank in Sweden (Clifford Chance 2020), and Nordea bank in Sweden (Mannheimer Swartling 2016) have provided evidence of criminal market structures in the banking sector. While the cases involving Danske Bank and Swedbank in money laundering were detected and reported by whistleblowers, the case involving Nordea in tax evasion was detected and reported by the Panama Papers. This chapter concentrates on the case of Danske Bank involved in money laundering in Estonia, while returning to the issue of criminal market structures in the banking sector toward the end of the chapter. Danske Bank is the largest financial institution in Denmark with focus on the Nordic region and presence in sixteen countries. Danske Bank is listed on the Nasdaq OMX Copenhagen stock exchange. The bank offers financial services, life insurance and pension, mortgage credit, wealth management, real estate, and leasing services.

3 Money Laundering Local law firm Bruun Hjejle (2018) investigated suspicion of money laundering at Danske Bank in Denmark. The suspicion focused on activities at Danske Bank’s branch office in Estonia. Danske Bank paid 210 million Danish kroner (about US$30 million) for the investigation by the law firm. The investigative knowledge strategy included mainly knowledge workers with legal training at Bruun Hjejle. In addition,

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forensic experts from PwC and Ernst & Young were assisting the law firm based on accounting and auditing knowledge, and the international data management software company Palantir Technologies deployed its software platform to integrate and enable analysis of the comprehensive magnitude of customer, transaction, and trading data available. CERTA Intelligence and Security was also assisting in these investigative tasks. The fraud examiners investigated thousands of customers and millions of transactions as well as trading activity. They examined the now terminated non-resident portfolio in the Estonian branch from the time of Danske Bank’s acquisition of Sampo Bank completed in 2007 until the termination of the non-resident portfolio in late 2015, with some accounts closing in early 2016. The main focus was on the customers in the non-resident portfolio and their payments and trading activities during this period. The employees and agents of the Estonian branch who handled the non-resident portfolio or could otherwise have been involved were also investigated to uncover potential internal collusion. The fraud examiners followed the guide on investigations issued by the Association of Danish Law Firms as well as the code of conduct issued by the Danish Bar and Law Society. The investigation was assisted by Danske Bank’s compliance incident management team as well as the Estonian branch’s IT department. Identified data included 87 million payments for all customers at the Estonian branch, which were transferred into Palantir’s software platform to store, structure, and enable data analysis. Relevant external data from other sources than the Estonian branch were also identified, collected, and ingested into the software platform. The fraud examiners conducted a large number of interviews with relevant persons. For preparation of interviews, they engaged consultants from Promontory. Interviews were conducted with employees, including members of the executive board in the bank as well as members of the board of directors. 49 individuals were interviewed, and a total of 74 interviews were conducted as part of the investigation. All interviews were conducted in accordance with rules on due process. The fraud examiners did let suspects and others comment on their findings (Bruun Hjejle 2018: 20): Based on all collected information, the conducted interviews and observations, Bruun & Hjejle assessed the potential institutional and individual accountability. All individuals subject to individual assessment were given the opportunity to review a draft assessment together with relevant material. Also, other individuals with knowledge of the events relevant to the accountability investigation, but not subject to individual assessment, were given the opportunity to review relevant material. Comments and proposed amendments received were subsequently evaluated and reflected where deemed appropriate.

One of the reasons why corporate control functions did not work was because the branch operated computer systems different from computer systems at the headquarters where internal audit functions only could operate on the latter systems. Not only was the IT platform different, but local bank executives also operated in the local language which executives from the headquarters did not understand. Money laundering is the process of removing illegitimate proceeds from attachment to crime such as drug trade and trafficking and introducing the proceeds in the

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legal economy such as real estate and business enterprises. Danske Bank was such a financial institution used by organized criminals and others to delete traces of the origin of large sums of money. Especially in Danske Bank’s branch office in Estonia, proceeds were transferred from Russian oligarchs and the Russian mafia, state officials in Azerbaijan, weapon smugglers in Ukraine, criminals in Pakistan, and other suspected places of origins (Hecklen et al. 2020). Chief executive Thomas Borgen at Danske Bank had ignored rumors and whistleblowers regarding money laundering in the Estonian branch, where most of the money came from Russian oligarchs and organized criminals. Borgen had to resign from his position when the Bruun Hjejle report was published. Later, he was investigated by Danish police and sued by Danske Bank shareholders (Corcoran 2019; Milne 2019a; Milne and Binham 2018; Sivertsen 2018; Moscow Times 2017). The body of Danske Bank’s former Estonian chief Aivar Rehe, who was at the heart of the 200 billion € money-laundering scandal, was “found dead in an apparent suicide” in September 2019 (Milne 2019b).

4 Financial Motive Wealth management is a profitable business for financial institutions. Especially Russian oligarchs and Russian organized criminals are willing to pay substantial bank fees to remove their funds out of Russia and into European banks where the political situation is stable, and the banking sector is predictable. By moving their wealth into the Western banking systems, wealthy Russians and others can also remove traces of the origins of their funds. For Danske Bank, this was thus possibilities for extraordinary corporate profits as indicated in Fig. 1. The financial motive for Danske Bank was to make money in Estonia by providing financial services to citizens and enterprises in Eastern Europe. A business enterprise is always looking for attractive corporate economic possibilities. Profitdriven crime is a result of a desire for more gain (Naylor 2003). We thus develop an understanding of profit-driven crime in mainly economic rather than in sociological terms. The profit-driven crime prospective suggests a typology that shifts the focus from actors to actions. Rather than focusing on profit-driven crime as a logical sequence of actions, it deconstructs the crime into its inherent characteristics, which differ radically according to whether an offense is predatory, market-based, or commercial in nature. Among the main characteristics is whether transfers of property occur by force, free-market exchange, or fraud, whether those transfers involve redistribution of wealth, distribution of income, or redistribution of income; and whether the crime occurs in a non-business, underground network, or legitimate business setting. The profit-driven crime perspective answers the how-question, rather than who-question or why-question concerned with white-collar crime. In his perspective of profit-driven crime by Naylor (2003), predatory offences involve redistribution of existing legally owned wealth from one party to another. Marked-based offences involve evasion of regulations, taxes, and prohibitions.

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Fig. 1 Convenience themes for Danske Bank money laundering

Commercial offences involve illegal methods to distribute goods and services. Predatory crime involves the illegal redistribution of existing wealth, market-based crime involves the illegal earning of new income, and commercial crime involves the illegal redistribution of legally earned income. Wealth refers to a stock of assets that accumulates or deteriorates over time, and wealth measurement takes place at a specific point in time. On the other hand, income refers to a flow of value per unit of time. Predatory crime is crime purely of redistribution of existing wealth. Examples include bank fraud and embezzlement. Marked-based crime is crime of distribution of new income. Examples include tax evasion and here money laundering. Convenience theory emphasizes that a white-collar offense is a crime-by-choice, where legal means less conveniently might enable satisfaction of needs. Convenience theory stresses that there are always alternatives to crime. The theory thus contradicts one part of Berghoff and Spiekermann’s (2018: 291) definition of whitecollar crime, where white-collar crime is an illegal act “to secure financial returns that cannot be collected by legal means.” While sometimes almost impossible, there

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will always be avenues available for legal paths to reach goals in more stressful and painful, yet legitimate ways. Motivation plays a central role in convenience theory insofar as it is convenient for corporations to expand possibilities for success by pursuing illegitimate financial gain when legitimate alternatives are less attractive and threats to success (Langton and Piquero 2007), or threats of detection and punishment can be easily avoided (Naylor 2003). Similarly, offenders may save time and energy while avoiding possible uncertainty or pain if they choose illegitimate over legitimate opportunities to climb the hierarchy of needs for status and success (Maslow 1943), to avoid failure or a fear of falling (Bucy et al. 2008), to realize the American dream of prosperity for local bank executives in Estonia (Schoepfer and Piquero 2006), to satisfy the need for acclaim as narcissists (Chatterjee and Pollock 2017), or to restore the perception of equity and equality (Leigh et al. 2010). Thus, convenience theory offers a unique theoretical integration of multiple perspectives of offender motivations for illegal behavior. Figure 1 illustrates that local Danske Bank executives had individual motives in addition to corporate motives. Goal setting is a common practice in the field of organizational behavior, where the pursuit and achievement of ambitious and high-performance goals tends to encourage unethical behavior (Welsh et al. 2019). The possibility of extra profit resulting from financial crime enables the offender to emphasize desired outcomes over feasible threats, including detection and punishment. It is the convenience associated with extra profit, rather than the convenience of illegal profit, that is important in the motive dimension of convenience theory. However, under certain circumstances, additional benefits may result from pursuing illegal extra profit rather than legitimate extra profit in general, since illegal funds avoid the attention of external and internal control mechanisms, including corporate compliance functions (Kawasaki 2020). Illegitimate financial gain can thus find its ways into pursuing desired outcomes and avoiding threats that funds obtained legitimately cannot. This phenomenon is at the core of convenience in the motive dimension of convenience theory.

5 Organizational Opportunity Controls and guardianship did not work at the branch office because of a separate IT platform with computer systems designed and programmed in software that the headquarters did not understand. This convenient concealment mechanism is illustrated in Fig. 1 by decay and chaos. Corporations have unique opportunities to engage in white-collar crime, but the link between crime and opportunity remains an underexplored area of criminology (Schnatterly et al. 2018). A convenient opportunity arises when individuals or groups may be enabled to engage in illegal and unethical behavior with the reasonable expectation that they may avoid detection and punishment. Individuals can have convenient access to resources and contexts in which financial crime can be easily

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perpetrated, obfuscated, and explicitly concealed, particularly in organizational contexts. For example, Benson and Simpson (2018) suggested that convenience to commit white-collar crime is derived through legitimate access to premises and systems, spatial separation from the victim, and the appearance of legitimacy. Similar theoretical perspectives integrated into the opportunity dimension of convenience theory include having specialized access to routine activities (Cohen and Felson 1979), blaming others through misleading attributions (Eberly et al. 2011), and institutional deterioration with lack of guardianship (Rodriguez et al. 2005). Within the convenience perspective, a typical white-collar offender might also be less likely to attempt avoiding detection using the same approaches and techniques of a typical street offender. Rather, office offenders would be expected to conceal financial crime among legal transactions to make illegal conduct appear legitimate. Similarly, the offender may conceal financial crime by removing certain activities from records. A typical white-collar offender with convenient and legitimate access to commit crime is more likely to exert most energy disguising crime in the professional context (Huisman and Van Erp 2013; McClanahan and South 2020). Social disorganization is the inability of an organization to realize common values of its members and maintain effective social control. Social disorganization implies that the ability of social bonds to reduce delinquent behavior is absent (Forti and Visconti 2020; Hoffmann 2002; Onna and Denkers 2019). Differential reinforcement of crime convenience develops over time as individuals become vulnerable to various associations and definitions conducive to delinquency. Both Danske Bank in Denmark (Bruun Hjejle 2018) and Swedbank in Sweden (Clifford Chance 2020) had branch offices in Estonia where organized criminals from Russia conducted money laundering because of social disorganization between bank headquarters and local branch offices. As a result, Danske Bank and Swedbank made conveniently extra, yet illegitimate, profits.

6 Deviance Willingness Justification and neutralization characterize the perception of innocence among offenders at Danske Bank. Neutralization techniques were described in the previous case study about Telia. Justification can be based on a perception of acts of wrongdoing being morally justifiable (Schnatterly et al. 2018), being based on upper echelon information selection (Gamache and McNamara 2019), and peer pressure (Gao and Zhang 2019). The slippery slope perspective suggests that a business can slide over time from legal to illegal activities without really noticing. The small infractions can lead to the larger ones. An organization that overlooks the small infractions of its employees creates a culture of acceptance that may lead to its own demise (Welsh et al. 2014). The slippery slope perspective applies to a number of situations, such as seventeenth century England, where “unregulated overseas trade was a slippery slope to fraud”

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(Pettigrew 2018: 313). Arjoon (2008: 78) explains slippery slope in the following way: As commonsense experience tells us, it is the small infractions that can lead to the larger ones. An organization that overlooks the small infractions of its employees creates a culture of acceptance that may lead to its own demise. This phenomenon is captured by the metaphor of the slippery slope. Many unethical acts occur without the conscience awareness of the person who engaged in the misconduct. Specifically, unethical behavior is most likely to follow the path of a slippery slope, defined as a gradual decline in which no one event makes one aware that he or she is acting unethically. The majority of unethical behaviors are unintentional and ordinary, thus affecting everyone and providing support for unethical behavior when people unconsciously lower the bar over time through small changes in their ethical behavior.

Welsh et al. (2014) argue that interpretation of many recent scandals as resulting from a slippery slope makes sense, in which a series of small infractions gradually increase over time. Committing small indiscretions over time may gradually lead people to complete larger unethical acts that they otherwise would have judged to be impermissible. The slippery slope perspective is in contrast to individual perspectives such as the standard economic model of rational choice. Psychological and organizational processes shape moral behavior, where individuals are motivated to view themselves in a positive manner that corresponds with their moral values. Individuals tend to rationalize minor unethical acts so that they may derive some benefit without feeling the burden of negatively to update their self-concept. For example, a minor transgression such as taking a pen home from the office may seem permissible, whereas taking money out of the company cash drawer more clearly may become stealing in the minds of observers (Welsh et al. 2014).

7 Criminal Market Recent scandals involving Danske Bank in Denmark (Bruun Hjejle 2018), Swedbank in Sweden (Clifford Chance 2020), and Nordea bank in Sweden (Mannheimer Swartling 2016) have provided evidence of criminal market structures in the banking sector. The current review of the banking sector was limited to Scandinavia, where the largest Norwegian bank DNB was involved in money laundering of corruption payments from Iceland to Namibia (Kleinfeld 2019, 2020; Seljan et al. 2019). The largest banks in Scandinavia—Danske Bank in Denmark, DNB in Norway, and Nordea and Swedbank in Sweden—were thus all involved in recent criminal market activities (Amundsen 2021). While the cases involving Danske Bank (Bruun Hjejle 2018) and Swedbank (Clifford Chance 2020) in money laundering were detected and reported by whistleblowers, the case involving Nordea in tax evasion was detected and reported by the Panama Papers (Mannheimer Swartling 2016), and the corruption payments through DNB were detected by investigative journalists at Al Jazeera (Kleinfeld 2019, 2020) and the

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Icelandic national broadcasting service (Seljan et al. 2019). A criminal banking sector in Scandinavia is probably no exception from banking sectors elsewhere in the world. While the case of Danske Bank has been presented above, a short review of the other Scandinavian cases is presented below. Starting with DNB in Norway, the broadcasting corporation Al Jazeera investigated allegations and published the report entitled “Anatomy of a bribe: A deep dive into an underworld of corruption— An Al Jazeera investigation into the corrupt power brokers and global business elites defrauding the Namibian people” (Kleinfeld 2019). The alleged corruption payments from the Icelandic fishing corporation Samherji traveled via the Norwegian bank DNB to state officials in Namibia to obtain fishing rights off the coast of Namibia (Amundsen 2021; Schultz 2019; Schultz and Trumpy 2019a, b). According to Reuters (2019), Samherji transferred more than $70 million through a shell company in the tax haven Marshall Islands from 2011 to 2018. Samherji transferred the money through bank accounts in DNB. The bank’s largest shareholder is the Norwegian state, which holds 34% stake in the bank (Ekroll et al. 2019; Kibar 2020). The scandal at Swedbank in Sweden was similar to the scandal at Danske Bank in Denmark. It was all about money laundering convenience for non-resident Russian clients. While CEO Thomas Borgen had to leave his position when the investigation report by Bruun Hjejle (2018) was published, CEO Birgitte Bonnesen had to leave her position when the investigation report by Clifford Chance (2020) was published (Johannessen and Christensen 2020; Makortoff 2019; Milne 2020). The next in line to leave the CEO position at Danske Bank because of money laundering was Chris Vogelzang. He was previously the CEO at the bank Abn Amro in the Netherlands that was investigated by Dutch police for money laundering activities (Solgård 2021). The firing of chief executives during a scandal is a way of scapegoating (Gangloff et al. 2016), where key individuals can be attributed blame. When the scapegoats have left the organizations and new CEOs are in place, banks attempt to create a clean image of their business. However, there is not necessarily reason to believe that the new CEO will react differently in a similar situation compared to the former CEO. Just like Danske Bank, Swedbank benefited from having oligarchs and other Russians as customers without implementing anti-laundering procedures (Amundsen 2021). The motive for violating anti-money laundering (AML) laws was to make extraordinary profits by corporate crime. The whistleblowers at Swedbank contacted the Swedish public broadcasting corporation. On February 20, 2019, the program “Uppdrag gransking” (Assignment investigation) began a series of programs alleging that customers of Swedbank’s Baltic subsidiaries in Estonia, Latvia, and Lithuania had engaged in suspicious transactions indicative of money laundering. Following the first program, Swedbank engaged law firm Clifford Chance (2020) to investigate the allegations that investigative journalists had presented and more broadly into Swedbank’s Baltic banking business from January 2007 through March 2019. The Nordea scam was also revealed by investigative journalists. Their source was the Panama Papers, which consisted of 11.5 million leaked documents that detailed financial and attorney-client information for more than 214,000 entities in tax

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havens. Law firm Mannheimer Swartling (2016) was hired by Nordea to investigate the allegations. They found illegal backdating of contracts by Nordea wealth management that was headed by Gunn Wærsted (Kristjánsson 2016): The big bank is one of the many banks that were caught with their pants down in the Panama Papers leak. The bank’s internal investigation establishes that offenses were committed in the Luxembourg branch, as the bank helped customers backdate documents. The bank also provided customers with annual reports that could be used to mislead tax authorities. Wærsted denies knowing about this but defends the practice of creating straw companies in tax havens, as long as they were used for “legitimate tax planning.”

Gunn Wærsted was not only head of wealth management at Nordea. She was also chairperson at the Luxembourg branch. Shortly after the scandal became public, Wærsted resigned from her position at the bank (Kaspersen and Eriksen 2015). Similar to industry deviance in the telecom services market involving companies like Telia, Telenor, and VimpelCom, industry deviance can also be found in the bank services market involving companies like Danske Bank, DNB, Nordea, and Swedbank. Criminal bank market activities in this chapter have focused on financial services concerned with money laundering and tax evasion. Another example of a criminal bank market activity is the rigging of the LIBOR as a form of market manipulation. Manipulation of the LIBOR (London InterBank Offered Rate) involves misrepresentations, false statements, artificial transactions, and trading schemes that influence participants in financial markets. Banks as perpetrators achieve financial gain that would not be possible in the absence of such deceptive practices (Jordanoska and Lord 2020). McGrath (2020) found that the banking culture can be characterized by aggressive risk-taking. Banks are lending money in an irresponsible manner to property developers, on the basis of fragile security without leveraging themselves properly or diversifying sufficiently into other forms of lending. Cheap and easy credit fuel an old-fashioned asset bubble. Irresponsible risk-taking in the banking sector is part of the criminal bank market. Regulators are too trusting of the banks they are supposed to regulate. The theoretical perspective of state-corporate crime is relevant here (Bernat and Whyte 2020; Ken and León 2021; Müller 2018: Osoria 2021; Rothe 2020; Rothe and Medley 2020; Tombs and Whyte 2003; Whyte 2014; Zysman-Quirós 2020). The Norwegian state owns 34% of the bank DNB. When the Panama Papers revealed that the bank helps wealthy clients hide their fortune in tax havens, and that the bank helps backdating contracts when desired by bank clients, the state did nothing to intervene. The government only asked for a review of the case, and the review was conducted by the law firm that served the bank and that was paid for by the bank (Hjort 2016). Similarly, when investigative journalists detected that DNB helped Icelandic fishing company Samherji launder money on its way to bribe Namibian officials, the Norwegian state did nothing (Reuters 2019; Schultz and Trumpy 2019a, b). In April 2021, the Danish prosecutor decided to close the case against former CEO Thomas Borgen while continuing the criminal investigation of Danske Bank. The former Danske Bank CEO was no longer charged in the money laundering scandal. In order for individuals to be convicted under the money laundering act in

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Denmark, it is required that there is solid evidence that they have shown gross negligence. The Danish prosecutor was unable to find such evidence for Thomas Borgen. Henrik Ramlau-Hansen and Lars Stensgaard Mørch, two other former Danske Bank executives, also had their charges dropped (Klevstrand 2021). In May 2021, Norwegian bank DNB got harsh criticism from the financial supervisory authority of Norway. The bank had to pay a fine of NOK 400 million (about US$45 million) that chief executive officer Kjerstin Braathen accepted. The public authority fund significant deficiencies in the bank’s compliance with the money laundering act (Norum 2021).

8 Next Bank Scandal Danske Bank admitted in September 2020 that they had known for years about the bank’s practice of collecting outdated and excessive debt from customers. Denmark’s financial watchdog Finanstilsynet (2020) launched the previous month an inquiry into how Danske Bank had wrongly collected debt from up to 106,000 customers since 2004. The bank blamed IT system errors (Reuters 2020): “There has been knowledge about at least parts of the problem in different parts and levels of the organization, including leaders, during the years,” Denmark’s largest bank said in a statement. “Despite attempts to manage the problems, the underlying data flaws were never fully addressed, and unfortunately this has caused the issues to continue for several years,” it said.

Blaming IT system errors and data flaws is not any more an acceptable excuse for digitized business enterprises such as banks. A computer system is programmed by people according to specifications. If bank managers have provided misleading specifications to computer programmers, then it is a matter of human error. If computer programmers have developed wrongful algorithms and coding, then it is a matter of human error. A computer system never creates errors by itself. Danske Bank is the largest financial institution in Denmark with focus on the Nordic region and presence in sixteen countries (Plesner 2020). Danske Bank is listed on the Nasdaq OMX Copenhagen stock exchange. The bank offers financial services, life insurance and pension, mortgage credit, wealth management, real estate, and leasing services. The data migration from an old computer system to the Debt Collection System (DCS) in 2004 contained pre-existing incorrect data in relation to outstanding amounts owed by certain customers. Over time an increased level of reliance on and trust in the DCS, a decreased level of institutional knowledge among those involved in the debt collection process, and a declining level of reference to historic paper records have contributed to the persistence of errors in handling the debt of some of the bank’s customers. Employees at different levels in the organization, including managers, at various points in time had known about the problem to varying degree. The executive management was informed of the systemic flaws affecting the bank’s collection systems in May 2019.

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A decade earlier, in 2009, Danske Bank launched an initiative known at Lean, which aimed to streamline existing businesses processes in an attempt to become more efficient in case handling. The focus on Lean meant that the employees in the debt collection area were under increasing pressure to rely on the data in DCS when carrying out debt collection and not to spend time looking at files in physical archives. This increased the transitioning into almost complete reliance on the data in DCS, and it implied the elimination of prior manual controls of the flawed data in DCS that had prevented, at least to a certain extent, the data flaws from ultimately impacting the customers wrongfully. While a correction team was established in 2007 with the purpose of manually correcting the cases in DCS on a continuous basis, the team was closed down again in 2016. The team leader argued then that also new cases included incorrect calculations. Bank management ignored this warning and decided not to allocate people to the task of correcting cases. The correction team was re-established in 2019. Fraud examiners suggested four root causes for the fraudulent debt collection. The first root cause is that accrued interest, fees, and costs on debt were incorrectly aggregated into a single amount and added to the principle amount. The implications of root cause 1 are that the systems do not distinguish between the different types of claims despite that in the context of time-barring principles such claims are subject to different time-barring periods. The second root cause is incorrect debt origination date. The statutory limitation period starts counting from the date the specific debt fall due. When a debt was transferred into DCS, however, the systemic statutory limitation period was effectively set to the date of the transfer—and not the actual due date. The incorrect origination date in DCS made the debt appear younger than it actually is. This meant that it was difficult, using DCS, to identify and control at which point in time the statutory period of limitation should be interrupted to avoid the debt becoming time-barred. The bank may thus have collected debt that at the time of the collection process was time-barred. The third root cause is the same treatment of guarantors and co-debtors. The bank may have pursued to collect the full debt from each of the debtors, co-debtors, and guarantors. In absence of a manual adjustment in DCS, this meant that if a settlement agreement had been made with a debtor, the system would still attempt to collect the full amount from co-debtors and guarantors. The fourth and final root cause was separate bank accounts for the principal debtor and related actors such as guarantors. Each account reflects the full debt as being owed. The full debt was consequently recorded on more than one account. Procedures required debtor accounts to be adjusted manually following debtor payments, accrued interest, and other financial items related to the debt. One customer might thus have repaid the debt in full, while the now non-existing debt was still registered as owed by the co-debtor and guarantor. The total number of potentially impacted customers was 106,000. Under Danish law, if a person or entity has paid an amount due to a mistake, misunderstanding or as a result of an error, the consequence is that the victim is eligible of a restitution against the offender. Examiners address the issue of how the bank handled information on identified errors by providing very general answers. The report describes a number of projects and activities, such as the data quality project, group risk

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management and compliance, and program Athens. It seems that rather than solving problems by correcting programming flaws, groups and projects were organized to discuss the issues. An example is the following sentence where a number of actors are mentioned, but there is no mention of actions (Plesner 2020: 10): The bank engaged EY to assist with program Athens and to provide the bank with an analysis and verification of system flaws identified by Plesner.

Examiners thus document a bureaucratic approach to solving technical problems. The manual effort required to review computer code seems ignored. The only manual effort described is concerned with actual transactions in terms of new manual controls regarding calculations for each customer. No new debt collection cases with effect from 2019 were to be initiated without manual calculation being done before. If the manual calculation resulted in different figures compared to the systems figures, then figures in the system were corrected. The bank was thus incapable of solving the underlying systems error, instead system results were corrected. The manual correction team was 4 people but grew quickly by 21 people to further accelerate the recalculation process. Consultants from Ernst & Young were also engaged to assist with the recalculations. In addition to the new manual control to stop new cases being brought to court before a recalculation, it was late 2019 also decided to withdraw all current court cases, including debt relief cases, private and business estate and bankruptcy court cases where the bank was uncertain about the real status for customers. It was decided to compensate all customers for their losses resulting from the identified root causes. To further minimize the risk of overcollection of debt, the bank decided to suspend approximately 17,000 customers’ debt collection cases until they had been recalculated as part of the ongoing efforts to remediate the identified errors in the bank’s debt collection system. These were the cases in which more than 60% of the principal amount had been repaid for which reason there was a higher risk that overcollection would take place before the cases had been reviewed. The collection would resume when each case had been reviewed and potential errors corrected. Furthermore, interest would not accrue while collection was suspended. It was not until 2020 that the real problems in computer systems were addressed. Then an IT implementation plan was set in motion, which included a number of technical safeguards and improvements to the implicated IT system in order to enhance existing and set up additional checks and controls. Examiners were asked to find out how many customers have been affected by the errors. As a starting point, a total of 402,000 customers with 600,000 accounts were processed. Examiners found that the total number of possibly impacted customers across systems, and who were at risk of potentially having made overpayments, was 106,000. On the other hand, examiners found that a total of 105,000 customers had not made any payments to the debt when entering the debt collection system. People who were eligible of repayments because of overpayments had so far received on average one or two thousand Danish kroner, but they were probably entitled to higher amounts. While the bank was recalculating accounts for potential overpayments, customers received no information about it. At the time of the investigation in

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INDIVIDUAL POSSIBILITIES MOTIVE THREATS

CORPORATE INDIVIDUAL CORPORATE STATUS

CONVENIENCE

COMMIT OPPORTUNITY

ACCESS DECAY

CONCEAL

CHAOS COLLAPSE IDENTITY

CHOICE

RATIONALITY LEARNING

WILLINGNESS INNOCENCE

JUSTIFICATION NEUTRALIZATION

Fig. 2 Convenience themes for Danske Bank fraudulent debt collection

2020, only 17,000 out of 106,000 customer cases had been recalculated. Therefore, no customers had been contacted so far (Plesner 2020: 15): All customers identified as having been affected by the root causes will be contacted directly by Danske Bank to disclose exactly what has gone wrong, what Danske Bank is doing to ensure that the customer receives proper redress, and what the customer can expect to happen next.

As of September 1, 2020, only 326 customers had received a compensation payment from Danske Bank. The total value of compensation paid to these customers was the equivalent of less than US$40,000. The fraudulent debt collection by Danske Bank represents corporate crime to benefit the business and not any specific individual at the bank (Bittle and Hébert 2020), as illustrated in Fig. 2. In many organizations, ends justify means (Campbell and Göritz 2014). If ends in terms of ambitions and goals are difficult to realize and achieve in legal ways, illegal means represent an alternative in many organizations (Jonnergård et al. 2010). Among most executives, it is an obvious necessity to achieve goals and objectives,

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while it is an obvious catastrophe failing to achieve goals and objectives. Welsh and Ordonez (2014) found that high-performance goals cause unethical behavior. Dodge (2009: 15) argues that it is tough rivalry making executives in the organization commit crime to attain goals: The competitive environment generates pressures on the organization to violate the law in order to attain goals.

Individual executives would like to be successful, and they would like their workplace to be successful. Being associated with a successful business is important to the identity of many executives. They explore and exploit attractive corporate economic possibilities in both legal and illegal ways, so that their organization can emerge just as successful, or as even more successful, than other organizations. Profit orientation becomes stronger in goal-oriented organizations whose aim tends to be an ambitious financial bottom line. There was a lack of oversight and guardianship that best can be labeled chaos, as indicated in Fig. 2. Nobody understood or tried to understand computer code. Bank executives noticed that there were some strange things happening when migrating into a new system, but they continued to study the symptoms rather than the causes. As evidenced by many internal investigation reports by fraud examiners after white-collar crime scandals, internal auditors, external auditors, compliance committees, and other internal and external control units do not function properly (e.g., Bruun Hjejle 2018). Oversight and control functions tend to be formal units without any insights into the substance of business activities and transactions in computer systems. They tend to review procedures rather than transactions within procedures. Therefore, ineffective control functions are often an important part of the opportunity structure for white-collar crime. Lack of justification can occur when an offender ignores information related to misconduct and crime. There is simply no need for justification. The upper echelon perspective suggests accordingly that white-collar offenders such as bank executives selectively attend to information when evaluating own decisions. As argued by Huang et al. (2020) in the upper echelon perspective, elite member’s cognitions, values, and perceptions, which are formed by previous experiences, can significantly affect the process of strategic choices. White-collar offenders may receive feedback from a range of actors while selectively ignoring some of the feedback by not paying attention to it (Gamache and McNamara 2019: 920): However, corporate executives operate in an environment where they receive feedback from a range of actors, yet we have a limited understanding of whether and to what extent these “soft performance feedback cues” influence their decision making.

Members of the upper echelon of society where we find white-collar offenders may thus combine neutralization techniques with disregard of negative information related to them personally. They try to choose what information they pay attention to and how they interpret that information.

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9 Convenience Reduction The elements of convenience reduction are evident from the structure of convenience theory. First, it is a matter of corporate executive status: disclosure of executive language, removal of powerful people, detection of misleading attribution, disregard of offender humor, and correction of power inequality. Next, it is a matter of access to corporate resources: Restrictions on access to systems, disclosure of entrepreneurialism, review of specialized access, and limits to strategic resources. Third, it is a matter of organizational improvement: transparency to avoid deterioration, replacement of disorganization, detection of crime signals, transparency in accounting, corporate social responsibility, and sharing of audit reports. Fourth, it is a matter of oversight and guardianship: coordination of principal and agent, sensemaking of executive actions, protection of whistleblowers, and corporate principal agent dynamics. Finally, it is a matter of markets and networks: reduction in rule complexity, avoidance of crime networks, combat of criminal market forces, and avoidance of victimization from cartel crime activities. While all these themes contribute to convenience reduction, some are more important than other themes. For example, ack of whistleblowing is an important part of the opportunity structure for white-collar crime. When people notice wrongdoing in the organization, they are reluctant to report it because of perceived retaliation threats. As argued by Keil et al. (2010), costs tend to exceed benefits for individual whistleblowers. In addition, as argued by Bussmann et al. (2018), employees in societies characterized by collectivist values are reluctant to blow the whistle on others. Whistleblowing is the disclosure by an individual in an organization or in society of deviant practices to someone who can do something about it (Bjørkelo et al. 2011). Whistleblowing is an action by employees who believe that their business or colleague(s) are involved in activities of misconduct or crime, cause unnecessary harm, violate human rights, or contribute to otherwise immoral offenses (Mpho 2017). Whistleblowing is the disclosure by an organizational member of deviant practices to someone who can do something about it. Whistleblowers stand out as a group of reporters who have made observations and who are willing to disclose what they have observed. However, executives may try to withhold bad news (Bao et al. 2019) and punish whistleblowers by reprisals and retaliation. A potential whistleblower might thus be afraid of retaliation. Retaliation makes informants reluctant to blow the whistle. Reprisal and retaliation against a whistleblower represent an outcome between an organization and its employee, in which members of the organization attempt to control the employee by threatening to take, or actually taking, an action that is detrimental to the well-being of the employee (Mesmer-Magnus and Viswesvaran 2005; Rehg et al. 2009). The lack of whistleblowing is an organizational inhibitor in relation to addressing white-collar crime and thus an enabler of wrongdoing. Shepherd and Button (2019) suggest that a range of avoidant rationalizations constructed by observers justify not noticing, reporting, or tackling white-collar crime. These rationalizations and justifications

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for disregard of observed wrongdoing can be similar to those rationalizations applied by offenders when committing crime, such as denial of victim and denial of damage (Kaptein and Helvoort 2019). There is a strong interaction between crime signal detection and whistleblowing intentions among potential whistleblowers. A low uncertainty that there is a crime signal will relate positively to whistleblowing intentions. If the signal is weak and confused by noise, whistleblowing intentions are likely to deteriorate as the potential whistleblower considers risk for him or her (Brown et al. 2016). It is convenient for an offender to know that even though others in the organization may develop suspicions, they will not notify others about what they have observed. They are not sure if something wrong has occurred, they are not sure who to notify, and they are not sure if any whistleblowing may have consequences for themselves in the form of reprisals. That is why many people are reluctant to report suspicion of misconduct and crime, even when they feel quite certain that something wrong has happened. Many who have cast light on critical conditions have experienced unwillingness, and they have been isolated and considered less attractive in the labor market afterwards (Rehg et al. 2009). According to Shawver and Clements (2019), potential whistleblowers often decide not to report ethical wrongdoing because of the likelihood of retaliation. Interactions between crime enablers occur in the organizational opportunity dimension of convenience theory. A whistleblowing routine with external handling of reports and real protection of the whistleblower will increase the likelihood of whistleblowing. Many of the other themes are important as well to reduce convenience, but here it is referred to further reading (e.g., Gottschalk 2022).

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Schultz J (2019) Wikborg Rein-gransker om Samherji: Planen er å være ute av Namibia innen få måneder (Wikborg Rein investigator about Samherji: The plan is to be out of Namibia within a few months). Daily Norwegian business newspaper Dagens Næringsliv, www.dn.no, published December 1 Schultz J, Trumpy J (2019a) NRK: DNB brukte mer enn et år på å stenge Samherji-kontoer (NRK: DNB spent more than a year to close Samherji accounts). Norwegian daily business newspaper Dagens Næringsliv. www.dn.no, published August 26 Schultz J, Trumpy J (2019b) Björgolfur Johannsson ble Samherji-sjef etter hvitvaskingsavsløring: -Jeg tror ikke det har vært noen bestikkelser. Norwegian daily business newspaper Dagens Næringsliv. www.dn.no, published December 13 Seljan H, Kjartansson A, Drengsson SA (2019) What Samherji wanted hidden, Kveikur at RUV, public broadcasting in Iceland. www.ruv.is/kveikur/fishrot/fishrot Shawver T, Clements LH (2019) The impact of value preferences on whistleblowing intentions of accounting professionals. J Forensic Investig Account 11(2):232–247 Shepherd D, Button M (2019) Organizational inhibitions to addressing occupational fraud: A theory of differential rationalization. Deviant Behav 40(8):971–991 Sivertsen NS (2018) Danske Bank siktet for hvitvasking (Danske Bank charged with money laundering). Daily Norwegian financial newspaper Finansavisen, November 28 Solgård J (2021) Danske Banks toppsjef Chris Vogelzang går på dagen (Danske Bank’s top executive Chris Vogelzang leaves on the day). Daily Norwegian business newspaper Dagens Næringsliv. www.dn.no, published April 19 Stadler WA, Gottschalk P (2021) Testing convenience theory for white-collar crime: Perceptions of potential offenders and non-offenders. Deviant Behav, published online https://doi.org/10.1080/ 01639625.2021.1919037 Tombs S, Whyte D (2003) Scrutinizing the powerful: Crime, contemporary political economy, and critical social research. In: Tombs S, Whyte D (eds) Unmasking the crimes of the powerful. Lang, New York, pp 3–48 Vasiu VI (2021) Convenience triangle in white-collar crime: Case studies of fraud examinations. In: Criminal law and criminal justice books, Rutgers, the State University of New Jersey, May. www.clcjbooks.rutgers.edu Vasiu VI, Podgor ES (2019) Organizational opportunity and deviant behavior: Convenience in white-collar crime. In: Criminal law and criminal justice books, Rutgers, the State University of New Jersey, July. www.clcjbooks.rutgers.edu Welsh DT, Ordonez LD (2014) The dark side of consecutive high performance goals: Linking goal setting, depletion, and unethical behavior. Organ Behav Hum Decis Process 123:79–89 Welsh DT, Ordonez LD, Snyder DG, Christian MS (2014) The slippery slope: How small ethical transgressions pave the way for larger future transgressions. J Appl Psychol 100(1):114–127 Welsh DT, Bush J, Thiel C, Bonner J (2019) Reconceptualizing goal setting’s dark side: The ethical consequences of learning versus outcome goals. Organ Behav Hum Decis Process 150:14–27 Whyte D (2014) Regimes of permission and state-corporate crime. State Crime J 3(2):237–246 Zysman-Quirós D (2020) White-collar crime in South and Central America: Corporate-state crime, governance, and the high impact of the Odebrecht corruption case. In: Rorie ML (ed) The handbook of white-collar crime. Wiley, Hoboken, NJ, pp 363–380. Chapter 23

Petter Gottschalk received his education at Technische Universität Berlin, Dartmouth College, Massachusetts Institute of Technology, and Henley Management College. He spent more than a decade in business as a chief executive officer at corporations before joining academics as a professor in the Department of Leadership and Organizational Behavior at BI Norwegian Business School (Norway). Dr. Gottschalk has published extensively on knowledge management, fraud investigations, white-collar crime, and convenience theory. He has published numerous books including: Investigating White-Collar Crime: Evaluation of Fraud Examinations (Springer, 2017); The Convenience of White-Collar in Business (Springer, 2020); Corporate Responses to

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Financial Crime: From Exposure to Investigation (Springer, 2020); Private Policing of Economic Crime: Case Studies of Internal Investigations by Fraud Examiners (Routledge, 2021); WhiteCollar Crime and Fraud Examinations: A Convenience Theory Approach (Routledge, 2021).

How the Battle Against Cybercrime Strengthens Sustainable Finance Avner Levin

1 Introduction Financial investment decision makers pay increasing attention to the sustainability of their investments, in addition, of course, to their profitability. Investment sustainability considerations have traditionally been understood, as discussed in this book, as encompassing environmental considerations, social considerations, and corporate governance considerations, known together as ESG considerations. Absent from these considerations, at least explicitly, has been the consideration of financial crime, which is the topic of this book, and within it more narrowly, the consideration of financial cybercrime, which is the topic of this chapter. It goes without saying (one hopes) that a decision maker interested in ESG would not deliberately invest in criminal activities. Beyond the potential illegality of such decisions they would also undermine the fabric of society, and the governance of affected corporations would suffer as well. Such direct investments in crime are not discussed in this chapter in much detail, yet the direct impact of cybercrime on sustainability is discussed and is important to understand for those seeking to make sustainable investment decisions. Still of more relevance to a normative decision maker is the understanding of how certain investments may indirectly and unintentionally support and facilitate cybercrime, to the detriment of sustainability and ESG. It is mainly such clarity that this chapter aspires to provide. To illustrate, considering the following information about bitcoin, the decentralized cryptocurrency that was created (alongside its facilitating technology, blockchain) in response to the 2008 recession. This chapter will provide a brief explanation of how bitcoin and blockchain operate, but for the moment consider that $18B CAD worth of bitcoin were used in criminal activities in 2021 (Chainalysis A. Levin (✉) Toronto Metropolitan University, Toronto, ON, Canada e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_17

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2022). During the same year, bitcoin “mining” (the computational work done in order to support the currency) consumed 204.50 Terawatt Hours (Digiconomist 2022). That amount is equal to the energy consumption of the country of Thailand (Digiconomist 2022). These are compelling reasons not to invest in bitcoin or in the infrastructure that supports it. Such a decision will not only combat crime, but also support the environment, which is of course a key sustainable finance consideration. However, blockchain technology also plays a key role in the advancement and development of “green” (i.e., environmentally-friendly) technologies (Power Ledger 2019) and in the promotion of investment instruments, by reducing transaction costs and thereby lowering the price of ESG-related bonds (OMFIF 2022). Consider, as well, that the $18B CAD noted above amount to only 0.15% of all bitcoin transactions for 2021 (Chainalysis 2022). In light of this additional information, should the decision still be to avoid investing in bitcoin or its infrastructure? After all, it seems that the currency is overwhelmingly used for benign and even ESG-supportive purposes (while the percentage may increase as more criminal activity is uncovered, percentages were 1% on average during the last 5 years; Chainalysis 2022). What this brief bitcoin example illustrates is that the relationship between cybercrime, its infrastructure, and sustainable finance is not always going to be obvious, hence the clarity that this chapter seeks to provide. To do so, the chapter opens with a necessary discussion of major cybercriminal activities and how they directly impact ESG considerations. The chapter then continues with a discussion of the cybercriminal infrastructure and its impact on ESG. This chapter understands such infrastructure to encompass both the technologies that are used for criminal purposes (some of which may be used for benign purposes as well) and the retail economy that has grown up around cybercrime. It is here, in the investments into infrastructure, where most normative decision makers may inadvertently have a negative impact on sustainability. In its third section the chapter offers suggestions that decision makers interested in sustainable finance can take into consideration in order to reduce and perhaps ultimately eliminate the impact of cybercrime. The chapter ends with some concluding thoughts on the relationship between cybercrime and sustainable finance.

2 The Impact of Cybercriminal Activities This section of the chapter discusses the straightforward impact of cybercriminal activities on ESG. As we shall see, in most cases the impact can be understood in societal terms and in terms of internal governance, although in some cases, as illustrated by the example in the introduction, the impact can definitely bear on environmental sustainability. The chapter discusses the most prevalent cybercrimes in recent years, as well as some potentially impact-heavy emerging cybercrimes, but it is beyond the scope of this chapter to cover each and every form of cybercriminal activity. What follows is a brief discussion of each criminal activity and its direct impact.

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2.1

331

Ransomware

Ransomware is a cybercrime in which a malicious person encrypts data that belong to an individual or an organization and then requires payment in order to decrypt the data and restore access. Estimates are that a ransomware attack was attempted every 11 seconds(!) in 2021 (ENISA 2021a). Successful attacks meant that organizations typically lost access for about 3 weeks to their data and paid an average ransom of $200,000 CAD (ENISA 2021a). It is estimated that ransomware attacks in 2021 caused $24B CAD of damages globally (ENISA 2021a). Ransomware has direct societal and corporate governance impacts. Societal impact ranges from the anxiety and stress that individuals feel when their cherished personal information (such as photos) has been taken hostage (Common 2015) to the impact on municipal and health care systems that are unable to function, resulting in health care or essential services not being provided to members of society (Ogilvie 2021). Broader societal conversations ensue, as to whether it is better to submit to ransom demands and solve such immediate problems or resist in the hopes that criminals will abandon this particular form of activity. As can be surmised from the data above, it would seem that most victims of ransomware do submit to ransom demands, resulting in an increasing number of such attacks year over year. To the extent that the victim is a corporate entity, such conversations occur within boardrooms as well, impacting corporate governance. The direct impact of any crisis (not only cybercrime) is that it leads to conflict around accountability for the crisis and for its resolution, between directors, between executives, and between the board and the corporation’s designated officers. Successful ransomware attacks exploit information technology (IT) vulnerabilities that exist because of outdated systems, and outdated systems exist because they were not a corporate priority for investment and improvement. The neglect of such systems is a symptom of poor corporate governance, and the cybercriminal activity exposes this poor governance to the corporation’s stakeholders and the public at large.

2.2

Cryptojacking

The criminal activity of surreptitiously taking over a computer, or a network of computers, in order to generate cryptocurrency through “mining” is known as cryptojacking. This is a crime specifically targeted to take advantage of the mechanism of “mining,” or “proof of work,” which is discussed in greater detail in the next section. The victim’s computing resources are used without the victim’s knowledge for this purpose, and the generated cryptocurrency is banked by the malicious hijacker of the resources. The rise in cryptocurrency value has made cryptojacking a more attractive crime, and as a result there were almost 100 million cryptojacking attempts in 2021 (Sonicwall 2022). The most targeted sectors appear to be the education sector and government (Sonicwall 2022). Presumably the public

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sector is targeted on the assumption that the private sector will be more diligent in the recognition and recovery of lost computation power. Estimates are that the loss of computation power because of cryptojacking is significant, and, accordingly, that immense monetary value is created. In 2018 that value was estimated at US $100 million, and that amount has likely increased year over year (Chainalysis 2022). That loss of computational power is a direct impact of cryptojacking. Poor computational power lowers productivity and drains resources that would be better spent elsewhere, as IT departments attempt to repair and replace equipment that may be erroneously taken to be outdated or obsolete due to its sluggish performance. That translates to a less efficient private sector, or (given the focus of cryptojackers on certain victims) to poorer delivery of public services, health care and education. The introduction to this chapter noted the environmental impact of bitcoin “mining” and how, since not all bitcoin is generated for criminal purposes, it is difficult to completely rule out investments in cryptocurrency and its infrastructure as unsustainable. Cryptojacking, however, is different. By its definition, all currency generation done as a result of cryptojacking is malicious, and therefore its direct negative impact on the environment cannot be qualified in any way. Finally, unlike a ransomware attack, cryptojacking attacks are not immediately apparent to the public or to corporate stakeholders, and as such their direct impact on corporate governance is not as severe. The most likely impact is with respect to the internal reputation of IT and information security (IS) departments and leaders.

2.3

Data Breaches

Data breaches are malicious attacks, seizures, and leaks of data, most often (although not necessarily) personal information that is held by organizations, whether in the public or private sector. Data breach criminal activity focuses on the exploitation of the data for other criminal purposes, such as identity theft and financial fraud. The attackers may use the data they capture directly, or they may sell the data on the black market, to be used by other criminals. In some sectors attackers exploit poor IS or human vulnerabilities, and in some sectors attackers launch more direct attacks against datasets. Government databases, for example, are mostly exploited through human “engineering,” i.e., manipulation (ENISA 2021a). IT companies, on the other hand, are mostly directly attacked (ENISA 2021a). Finally, the financial sector suffers roughly evenly from breaches caused by human error that are then exploited and from breaches caused by explicit external attacks on the sector’s data (ENISA 2021a). These different forms of attacks are probably a reflection of criminal assessments of potential victim awareness of data breaches and how they differ between sectors. Data breaches are a drain on victims. The estimated cost of each lost personal information record is US $180, and the average breach costs the victim US $4.24 million (IBM 2022). The health care sector has suffered the most in recent years (perhaps due to a combination of antiquated IT and the pandemic, IBM 2022). Ironically, the more personal information is stolen, the less valuable it becomes on

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the black market, but some estimates are that the global annual personal information market is worth US $160 billion (McGuire 2018). That is a staggering number, and although it may be exaggerated, and although it includes credit and other payment card information within the definition of personal information, it is still quite large. The direct impacts of data breaches are mainly social and organizational. Although identity theft can be thought of as a “victimless crime” (mainly because of the compensation policies of financial institutions that seek to boost confidence in online transactions), victims of identity theft describe nonetheless the stress, psychological impact, and bureaucratic nightmare that ensue following a successful attack (Mills 2022). But while the levels of awareness and concern over data breaches more generally within society are debatable and subject to a wide range of estimates in terms of its direct societal impact (from 0.6 to 33%; Fortunly 2022), the direct impact on organizations and their governance is quite clear. Generally, it appears that corporate leaders have little concern over data breaches, mainly because these are thought to be internal, operational matters, that may require a refresher of IT policies and equipment, or an awareness campaign among employees, but that have little impact on the corporation and its leaders beyond that. Indeed, for publicly traded corporations market values may dip slightly immediately after a breach, but only to bounce back—markets clearly do not see data breaches as having long-term implications, and neither do leaders (Bischoff 2021; Hernandez 2021; it is of course difficult to disentangle the impact of a data breach on share value from that of numerous other factors). However, there may be signs that this attitude is changing and some data breaches have resulted in personal accountability implications for corporate leaders. A Target data breach that exposed the personal information of 70 million of its customers led to the resignation of its CEO, the dismissal of its CIO, and the creation of a CISO position (Roman 2014). An Equifax data breach that exposed the personal information of 143 million people led to similar resignations of its CEO, CIO, and CISO (Dwyer 2017). Time will tell whether such resignations and dismissals remain exceptions, or become the rule, but such high-profile resignations and dismissals have indirect implications as well, that are discussed below, as corporations move to shift data breach risks from their boards to insurers.

2.4

Malware

Malware is a generic term for malicious software, software which operates on computers and networks for malicious purposes, against the wishes of the legitimate operators of such systems. Examples of malware are viruses, worms, and Trojans as well as subcategories known as adware and spyware. Computer viruses are probably the most infamous and oldest type of malware, and they require some human action in order to activate and replicate. Their activity is malicious, ranging from annoying pop-up windows to computer shutdowns, data encryption and erasure. Worms, on the other hand, spread across a network independently of any human act. Their malice manifests itself typically as a loss of computational performance, which

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increases as the worms replicate through the system. Trojans (or Trojan horses) do not necessarily replicate. Their malicious activity is in their capturing of sensitive information (such as passwords or credit card numbers) in order to use this information to commit further criminal activity, such as financial fraud or identity theft. Adware is a subcategory of malware that focuses on the presentation of advertisements and commercials to victims without their consent. Spyware is a subcategory of malware that focuses on the collection of victim information that is then used for commercial purposes, such as the creation of targeted advertisements. Spyware and adware often work hand-in-hand. Unlike Trojans, the purpose of spyware is not explicitly criminal. In principle, the criminal activities already mentioned above, such as ransomware and cryptojacking, are also types of malware, but they are presented separately in this chapter because of the scale and specific nature of their impact. The direct impact of malware, as defined in this section, has been mostly social. Most individuals are probably not continuously aware of how their use of computational resources has changed because of malware. From the installation of countermeasures such as antivirus software on personal computers to the more secure—and difficult—access to online resources using two-factor or multi-factor authentication systems (systems that require several pieces of information, e.g., a password, a temporary code, an image, in order to allow their use), malware has imposed a burden on users, increased costs, and created entire industries for the provision of cybersecurity.

2.5

Distributed Denial of Service

Attacks on a network or system in order to make it inaccessible and unavailable to its users are known as Distributed Denial of Service (DDoS) attacks. In such attacks, criminal typically leverage computers and networks under their control (colloquially known as botnets) so that a large number of fictitious users require access to the system under attack. This large, simultaneous number overwhelms the system, resulting in a complete or partial lack of functionality, and service outages. DDoS attacks are not a new form of cybercrime and have been executed for reasons ranging from political and social activism to criminal extortion. Indeed, in recent years DDoS attacks have been accompanied by ransom demands, and at times such demands are made as a threat, before an impeding attack (ENISA 2021a). DDoS attacks have also increased since they are increasingly offered as a commercial service by criminals to other malicious actors. This trend is discussed below in the section dedicated to cybercriminal infrastructure. It could be said that the vast numbers (tens of millions) of computers that are part of criminal botnets have an environmental impact, but it may be that the environmental impact of DDoS attacks is only now emerging, with the development of attacks that utilize devices connected to the internet (internet-ofthings, or IoT, attacks). Such attacks manipulate the energy consumption of devices such as air-conditioners and vehicle chargers in ways that could impact local energy grids and the price of energy (Shekari 2021). However, the main impact of DDoS

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attacks remains social, and there is a lesser, internal governance impact as well. Socially, the impact is very similar to the impact of malware, ranging from the inconvenience caused to users unable to access services as expected to the added costs and layers of security. Internally, DDoS attacks, similar to the other forms of cybercriminal activity described in this section, lead corporate executives to give corporate officers in charge of IT and IS greater prominence and to transfer risks of such attacks away from their corporations through the purchase of insurance policies.

2.6

Social Engineering

Last but not least in the list of established cybercrimes are those attacks that exploit human vulnerabilities, rather than software or hardware flaws. Obviously, attacks can often target both types of flaws, but it is worth discussing separately attacks that attempt to manipulate human beings directly. Generally, all such attacks attempt to deceive individuals by convincing them to disclose valuable information (such as financial information, or credentials) on the basis of some fraudulent communication that is engineered so it will seem valuable, important, or interesting to the victim, and move the victim to share the information which is of interest to the criminals. Many social engineering attacks use email as the medium of communication, and they range from broad “spam” attacks that operate on the basis that statistically enough victims will respond to them (Rao and Reiley 2012) to more targeted attacks known as “phishing,” “spear-phishing” (even more targeted than phishing attacks), and “whaling” (when the target is an executive). Other attacks use text messages and are known as “smishing,” or voice messages and are then known as “vishing.” A variation of the email attacks on executives are known as “business email compromises” (BEC). Rather than targeting executives, they target employees of an organization and appear to be sent from an executive. Typically, such attacks would leverage the authority of the executive to motivate employees to transfer funds or disclose credentials. BEC can exploit an actual executive account or are crafted to appear as if they are from an executive’s account. Although they are new in comparison with the more established forms of spam, they are estimated to be the costliest form of social engineering and caused organizations to lose US $1.8 billion in 2020 (ENISA 2021a). As could be expected, the primary impact of social engineering attacks is, well, social. The exploitation of human weaknesses undermines societal trust and diminishes social bonds. Although there are certainly more than enough attempts that take advantage of the negative side of humanity, from getrich-quick schemes (Newmyer 2022) to the laundering of money for a fee (Lindquist 2022), social engineering often makes the news precisely because of this heartbreaking, gut-wrenching element that repeatedly appears in situations in which individuals are deceived to believe in true love (Lindquist 2022), altruism (DeClerq 2022), and generally positive human virtues. Some specific forms of social engineering have a direct impact on corporate governance as well. For example, those attacks that target

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executives, or leverage executive positions, undermine the trust and hierarchy of organizations, and the confidence of employees and board directors alike in the capabilities of executives, their awareness of cybercrime, and their commitment to cybersecurity. Most of the cybercriminal activities listed above are well known and established, and as discussed for each one, create enormous costs and impose significant burdens on individuals and organizations. The following three forms of activities may not be as established perhaps, but have rapidly emerged on the cybercrime scene, and possess great potential to further add to the harm caused by cybercrime.

2.7

Supply Chain Attacks

The hardening of computers and networks against attacks such as those described above has led malicious actors to target less protected technological resources in the hopes that these would be a “weaker link” that would enable access to the better protected information and networks that such actors covet. Such attacks threaten what are known as the “supply chain” of the ultimate target. For example, a malicious actor may not be able to attack an organization directly but may be able to succeed in attacking one of the organization’s service providers or vendors and gain access to the organization’s resources by exploiting the provider or vendor’s credentials. Threats against supply chains are currently emerging as a great concern for the bodies entrusted with cybersecurity, nationally and internationally (ENISA 2021b). The attack that most likely triggered these concerns is known as the SolarWinds attack (ENISA 2021b). In this attack software developed by the SolarWinds company for the purposes of IT management was compromised by attackers and then used to exploit information from SolarWinds’ customers (ENISA 2021b). The attackers took advantage of the access granted by customers to SolarWinds for the purposes of routine updates of its software (much in the way that individuals configure software from companies such as Microsoft or Adobe to be automatically updated). The number of supply chain attacks grew rapidly during the COVID-19 pandemic (from 2020 to 2021), and it is estimated that supply chain attacks will continue to grow in number and sophistication (ENISA 2021b). Because these are attacks on secondary targets (the “suppliers”) it is difficult to discern the direct impact that such attacks have on ESG considerations until the attacks manifest with the ultimate target, which due to the sophistication of supply chain attacks is a process that can take several months (ENISA 2021b). In addition, the ultimate direct impact can be difficult to determine because supply chain attacks can be carried out for different ultimate goals. For example, the attack on software provider Kaseya resulted in ransomware attacks on its customers (ENISA 2021b) while the attack on cryptocurrency wallet provider Ledger resulted in cryptocurrency theft from its customers (ENISA 2021b). As a result, the direct social impact and the direct environmental impact of supply chain attacks both vary depending on the ultimate target of the attack, and so will not be discussed here. On the other hand, the direct

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impact of supply chain attacks on organizational governance is easier to ascertain. Supply chain attacks place pressure on supply chain organizations, pressure that originates mainly with the customers or clients of these organizations, which may range from individuals to governmental bodies. The purpose of such pressure is to ensure that suppliers are held accountable to security standards that may either be industry standards or contractually imposed standards. The anticipated increase in attacks will be met by an increase in such pressure on suppliers, and internally, by pressure to hold organizational officers to account due to the significant business risk of losing supply contracts.

2.8

Disinformation

Another emerging and concerning cybercriminal activity is the deliberate dissemination of misleading, incorrect information. It is possible of course to spread such information innocently or carelessly, an act which would be termed misinformation. Although misinformation can have, and has been shown to have, significant impact it is not considered an act of cybercrime for the purposes of this chapter due to the lack of malicious intent. Disinformation, on the other hand, or at least part of it, is very much an act of cybercrime, which has risen in recent years in prominence and infamy. Disinformation can be divided, depending on the malicious intent behind it, into cybercrime and cyberwar. When instigated by state actors, disinformation is usually carried out for a purpose that furthers those actors’ national interests. Russia, for example, has executed many disinformation campaigns to destabilize what it sees as threatening nations and alliances, including most recently its attacks against NATO and NATO-friendly countries (ENISA 2021a). While such disinformation certainly has considerable ESG direct impact, it too is beyond the scope of this chapter (although, to be clear, cyberwarfare is often carried out with the assistance of cybercriminal elements). The chapter therefore focuses on disinformation which is carried out in order to further cybercrime. Social media channels are the dominant method by which such disinformation (and indeed all disinformation, as well as misinformation) are contemporarily disseminated. For example, Twitter was used to spread false information about bitcoin in order to convince currency holders to transfer funds to the criminals spreading this disinformation (ENISA 2021a). Similarly, the COVID-19 pandemic has seen a whole host of conspiracy theories and disinformation campaigns that have targeted prominent individuals such as the founder of Microsoft Bill Gates and pharmaceutical corporations and vaccine developers such as Pfizer and Moderna (ENISA 2021a). These campaigns have pursued political goals but have also been used for illegitimate financial gain. They have been the cause of financial harm to such corporations and other corporations tarnished by disinformation, such as the claims that the pandemic was caused by 5G telecommunication technology (ENISA 2021a). It is difficult to disentangle the impact of disinformation and misinformation attacks that are conducted for a variety of purposes, but it could probably be stated that the overwhelming direct impact has

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been social. Although there are some campaigns that have direct environmental impact (e.g., disinformation with respect to climate change or global warming), these attacks are typically carried out for political, and not criminal reasons. Even the criminal campaigns, however, impact society by attacking fundamental notions of truth, trust, and authority. The resulting social impact is that of a polarized, suspicious, and distrusting public and the fracturing of society, that is in turn fertile ground for further criminal activity. Finally, while not an impact on governance as such, the prominence of social media in the dissemination of disinformation has led to calls for regulatory reform, holding social media organizations to account and establishing liability for their disseminating role and the resulting social impact.

2.9

Deepfakes

Deepfakes are forms of media created with the assistance of artificial intelligence technology that fraudulently represent individuals. One of the most notorious examples of the use of deepfake technology is for the generation of pornographic images and videos that falsely depict female individuals. Such images are either used to blackmail the real women targeted by them or simply disseminated in order to cause the women shame and humiliation. In addition to such malicious activity, deepfakes have an emerging use as a criminal countermeasure to the use of facial biometrics as secure credentials. Facial recognition is increasingly used in a range of applications, from border control to cellular phone protection, and financially, in order to confirm the identity of financial customers (part of the Know Your Customer, or KYC, obligations of financial institutions). A typical KYC process incorporating facial recognition would require a customer to take a “selfie” (photograph of their face) which would then be matched to a photo from official ID submitted by the customer at the time of enrollment (Sensity AI 2022). Such processes are relatively easy to circumvent, however, even without deepfake technology (Sensity AI 2022). In order to bolster security, KYC processes have begun to incorporate a requirement for live videos. Live videos are an attempt to confirm whether the person in front of the camera is the actual customer or a malicious individual. Live videos typically require customers to perform certain actions such as smiling or blinking or various head movements. Deepfake technology, however, has the capacity to mirror live videos and is therefore increasingly used as a tool to circumvent the live video requirement (Sensity AI 2022). As this is an emerging malicious activity there are relatively few examples at the time of writing, but a notable use of deepfakes in such a manner was carried out in China in 2021, resulting in a loss of over US $75 million (Borak 2021). It seems that the main direct impact of deepfake technology will be social. The devastating social impact of deepfakes on (mostly) women who are victimized by it is already well appreciated (Citron and Chesney 2019). The socially destabilizing impact of deepfakes will only increase once they are widely used by cybercriminals. A variety of organizations will lose trust in well-established procedures that were designed to ensure trust, verification, and confidence, and individuals will lose trust

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and confidence in organizations as well. The chapter discusses later on some ideas as to how to mitigate this potential social impact. The discussion of deepfakes brings this section to a close. In it, various leading forms of cybercriminal activities were introduced, and their direct impact on ESG considerations was discussed. For most activities it would seem that the direct impact, as could be expected of most criminal activities, is social. However, as noted above, some activities have very clear environmental repercussions, and some have an internal organizational governance impact as well. The next section proceeds to discuss the impact of the infrastructure used for cybercrime on ESG aspects, apart from any specific malicious activity.

3 The Impact of Cybercriminal Infrastructure By “infrastructure” this chapter refers to several elements that play a facilitating role for cybercrime, although some of them, like many technologies, could be thought of generally as morally and legally neutral. Digital file copying, for instance, could be used for benign purposes but could also be used for copyright infringement. Such is the case with many of the technologies that are used by cybercriminals, such as blockchain, and even the dark web. Blockchain, it may be recalled from the introduction to this chapter, is a technology that was originally developed as a response to the major financial market crisis of 2008, and as an attempt to avoid the risky activity that led to that crisis. Blockchain is also used for positive ESG purposes and is the backbone for many recent environmentally-friendly initiatives that are considered valuable ESG investments by financial institutions. Even commonly thought of as “evil” elements, such as the ominous “dark” web, and the technological tools used to access it, such as The Onion Routing (Tor 2022) web browser, may have a positive side to them. The Tor browser bills itself, for example, as a legitimate tool that circumvents political censorship, ensures privacy, and generally promotes human rights (Tor 2022). There are also many parts of the internet that are not accessible through popular search engines such as Google that do not necessarily contain malicious content and are sometimes referred to as the “deep” web (as distinguished from the “dark” web). Some of the content on the deep web may be simply obsolete information, or it may be specialized knowledge such as court records or academic journals that are not indexed by common search engines. With such caveats in mind, this section discusses the negative impact, nevertheless, that this potentially neutral infrastructure has on ESG aspects, when used for malicious purposes. The discussion is divided into subsections that correspond to the elements of the cybercriminal infrastructure, namely technologies such as blockchain and encryption, tools such as the Tor browser and the dark web, and last but not least, the criminal economy that has developed in recent years around cybercrime. Together and in parts, these elements support cybercrime and spur its growth.

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Blockchain

Blockchain technology has already been mentioned several times in this chapter, and this section will provide a brief explanation of its underlying concepts and mechanism. Simplistically, as its name adduces, the technology is a way to create a “chain” of “blocks.” The blocks are records of data, and these records are linked through a “chain” which has two key aspects. First, each block is encrypted and a hash of it is created, which then becomes part of the next block in the chain. This computational activity that creates and encrypts the block is called “mining” (which was also mentioned above, in the context of cryptojacking). Second, the records are not centrally located, but distributed among all the computers and networks that participate in the chain, to create a shared, decentralized ledger of these records. Blockchain technology, therefore, allows for a decentralized accounting of information that is of interest to those that participate in the creation of the chain. One such information, of course, is cryptocurrency, and specifically bitcoin, which was created in tandem with blockchain as a reaction to the financial crisis of 2008. The anonymous developers of blockchain and bitcoin proceeded on the basis of an assumption that centralized institutions such as governments and banks played a crucial role in that crisis and that the prevention of future crises was to be found in the creation of decentralized mechanisms for currency and, later on, governance. Blockchain plays a key role, for example in the development of digital identity as well, and governments are struggling with the tension of their desire to control the definition of how individuals are identified, and the decentralizing capabilities of blockchain. The very nature of blockchain as a decentralized platform appeals to individuals with a healthy suspicion of government, and these range from idealistic anarchists to common criminals. In the decade or so since the creation of blockchain, it has become instrumental in the hands of criminals that exploit its encrypted and decentralized nature in order to cover their activities, but that also increasingly exploit others that are drawn to blockchain through malicious activities that target them, some of which that were discussed in the previous section. What turns blockchain into a vexing problem for cybersecurity experts, and in the context of this chapter, for organizations and individuals interested in ESG, is its growing potential for legitimate uses at the same time as its criminal uses grow. The elimination of the need for central authorities reduces transaction costs and creates possibilities for innovative ideas such as cryptocurrency, but also for the technological enforcement of agreements (an idea known as “smart contracts”). One example in the context of the environment is the ability to offset carbon emissions by purchasing credits (a transaction known as “carbon trading”) utilizing a blockchain platform, in a decentralized, efficient, and relatively inexpensive manner (ClimateTrade 2022). At the same time, and as mentioned above, blockchain itself is a carbon-guzzling technology. This guzzling is at the time of writing (and some proposed solutions are discussed below) at least an order of magnitude higher than any positive impact that blockchain solutions might otherwise have. For the moment, therefore, blockchain has an

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unquestionable negative impact on the environment, and one of the key challenges of proponents of its ESG-friendly solutions is to demonstrate how this negative impact may change. The negative impact of blockchain is not limited just to the environment, unfortunately. The impact of blockchain on society has been so far negative as well. The proposed benefits of cryptocurrency, smart contracts, and other blockchain applications have yet to materialize and become part of the social mainstream. The negative impact, however, has not failed to arrive. Cryptocurrency investors suffer from a fluctuating and erratic market, and from the refusal of governments to recognize these instruments as currencies. Some of the most successful and prevalent cybercrimes discussed in the previous section rely on blockchain in order to function and have raised both financial and emotional costs for their victims. While it is difficult to discern a direct impact that blockchain has had on organizational governance as such, the combined impact on the environment and on society lead to the conclusion that the overall impact of blockchain on ESG is negative.

3.2

Encryption

Data encryption has become such a ubiquitous technology that it is probably surprising that it warrants a special discussion in the context of cybercrime, yet this technology, which at first seems to be necessary for the functioning of modern financial markets and therefore overwhelmingly positive, does have a negative aspect. The encryption methods used to protect conversations over social media, web searches, and financial transactions all rely on the difficulty to decrypt them using computational resources within a reasonable timeframe. In fact, some commonly used financial encryption algorithms, such as RSA, require more time to decrypt them using regular computers than the entire age of the universe. The emerging technology of quantum computing poses a risk for the security of some algorithms, but not all. However, the risk posed by encryption discussed here is not its vulnerability to quantum computing, but its resilience that has made it into the backbone of electronic commerce. This very resilience is used by some cybercrimes for malicious purposes. By encrypting information against the wishes of its rightful controllers, cybercriminals use the robust nature of encryption in order to blackmail organizations and individuals, as discussed above. Encryption has therefore had an increasingly negative ESG impact, but despite this concerning trend, it cannot be concluded that the overall impact of encryption is negative.

3.3

The Dark Web

As mentioned in the introduction to this section, the dark web is a subset of the deep web, which in turn is the name given to information available through internet

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communication protocols that is not indexed, and therefore not accessible, through common search engine interfaces such as Google. While historically there were (and still are) a variety of ways to access the internet such as through home pages created by internet service providers, by software providers, by broadcasters and others, it is clear that the overwhelming majority of internet users (almost 70%) end up accessing information that is generated as a result of an internet search (BrightEdge 2019). The generic term “internet search” is a misnomer, as over 90% of such searches are in fact done through Google (GlobalStats 2022). Google and the information that Google retrieves are therefore de facto the same as “the internet” for almost everyone that uses the internet. In fact, it is only the first page of Google’s search results that are “the internet,” since three quarters of users never access results from the pages that follow (Hubspot 2022). The exact ratio between the internet as indexed by Google and the total amount of information that is available online is unknown, but it is estimated that Google has only indexed mere fractions (1 of 25,000 pieces) of all of this information (McGuigan 2022). Even assuming that most of this information is not intended to be publicly accessed, the ratio is still quite large. That portion of the internet that is accessible, but not through Google, is known as the deep web. The deep web consists mainly of obsolete information (that was therefore de-indexed) but it also consists of information that is not indexed for other reasons. For example, proprietary databases, such as (in certain jurisdictions) real estate listings, or documents pertaining to litigation, or academic knowledge repositories, may not be indexed but are still available to those with appropriate credentials. Similarly, what are appropriately known as “deep links,” addresses that lead directly to specific information, such as a particular product offered by an online merchant, may not be indexed for commercial reasons (such as the desire to change prices with ease) and will therefore not be available. In fact, when such parts of the deep web are disclosed, conflict often ensues, as was the case when Dell attempted to restrict access to such pages (Dell 2007). Technologically, however, access to the deep web is not that much more complicated for individuals than it is to the regular, “Google” web. Although access as a result of a search is not possible, knowledge of a deep link, or of the appropriate credentials, grants access without difficulty. In addition, as can be seen from the examples above, the contents of the deep web are not malicious and could in fact have great social utility. However, while technically a subset of the deep web, the dark web differs from it on both counts. The discussion of the technological tools immediately follows, so the discussion here focuses on the content of the dark web. Unlike the deep web, most (but not all) of the dark web is malicious. Content available on the dark web is content that is illegal, such as copyright infringing material, or audiovisual files of individuals being sexually and physically abused, or goods and services that are criminal, such as prohibited drugs or weapons. Cybercriminal tools and services are also available on the dark web, as are the profits of cybercrimes, such as stolen identities, financial information, and access credentials (CRS 2017). At the same time, it is important to note that the dark web is used to circumvent oppressive, dictatorial regimes and the restrictions that they impose on regular internet use, and that the dark web is also used to maintain

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journalistic confidentiality and whistleblowing activities that are essential even within robust democratic jurisdictions. Reputable members of the press, such as the New York Times and the BBC, have a dark web presence, and important whistleblowing information released by WikiLeaks and by Edward Snowden was released initially on the dark web. Assessing the ESG impact of the dark web is therefore not straightforward. There is undoubtedly a positive social impact, especially for individuals living under repressive regimes, and arguably there is a positive benefit to be had even for democratic societies thanks to the exposure of scandals and corruption that the confidential aspect of the dark web allows. While it is possible to argue that this positive aspect of the dark web overweighs its negative impact in the context of dictatorial jurisdictions, it is probably more difficult to sustain this argument for regular (albeit imperfect) democratic societies such as Canada. It would seem that for regular societies the severe negative impact that the criminality of the dark web has had on society is far greater than whatever positive affect that its whistleblowing or confidentiality-preserving measures may have. Such a conclusion would have implications for the conduct of organizations that use the dark web, and these are discussed below.

3.4

The Onion Router Browser

Just as the regular internet is essentially the results of searches conducted on Google, so is the dark web essentially the results returned by using one major technological tool—the onion router (Tor 2022) browser. This browser relies on the encryption of communication and on a network of servers through which communication is relayed multiple times (as in the layers of an onion) to obscure both the identity of the individuals using the browser and the content of their browsing. Tor uses a unique protocol for internet addresses, and unlike regular addresses these are not comprised of easily remembered words, but of strings of letters and numbers, and these strings end in the “.onion” domain extension. These websites can only be accessed through Tor or through similar, complementary but less popular tools that utilize the same technology as Tor, such as Tails (Tails 2022). As a result, the dark web is de facto websites with the .onion extension that are accessed through Tor. The central, if not essential role, that Tor plays with respect to the dark web leads to the question of the impact that this browser has on ESG, and within it mainly on social considerations. As with the dark web, it is important to note that Tor was created with good, civic intentions and concerns over privacy online and unfettered government surveillance (Tor 2022). Concerns that were in fact largely born out following the revelations of Edward Snowden about the NSA that were made possible, significantly, thanks to Tor and the confidential methods of communication that it enables (Snowden 2019). For such purposes, and for the purposes of circumventing the restrictions imposed by more oppressive regimes, Tor is indispensable. However, at the same time it is undeniable that Tor has also been a tool which has facilitated

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much harm in the world, by enabling access to the malicious and illegal material found on the dark web. Tor has also enabled the execution of malicious activity with greater ease, since relatively unsophisticated individuals increasingly rely on the anonymity offered by Tor for “hacking” purposes (Derworiz 2022). Tor is therefore a critical part of the overall infrastructure that enables most, if not all, of the cybercrimes discussed above. For these reasons it would appear that the overall impact of the creation of Tor on (democratic) society has been negative and that organizations need to carefully consider the significance of their use of Tor and related tools for their own purposes, however noble these may be.

3.5

The Retail Environment of Cybercrime

Most malicious actors are not very sophisticated computer users and may have only basic skills, similar to the myriad of internet and telecommunication users worldwide. Their ability to successfully execute many of the crimes described in this chapter is completely dependent on access to malicious software, and in some cases hardware, that was developed by other, more sophisticated programmers. Such malicious tools, and the online markets in which they are bought and sold, are accessed on the dark web through Tor, as was just discussed. This section focuses on the criminal economy, and the criminal retail environment that has emerged over the years as more and more individuals have attempted to illicitly profit from the increased connectivity of contemporary society. There is an implicit hierarchy to this environment, based on the level of sophistication and knowledge of cybercrime and malware. At its lowest level are users of malware and purchases of illicit goods and services. As mentioned above, many cybercrimes can be purchased as a service. For example, a low-intensity, one-hour long DDOS attack can be commissioned for as little as US $10 (Ruffio 2022). At a higher level from basic users of cybercrime stand the various intermediaries that facilitate the illegal commerce on the dark web. These are not necessarily the individuals and groups that commit cybercrimes, but they peddle the proceeds of crime, and profit by taking a cut of the transaction, as well as, in some cases, for vouching for the integrity of transactions (much as eBay vouches for transactions on the regular web). An example of a commonly used market for such purposes was Raidforums, which was shut down in 2022 (McCallum 2022). At what could then be considered an even higher level stand those individuals and organizations that are sophisticated enough to create malware and other forms of attack. Depending on the level of sophistication some of these could be operations on behalf of state-entities, and some are “simply” criminal organizations. For example, one malware creator known as DevilScream has created a malware kit called 16Shop (ZeroFox 2021). The 16Shop kit allows basic users of cybercrime to launch phishing attacks against customers of well-known brands such as Amazon and Apple (ZeroFox 2021). DevilScream is thought to be an Indonesian individual (ZeroFox 2021) but in other cases the creators of malware are thought of as groups, such as the hacktivist group Anonymous.

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The breadth of malware and stolen credentials available for retail is quite impressive. From US $18 for Canadian credit card details, to US $20 for paypal account details, to US $4 for 1000 Instagram followers, to US $150 for an American driver’s license, to US $3800 for a French passport (Ruffio 2022), the amount of stolen credentials is only rivaled by the amount of malware for sale. 10 million American email addresses are sold for US $120, while 1000 installations of malware are sold for prices ranging from US $45 to US $5500, depending on the “quality” of the malicious software (Ruffio 2022). The availability of such a “buffet” of criminal products and services has had a great impact on society. While notions of cybercriminals or malicious hackers, that both develop and execute their malware and crimes continue to exist in the popular perception of cybercrime, the reality is that most criminals have basic knowledge of software and hardware, and so their ability to commit cybercrimes has been greatly enhanced, if not completely created, by the existence of “off-the-shelf” criminal solutions. The retail nature of cybercrime has greatly increased its prevalence and correspondingly, its impact on society. The retail aspects of cybercrime are also where most law enforcement efforts are concentrated, in another indication that the overall level of cyber-sophistication among criminals is not very high. Without easy access to malware and to related services most cybercriminals would migrate to other crimes that are within their ability to execute, and it is safe to assume that the overall level of cybercrime would reduce. Countering and neutralizing the contemporary retail nature of cybercrime is therefore a key consideration of any attempt to combat cybercrime and increase cybersecurity. More difficult to analyze are the challenges posed by seemingly neutral technological tools, or even tools created with lofty ideals in mind (such as Tor, or blockchain) that are then used for less stellar purposes. In conjunction with the retail environment of cybercrime, these all work together to increase crime and reduce security. Whether it is possible to reduce the negative impact of such tools, while retaining their more positive aspects, and end up bolstering sustainable finance are questions that are discussed in the following section.

4 How to Reduce the Impact From the discussions in this chapter, it should be hopefully evident that there is no easy solution, or “one-size-fits-all” approach that will both combat cybercrime and strengthen sustainable finance. This is because key elements that foster cybercrime can also be said to encourage, in parts, ESG considerations. Blockchain is one notable example that can be used for both the reduction of environmental impact in ESG-friendly investments and that can have a negative environmental impact itself. Other tools of cybercrime, such as the Tor browser that acts as the entry-point to much criminal infrastructure, can also be used for socially laudable goals such as democracy, freedom, and privacy. This section will discuss each of the ESG considerations separately and offer potential solutions and suggestions in light of the issues caused by cybercrime. The discussion is driven by the following

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reasoning: since, as seen above, cybercrime has a negative impact on one or more ESG factors, reducing, if not eliminating cybercrime or certain forms of malicious activities, will have a positive ESG impact and will end up strengthening sustainable finance.

4.1

The Environment

The detailed discussion above evidenced that the environment is most negatively impacted by blockchain technology and by cybercrimes that rely on it. To some extent, given the popularity of cryptocurrency as the currency of choice of criminals, it could be said that all crime is bolstered by blockchain technology. Any manner of reducing the harmful impact of blockchain could therefore be said to strengthen the environmental concerns over it and ease financial decisions. Luckily, alternative blockchain solutions are being developed that will reduce its negative impact. Recall that blockchain is founded on the environmentally detrimental concept of “mining,” or “proof of work,” which requires networks of computers to consume vast amounts of energy for computational purposes that will allow them to generate the next block in the chain (and some cryptocurrency as an added benefit). The proposed alternative is known as “proof of stake” (Ethereum 2022). “Proof of stake” requires blockchain users to stake some of their legitimacy (i.e., their cryptocurrency) on the validity of the next block in the chain. The more users stake their currency, the more valid the block becomes. Since “proof of stake” does not require computational activity, its environmental impact is not negative, and in fact its proponents estimate that it will reduce the energy consumption of users by more than 99% (Ethereum 2022). While it can be perceived as biased toward wealthier users, and more centralized as a result, such bias is a trade-off many are willing to accept. Indeed, proponents of sustainable finance should not merely accept “proof of stake” blockchains, but demand that all investments are done in such chains, and not in the more environmentally damaging “proof of work” alternative. Bitcoin, notably, is still created through “mining” and should therefore not be invested in, whether directly or indirectly, by environmentally conscious organizations. Finally, it should be noted that a move to “proof of stake” may diminish the negative environmental impact of cryptocurrency, but that it does not eliminate or reduce the many cybercriminal activities that rely on blockchain. It would be a welcome first step however in the hopes that users with greater legitimacy will be more reluctant to be associated with malicious activities, even if indirectly.

4.2

Corporate Governance

Canada is moving toward more specific guidelines that will apply to financial institutions with respect to cybersecurity (OSFI 2022). While space prohibits a

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discussion of these guidelines here it is worth noting that they will be relevant to many institutions interested in ESG considerations, and that substantively, they react to many of the concerns and issues raised in this chapter. Accordingly, there are some important, internal steps that can be taken by many organizations and that will reduce the impact of cybercrime on corporate governance. Investors wishing to support financial sustainability would therefore direct their investments toward such organizations and prefer them over those that appear to care less about cybercrime. As discussed above, these mitigating steps are the result of several existing governance issues. The emergence of cybercrime led many organizations to realize that they lacked internal accountability for cybersecurity. The resulting years have seen the elevation of several executive functions, first with the creation of chief information officer (CIO) positions and subsequently with the creation of chief information security officer (CISO) positions. Despite these trends there are still numerous organizations which lack either a CIO, CISO or both and as a result could be thought to be less focused on cybersecurity and cybercrime. Sustainable financial investors should direct their resources toward corporations that demonstrate such basic awareness, and away from corporations that continue to neglect cybercrime. Further (and very much related to the previous point), cybercrime has historically had very little impact on the market value of publicly traded corporations. While stock markets have dipped following a malicious attack or data breach, such changes were quickly erased. In a market economy focused on one (and not three) bottom lines, the resilience of market value in the face of cybercrime sent a clear internal message to corporate executives that cybercrime and cybersecurity are of little concern. ESG investors should therefore send a clear message to corporations that suffered attacks that they except to see clear remedial action, regardless of market impact, and they are prepared to invest elsewhere if such action is not forthcoming. Such informed investment decisions will strengthen the resolve and interest of corporate executives to invest in robust internal cybersecurity and will eventually impact the market value of those corporations that continue to ignore cybercrime. The relatively recent resignations of corporate executives in the aftermath of successful cyberattacks, discussed earlier, are welcome indicators in this regard. Investors interested in financial sustainability should also clarify what is meant by clear organizational remedial action. Corporate executives and directors have been attracted to the possibility of managing cybercrime risks through the purchase of insurance policies. Insurance does not reduce any risk, but instead shifts it from the organization to the insurer. Insurance is superficially appealing since it does not require the ongoing dedication and commitment of resources to the actual internal work that is necessary for the reduction, if not elimination, of cyber risks and vulnerabilities. Insurance is, in other words, a “band-aid solution” to cybercrime and a reflection of relatively poor corporate governance commitment to cybersecurity. By insisting on actual internal risk reduction ESG-concerned investors could therefore improve corporate governance and contribute to the elimination of cybercrime. We see, in sum, that cybercrime supports poor corporate governance trends—an exclusive focus on the bottom line at the expense of environmental and societal impact, a lack of corporate accountability, with no dedicated executive

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functions to oversee cyber-risk and cybersecurity, and finally, minimal investment in initiatives that do not appear to be part of the “core mission” of the organization. These poor trends must all change, and such change can come about thanks to the insistence of ESG investors that organizations combat cybercrime and tackle it headon. Engaging cybercrime and treating it as a top organizational priority will, in such a manner, improve corporate governance.

4.3

Society

Whether under the heading of corporate social responsibility, or whether under the heading of ESG considerations, organizations and investors have always prioritized certain social causes over others. Supporting a health-related cause, such as the battle against cancer (CIBC 2022), or mental illness (Bell 2022) takes priority over other social issues, such as reform of the criminal justice system (Innocence 2022). There are many reasons for prioritizing social causes, not least of which is the potential impact of the cause on the reputation of the organization. Causes that pose a risk (such supporting the struggle of a convicted criminal that is claiming their innocence) are less attractive than causes without an obvious downside (such as healthcare). Combatting crime in general has never been a mainstream corporate cause. Unlike healthcare, public safety does not enjoy a broad reputational consensus, and there is enough of a part of society that sees itself as unfairly targeted by the fight against crime to turn the broader cause into a reputational risk. That is one reason why combatting cybercrime has not been widely embraced as an ESG cause. Another reason is the lingering perception of cybercrime as a “victimless” crime (White 2018). Organizations that may not wish to be active in the fight against crime may nevertheless be supportive of victims and survivors (RBC 2022). Yet even such a form of support of cybercrime victims may be questionable against the backdrop of more serious, violent, and traumatic crimes. As a result, the battle against cybercrime has yet to be embraced as a mainstream corporate cause. Nevertheless, this chapter argues that the benefits of considering cybercrime as part of ESG considerations greatly outweigh any potential investor reputational risks. Cybercrime impacts society, and while other crimes may impact individuals more violently, the magnitude of cybercrime causes it to have a widespread social impact. The malevolent activity discussed in this chapter, without exception, has a long-lasting impact on society regardless of whether it impacts the environment or internal corporate governance. Societal impact should therefore be at the forefront of ESG considerations, and there are a number of ways in which such considerations could incorporate them. First, ESG investors should directly invest in organizations that actively work to reduce cybercrime, such as companies that develop cybersecurity products and services. From start-ups to more established corporations, a private sector commitment to the elimination of cybercrime is a laudable goal that should be supported by ESG investors. Second, ESG investors should invest in organizations that work to

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ameliorate the impact of cybercrime on other organizations and of course on individuals, such as providers of identity protection and restoration after data breaches and identity theft. Third, ESG investors should invest, where possible, in technological products and services that have not been used to facilitate cybercrime, or that constitute a “lesser evil.” For example, products based on ethereum would be relatively better ESG investments than products based on bitcoin. Fourth, ESG investors should invest as little as possible in jurisdictions that allow, tolerate, or utilize cybercrime as a geopolitical tool, and as little as possible in jurisdictions that curtail or censor the use of technology (unsurprisingly, these two sets of jurisdictions greatly overlap). No doubt other considerations could be contemplated, but even a partial focus on considerations such as those listed immediately above will lead to a much more concerted investment effort to reduce, if not combat, cybercrime and therefore to an observable reduced impact of cybercrime on society.

5 Conclusion The relationship between efforts to combat cybercrime and sustainable finance initiatives is not immediately obvious, but as discussed in this chapter, it very much exists. Cybercriminal activity impacts the environment, corporate governance, and society at large. Cybercriminal infrastructure impacts the environment, corporate governance, and society at large. Investors conscious of ESG considerations are able to tackle in their deliberations this debilitating impact head-on by insisting on several measures with respect to each aspect of ESG. First, the protection of the environment will be bolstered by investing in blockchain technology that is based on “proof of stake” and by moving away from technology that is based on “proof of work.” Second, corporate governance will be bolstered by investing in organizations that have dedicated executive functions to oversee cyber-risk and cybersecurity, clear measures of accountability for these and other executives in the event that cybercrimes occur, and a track record of internal investments in cybersecurity. ESG investors should invest, in other words, in organizations that treat the battle against cybercrime as a top organizational priority. These are the very organizations that will not be exclusively focused on their bottom line at the expense of ESG. Third, society at a whole will be strengthened when investments are made in organizations that actively work to reduce cybercrime, in organizations that work to ameliorate the impact of cybercrime on other organizations and individuals, in technological products and services that have not been used to facilitate cybercrime, and in jurisdictions that do not allow, tolerate or utilize cybercrime as a geopolitical tool, or curtail or censor the use of technology. Such investments, informed by the impact and consequences of cybercrime, battle cybercrime, and in so doing inevitably reduce the impact of cybercrime on the ESG goals that motivate sustainable finance, contribute to the sustainability of economic activity and finally, strengthen sustainable finance. Hopefully, ESG

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investors will take increasing note of the relationship between efforts to combat cybercrime and sustainable finance initiatives, and act accordingly.

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Avner Levin is a professor at Toronto Metropolitan (formerly Ryerson) University’s Lincoln Alexander School of Law. He is the founding director of the university’s Privacy and Cyber Crime Institute and of its Law Research Centre. Professor Levin’s research interests include privacy, cybercrime, law and technology, and the legal profession. He has been a recipient of funding from bodies such as the Social Sciences and Humanities Research Council (SSHRC), the Office of the Privacy Commissioner of Canada (OPC), Public Safety Canada, Industry Canada, and the Blavatnik Interdisciplinary Cyber Research Center at Tel-Aviv University.

Terrorism Financing, the United Kingdom, and the Financial Action Task Force: A Series of Omissions or Missed Opportunities? Dominika Benton and Nicholas Ryder

1 Introduction In its 2018 Mutual Evaluation Report of the United Kingdom’s (UK) compliance with its Recommendations,1 the Financial Action Task Force (FATF) rated the UK’s anti-laundering and counter-terrorism financing (AML/CTF) regime as the best in world. 2 In order to achieve this rating, the UK has adopted an aggressive and, at times, holistic strategy towards tackling money laundering and terrorism financing.3 For the purpose of this chapter, the UK’s response was identified by reviewing related legislation and policy developments since the UK’s 2007 Mutual Evaluation

1

The Financial Action Task Force Recommendations are the internationally recognised anti-money laundering and counter-terrorism financing standards. See Financial Action Task Force International standards on combatting money laundering and the financing of terrorism and proliferation—the FATF Recommendations (Financial Action Task Force, 2012). 2 Financial Action Task Force Anti-money laundering and counter-terrorist financing measures United Kingdom Mutual Evaluation Report (Financial Action Task Force: 2018) at 5. Also see HM Government ‘UK takes top spot in fight against dirty money’, December 8 2018, available from https://www.gov.uk/government/news/uk-takes-top-spot-in-fight-against-dirty-money. Accessed July 6 2020. 3 The HM Treasury Select Committee noted that prior to the publication of the Fourth Mutual Evaluation Report in 2018, ‘the pace of reform in this area [money laundering and terrorism financing] has increased’. See HM Treasury Select Committee Economic Crime—Anti-money laundering supervision and sanctions implementation (HM Treasury Select Committee, 2019) at 10. D. Benton University of West England, Bristol, UK N. Ryder (✉) Cardiff University, Cardiff, UK e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 M. Dion (ed.), Sustainable Finance and Financial Crime, Sustainable Finance, https://doi.org/10.1007/978-3-031-28752-7_18

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Review.4 The legislative measures included the introduction of a comprehensive AML legislative framework that exceeds the international standards.5 The UK has an established approach towards implementing a robust CTF regime, which is identified by the FATF as an example of international best practice. HM Government (HMG) stated that the UK ‘has the strongest overall . . . CTF regime of over 60 countries assessed’. However, the rating has been questioned by the Royal United Services Institute (RUSI) who stated that ‘the UK remains central to global money laundering schemes . . . [thus it] brings into question the relevance of this evaluation’.6 HMG dismissed these criticisms and referred to the findings of the 2018 Mutual Evaluation Report, which does not consider, among others, the ramifications arising out of the length of time to report and review. The use of Distributed Ledger Technology See generally Financial Action Task Force Anti-money laundering and counter-terrorist financing measures United Kingdom Mutual Evaluation Report (Financial Action Task Force, 2007). 5 See generally HM Government Economic Crime Plan 2019-22 (HM Government, 2019). This is often referred to as the UK government ‘gold-plating’ its financial crime legislation. See Srivastava, A., Moffatt, N., Burkova, K., Best, T. and Dayanim, B. ‘Money laundering update’ (2019) Compliance Officer Bulletin, 167(Jun), 1–23. There are other ‘international best practices’, which countries are encouraged to adopt, but any detailed discussion is beyond the scope of this article. The UK left the EU on 31 January 2020 and the future relationship regarding the prevention of money laundering and/or terrorism financing was provided by the Sanctions and Anti-Money Laundering Act 2018. At the stage of writing this paper it is impossible to determine the impact of BREXIT on the UKs efforts to money laundering and terrorism financing, but some commentators have suggested that the risk will be increased. See for example Transparency International ‘Parliament’s economic crime report—a call to act against dirty money entering the UK’, March 8 2019, available from https://www.transparency.org.uk/parliament-s-economic-crime-report-callact-against-dirty-money-entering-uk. Accessed January 7 2021; National Crime Agency National Strategic Assessment of Serious and Organised Crime (National Crime Agency, 2018) at 8, 26, 45; Hoque, I. ‘Brexit could make the UK the money laundering capital of the world’, January 10 2019, available from https://www.independent.co.uk/voices/brexit-europol-money-laundering-crime-ter rorism-trafficking-a8720551.html. Accessed January 7 2021; Vincent, M. ‘Brexit risks making London’s fight against dirty money fight harder, says lawyer’, May 26 2020, available from https:// www.ft.com/content/b9ab08ce-7a90-439a-8463-f552f2dcbb85. Accessed January 7 2021; Barrington, R. ‘Will post-Brexit Britain be beacon or buccaneer on financial crime?’, May 12 2019, available from https://www.transparency.org.uk/will-post-brexit-britain-be-beacon-orbuccaneer-financial-crime. Accessed January 7 2021 and Keatinge, T. ‘Financial Crime and Brexit: Can We Agree on Nothing?’, June 1 2020, available from https://rusi.org/commentary/financialcrime-and-brexit-can-we-agree-nothing. Accessed January 7 2021. 6 Royal United Services Institute ‘RUSI Experts React to UK’s Financial Action Task Force Mutual Evaluation Report’, December 8 2018, available from https://rusi.org/rusi-news/rusi-experts-reactuk-financial-action-task-force-mutual-evaluation-report. Accessed July 24 2020. For similar criticisms see United States Department of State Bureau of International Narcotics and Law Enforcement Affairs International Narcotics Control Strategy Report Volume II Money Laundering (United States Department of State Bureau of International Narcotics and Law Enforcement Affairs, 2020) at 198; House of Commons Foreign Affairs Committee Moscow’s Gold: Russian Corruption in the UK Eighth Report of Session 2017–19 (House of Commons Foreign Affairs Committee, 2018) at 11 and Intelligence, Security Committee of Parliament Russia (Intelligence and Security Committee of Parliament, 2020) at 11 and Nice, A. ‘The ISC Russia report highlighted problems that cannot be solved by the intelligence services alone’, n.d., available from https://www. instituteforgovernment.org.uk/blog/isc-russia-report. Accessed January 11 2021. 4

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(DLT) has the potential of overseeing financial transactions for AML/CTF compliance purposes, which by alleviating the need for manual oversight would limit costs and time owing to the innate qualities of the ledger automatically updating its records, thereby facilitating organisations in meeting their regulatory obligations more efficiently as well as working towards a more sustainable regulatory model. Overall, the use of technology can be beneficial for gathering intelligence through open sources, including social media as evidenced by the work carried out by the Centre for Strategic Counterterrorism Communications in the United States (US). Therefore, this chapter presents evidence that there are inherent weaknesses within the UK’s CTF strategy, related legislation and challenges the findings of the UK’s Fourth MER and considers the ways in which technology can be used to tackle terrorism financing.

2 The Evolution of Terrorism Financing: Emerging Typologies The first part of the chapter identifies an emerging terrorism financing model that involves a combination of cryptoassets and social media platforms—the Social Networking Funding Model. Traditionally, terrorists have relied on two sources of funding: state and private sponsors. State-sponsored terrorism involves governments providing logistical and financial support to terrorists, or governments even conducting acts of terrorism against their own citizens.7 As of January 2021, the US Department of State identifies four state sponsors of terrorism—the Democratic People’s Republic of Korea, Iran, Cuba and Syria.8 However, since the instigation of the Financial War on Terrorism, there has been a decline in state-sponsored terrorism and terrorists have been forced to modify and adapt their funding models and it is more likely that terrorists will receive funding from private sponsors or donors. The demise of state-sponsored terrorism was acknowledged by Hardouin who stated that ‘state sponsorship [terrorism] has been decreasing (not disappearing) as terrorist groups find it harder to obtain state support, and states that are not respecting international standards are less willing to risk exposure to severe international sanctions’.9 It has been suggested that there are two factors that have contributed

See generally Ryder, N The Financial War on Terrorism—a review of counter-terrorist financing strategies since 2001 (Routledge, 2015). 8 The United States Secretary of State is permitted to designate a country as a state sponsor of terrorism by virtue of powers provided by the s. 6(j) Export Administration Act (1979), s. 40 the Arms Export and Control Act (1976) and s. 620A of the Foreign Assistance Act (1948). For an early discussion of state sponsored terrorism see Roberts, G. ‘Self-help in Combating State Sponsored Terrorism: Self-Defence and Peacetime Reprisals’ (1987) Case Western Reserve Journal of International Law 19(2): 243–293. 9 Hardouin. P. 2009. Banks governance and public-private partnership in preventing and confronting organized crime, corruption and terrorism financing Journal of Financial Crime 16(3): 199–209. 7

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towards the decline in state-sponsored terrorism. Firstly, ‘there are fewer states engaged in supporting terrorists’.10 Secondly, ‘the new global terrorist networks have arisen that no longer rely on states for support. Instead, terrorist groups rely more and more on networks of private donors and supporters and direct engagement with criminal activities to raise funds’.11 Further evidence of the shift away from state-sponsored terrorism towards private donors was highlighted by the National Commission on the Terrorist Attacks upon the United States who concluded that al-Qaeda relied on finances raised by private benefactors and not from state sponsors.12 Additionally, the Inter-governmental Action Group Against Money Laundering in West Africa noted that Boko Harem has been partly financed through private donors and misapplied charitable donations.13 The increased use of private financial benefactors was also highlighted by the US Department of Treasury who conducted an analysis of terrorism financing cases and prosecutions between 2001 and 2014 and determined that approximately one third of the cases involved financial support from private donors.14 The FATF stated, ‘wealthy private donors can be an important source of income for some terrorist groups. For example, the FATF Islamic State of Iraq and the Levant (ISIL) report acknowledges that ISIL has received some funding from wealthy private donors in the region’.15 Terrorists are able to access funds through a spectrum of mechanisms including, inter alia, kidnap for ransom, robbery, drug trafficking, fraud, the control of oil reserves, the sale of ivory, abuse of natural resources, misapplied charitable donations and the Internet. More recently, terrorists have obtained finances from a wide range of emerging sources including cryptoassets and social media platforms.16 The extent to which cryptoassets are exploited for money laundering and/or terrorism financing is impossible to determine. Yet, it has been estimated that between £3 and 4 billion is annually laundered via cryptoassets within the EU and that ‘cryptocurrencies have become the favoured detergent for criminals to launder money’.17 However, even if

10 Richard, A. Fighting Terrorist Financing: Transatlantic Co-operation and International Institutions (Centre for Transatlantic Relations: John Hopkins University, 2005) at 6. 11 Ibid. 12 National Commission on Terrorist Attacks upon the United States The 9/11 Commission Report (Norton and Company: New York, 2004). 13 Inter-governmental Action Group Against Money Laundering in West Africa Threat Assessment of Money Laundering and Terrorist Financing in West Africa (Inter-governmental Action Group Against Money Laundering in West Africa, 2010) at 94. 14 United States Department of Treasury National Terrorist Financing Risk Assessment 2015 (2015). 15 Financial Action Task Force Emerging Terrorist Financing Risks (2015), p.13. 16 See generally Ryder, N. ‘Cryptoassets, social media platforms and defence against terrorism financing suspicious activity reports: a step into the regulatory unknown’ (2020) Journal of Business Law, 8, 668–693. 17 V. Marria, ‘How Cryptocurrencies Are Empowering Cyber Criminals’ (4 February 2019, https:// www.forbes.com/sites/vishalmarria/2019/02/04/how-cryptocurrencies-are-empoweringcybercriminals/#690a4eb237c5. Accessed 18 September 2020).

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this figure is accurate, it only represents a small percentage of the money laundered within the EU. The association between cryptoassets and financial crime has been illustrated by several investigations and subsequent criminal convictions obtained by Law Enforcement Agencies (LEAs) in the US and UK. One of the first cases surrounding the illegal use of cryptoassets was ‘Silk Road’, an online black-market platform that was used by organised criminals and terrorists via the dark web.18 Silk Road was able to ‘generate total sales revenue of approximately $1.2 billion and approximately $80 million in commissions . . . and hundreds of millions of dollars were laundered from these illegal transactions’.19 The users of Silk Road were able to protect their anonymity by using ‘The Onion Router’ and virtual private networks.20 However, these platforms prevented anonymous payment methods. Ross Ulbriant was able to solve this problem by using Bitcoin, which, via blockchain, provided a mechanism that was able to confirm if the payments had been made and received.21 The website was launched in February 2011 and eventually closed by the Federal Bureau of Investigation (FBI) in 2013 following the arrest of its founder Ross Ulbricht, who was convicted of money laundering and computer hacking in February 2015.22 The second example that illustrates the association between cryptoassets and financial crime is ‘Liberty Reserve’, a Costa-Rican digital currency service that attracted over one million users. Liberty Reserve advertised itself as the internet’s ‘oldest, safest, and most popular payment processor... serving millions all around [the] world’.23 The users of Liberty Reserve were required to provide personal details including their names, date of birth and e-mail addresses, but in most cases, the information provided was false. The account holders would ‘convert’ their cash into Liberty Dollars following an instantaneous transfer and the cash would be converted back into useable currencies. Liberty Reserve would charge its users approximately $3 per transaction and operated on an unprecedented scale: it included over 200,000 users in the US and conducted over 55 million online For a more detailed discussion of the ‘Dark Web’ see Shillitto, M. ‘Untangling the ‘Dark Web’: An Emerging Technological Challenge for the Criminal Law’ (2019) Information & Communications Technology Law, 28(2) 186–207. 19 Financial Action Task Force, Virtual Currencies: Key Definitions and Potential AML/CFT Risks (2014), p. 10. 20 TOR is a free and open-source software that enables its user to conduct anonymous communication and other internet usage from any surveillance or online analysis. 21 Blockchain is a system in which a record of financial transactions made by Bitcoin and other cryptoassets are maintained across several computers that are linked in a peer-to-peer network. 22 United States Department of Justice, ‘Ross Ulbricht, A/K/A “Dread Pirate Roberts”, Sentenced In Manhattan Federal Court To Life In Prison’ (29) May 2015), https://www.justice.gov/usao-sdny/pr/ ross-ulbricht-aka-dread-pirate-roberts-sentenced-manhattan-federal-court-life-prison. Accessed 18 September 2020. Ulbricht was sentenced to two life sentences, which were upheld by the Court of Appeals for the Second Circuit in May 2017. In June 2018, the US Supreme Court declined to consider Ulbricht’s appeal. See Ulbricht v United States (28 June 2018). 23 BBC, ‘Liberty Reserve Digital Cash Chief Jailed for 20 Years’ (9 May 2016), BBC, https://www. bbc.co.uk/news/technology-36247289. Accessed 18 September 2020. 18

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transactions, ‘almost all of which were illegal. It [Liberty Reserve] had its own virtual currency, Liberty Dollars, but at each end, transfers were denominated and stored in fiat currency’.24 The Liberty Dollar was a private currency produced in the US that was issued an ‘electronic money’ or ‘e-money’.25 Liberty Reserve has been described as the largest online money laundering cases in US history and it was eventually closed by the US Department of Justice (DoJ) after its co-founder, Arthur Budovsky, was convicted of laundering between $250 million and £550 million and sentenced to 20 years imprisonment in May 2016.26 The connection between cryptoassets and financial crime is illustrated by the third example—Western Express International, a virtual currency exchanger and unregistered money transmitter. Here, 16 members of the Western Express International Cybercrime Group were convicted for their role in numerous fraudulent schemes. Gang members stole over 100,000 credit card numbers and personal identities, which were sold and paid for with e-Gold and Webmoney.27 Egor Shevelev used multiple internet forums to claim that he has millions of stolen credit cards and account numbers that were for sale. Douglas Latta and Anna Ciano agreed to purchase 1000 of the credit cards and account numbers from Egor Shevelev by an online currency, that was difficult to trace. In February 2013, Egor Shevelev pleaded guilty to money laundering, fraud and conspiracy charges and was sentenced to 14 years imprisonment.28 There are also several examples illustrating the association between cryptoassets and financial crime within the UK. For example, Thomas White, who took over the administration of Silk Road after it was closed by the FBI in 2013, continued to use the technology that had previously permitted its users to illegally purchase drugs, computing hacking software and other illegal products by using cryptoassets. White was convicted and sentenced to 5 years imprisonment for drug trafficking offences, money laundering and making a number of indecent images of children.29 Furthermore, in August 2019 Grant West was convicted of fraud after he carried out numerous cyber-attacks on over 100 UK-based companies. West attempted to 24

Financial Action Task Force Terrorist Financing (2008), p.10. E-money has been defined by the European Central Bank as ‘an electronic store of money value on a technical device that may be widely used for making payments to entitles other than the e-money issuer’. See European Central Bank ‘Electronic Money’, n.d., available from https://www. ecb.europa.eu/stats/money_credit_banking/electronic_money/html/index.en.html. Accessed July 3 2019. 26 United States Department of Justice, ‘Liberty Reserve Founder Arthur Budovsky Sentenced In Manhattan Federal Court To 20 Years For Laundering Hundreds Of Millions Of Dollars Through His Global Digital Currency Business’ (6 May 2016, https://www.justice.gov/usao-sdny/pr/libertyreserve-founder-arthur-budovsky-sentenced-manhattan-federal-court-20-years. Accessed 22 September 2020 27 Financial Action Task Force Terrorist Financing (2008), p.10. 28 United States v Shevelev 2014 WL 495393. 29 Crown Prosecution Service, ‘Dark web drug dealer jailed after rebooting world’s biggest online drug marketplace’ (12 April 2019), https://www.cps.gov.uk/cps/news/dark-web-drug-dealer-jailedafter-rebooting-worlds-biggest-online-drug-marketplace. Accessed 18 September 2020. 25

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defraud the companies by installing ransomware software on their computer systems and then demanded a ransom payment via Bitcoin to uninstall the illegal software.30 As these examples illustrate, there is a clear link between technological innovation and financial crime. Now that the association between cryptoassets and financial crime has been illustrated, this should be taken seriously, even more so when cryptoassets and social media platforms are used to accumulate funding for terrorist purposes. For example, the Indonesian Financial Transaction Reports and Analysis Centre reported that ISIL had used Bitcoin for terrorism financing purposes.31 In August 2015, a computer hacker demanded a ransom of two bitcoins from a retailer in exchange for removing bugs from their computer system.32 The hacker was able to use the extracted data from the server to create a ‘kill list’ of over 1300 names of US government and military personnel that was provided to ISIL. Another example of ISIL attempting to acquire funding via cryptoassets was Ali Shukri Amin, who was convicted and sentenced to 11 years and 4 months imprisonment for using the ‘internet to provide material support and resources’ to ISIL.33 Amin pleaded guilty and admitted to using his Twitter handle ‘@Amreekiwitness’ to ‘provide instruction [to ISIL] on how to use Bitcoin . . . to mask the provision of funds to ISIL’.34 This case demonstrates that terrorism financiers are using both social media platforms and cryptoassets to provide support and resources to ISIL. Another example of terrorism financiers exploiting cryptoassets was Zoobia Shahnaz, who was arrested by the FBI after attempting to transfer $62,000 worth of bitcoin to ISIL. The DoJ alleged that Shahnaz had ‘engaged in a bank fraud scheme, purchased bitcoin and other cryptocurrencies and laundered money overseas, intending to put thousands of dollars into the coffers of terrorists . . . allegedly tried to launder virtual currency to bolster terrorists’ dwindling financial support’.35 The DoJ stated that Shahnaz had entered into a number of financial transactions designed to circumvent the transaction reporting obligations imposed by the Currency and Foreign Transactions Reporting Act (1970). Subsequently, Shahnaz pleaded guilty to providing material

30 Busby, M. ‘Bitcoin worth £900,000 seized from hacker to compensate victims’, April 23 2019, available from Bitcoin worth £900,000 seized from hacker to compensate victims | Cybercrime | The Guardian. Accessed 13 September 2022. 31 Indonesian Financial Transaction Reports and Analysis Centre, Indonesia National Risk Assessment (2015), pp.70–72. 32 Centre for New American Security, Terrorist Use of Virtual Currencies—Containing the Potential Threat (2017), p. 12 33 United States Department ofJustice, ‘Virginia man sentenced to more than 11 years for providing material support to ISIL’ (28 August 2015), https://www.justice.gov/opa/pr/virginia-mansentenced-more-11-years-providing-material-support-isil. Accessed 18 September 2020] 34 Ibid. 35 United States Department of Justice, ‘Long Island Woman Indicted for Bank Fraud and Money Laundering to Support Terrorists’ (14 December 2017), https://www.justice.gov/usao-edny/pr/ long-island-woman-indicted-bank-fraud-and-money-laundering-support-terrorists. Accessed 18 September 2020.

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support to ISIL and faces up to 20 years’ imprisonment.36 Another case illustrating the use of cryptoassets to fund terrorism is that of Hisham Chaudry, who used bitcoin to help free ISIL supporters from Syria’s detention camps, using social media accounts under the name of John Smith to spread his propaganda. Chaudry was charged with seven offences under the Terrorism Act and was sentenced to 12 years imprisonment.37 Therefore, terrorists are ‘creating safe havens to raise funds hiding in the shadows of the dark net . . . using cryptocurrencies such as Bitcoin to generate funds’. The Jackson Society noted that an al-Qaeda-linked entity, al-Sadaqah, used a public channel on Telegram to campaign for Bitcoin funding.38 Similarly, in 2019 Hamas issued an appeal for bitcoin donations to aid in countering its financial despairs, and launched an experimental program using a complex cryptocurrency system to raise funds from international donors.39 Clearly, then, modern forms of technology, especially social media platforms are used by terrorism financiers. More often than not, the payments made over the internet, the Dark Web or social media platforms involve small amounts of funding which do not raise suspicion. In terms of Bitcoin transactions, these often involve the use of mixers, which are designed to provide an increased level of privacy in cryptoassets transactions, and/or the use of multiple inputs whereby a bitcoin transaction is divided into several transactions (thus, multiple inputs) all of which received by one recipient. The Capitol attacks of January 2021, however, used neither of the abovementioned and the transaction was very direct; 28.15 bitcoins (worth approximately $522k at the time of the transfer) were transferred to 22 separate addresses in a single transaction by a French donor.40 This illustrates the failure of the current suspicious activity reporting (SAR) regime to effectively and efficiently identify suspicious transactions. This section of the chapter has illustrated that terrorists have continued to develop new funding mechanisms by exploiting the high levels of pseudonymity provided by the dark web and cryptoassets. The anonymity and speed provided by the Internet is an appealing tool for terrorists to solicit financial donors. In evidence presented to the House Foreign Affairs Committee (Subcommittee on Terrorism, Non-proliferation, and Trade See United States Department of Justice, ‘New York woman pleads guilty to providing material support to ISIS’ (26 November 2018), https://www.justice.gov/opa/pr/new-york-woman-pleadsguilty-providing-material-support-isis. Accessed 18 September 2020. 37 BBC News ‘Hisham Chaudhary: Oadby terrorist who funded IS with Bitcoin jailed’, September 3 2021, available from Hisham Chaudhary: Oadby terrorist who funded IS with Bitcoin jailed— BBC News. Accessed September 2 2022. 38 The Jackson Society, Terror in the Dark: How Terrorists use Encryption, the Darknet and Cryptocurrencies (2018), p. 42. 39 United States Department of Treasury, ‘Under Secretary Mandelker remarks at the 19th Annual International Conference on Counterterrorism’ (11 September 2019), https://home.treasury.gov/ news/press-releases/sm773. Accessed 18 September 2020. 40 Chainalysis, ‘Alt-right Groups and Personalities Involved in the January 2021 Capitol Riot Received Over $500k in Bitcoin From French Donor One Month Prior’ (14 January 2021) available from https://blog.chainalysis.com/reports/capitol-riot-bitcoin-donation-alt-right-domestic-extrem ism/. Accessed 14 February 2022. 36

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Subcommittee on the Middle East and North Africa) the Washington Institute for Near East Policy stated that some of terrorism fundraising was carried out in plain sight on online social media platforms.41 The evidence referred to a video uploaded to YouTube in October 2016 by Abd Allah al-Muhaysini who ‘thanked Gulf donors for supporting jihadists in Syria: “As for the businessmen, and I will mention some of them, the ones who prepared these hundred rockets, may Allah reward them . . . I tell all the businessmen of the Muslims, this is your money now, fighting in the path of Allah”’.42 Further evidence of the association between social media platforms and terrorism financing is illustrated by the US Department of the Treasury, which in 2014 imposed sanctions on three terrorism financiers for ‘fundraising appeals on social media’. Here, the US Department of the Treasury stated that, ‘Al-Ajmi operates regular social media campaigns seeking donations for Syrian fighters and is one of the most active Kuwaiti fundraisers for Al-Nusra Front (ANF).43 In July 2014, Al-Ajmi publicly admitted that he collected money under the auspices of charity and delivered the funds in person’.44 Further sanctions were imposed on Abdul Mohsen Abdullah Ibrahim al-Sharikh, who ‘is a senior ANF leader and al-Qaida facilitator based in Syria . . . in this role, al-Sharikh has used social media posts to demonstrate his aspiration to target Americans and U.S. interests’.45 Furthermore, in 2015 Mohamed Elshinawy was convicted for ‘conspiracy to provide material support to ISIS, providing and attempting to provide material support to ISIS; terrorism financing; and making false statements in connection with a terrorism matter’.46 Elshinawy admitted his role in a conspiracy to provide funding for ISIL via a variety of mechanisms including PayPal and Western Union, totalling $8700. In March 2019, Gregory Lepsky was sentenced to 16 years imprisonment after 41 K. Blumenstein-Katz, ‘The Washington Institute for Near East Policy “Grading counterterrorism Co-operation with GCC states”—Testimony submitted to the House Foreign Affairs Committee Subcommittee on Terrorism, Nonproliferation, and Trade Subcommittee on the Middle East and North Africa’ (26 April 2018), http://www.washingtoninstitute.org/uploads/Documents/testimony/ BauerTestimony20180426.pdf. Accessed 18 September 2020. 42 Ibid. 43 United States Department of the Treasury, ‘Treasury Designates Three Key Supporters of Terrorists in Syria and Iraq’ (6 August 2014), https://www.treasury.gov/press-center/pressreleases/Pages/jl2605.aspx. Accessed 18 September 2020. 44 Ibid. 45 US Department of the Treasury, ‘Treasury Designates Additional Supporters of the Al-Nusrah Front and Al-Qaida’ (22 August 2014), https://www.treasury.gov/press-center/press-releases/ Pages/jl2613.aspx. Accessed 18 September 2020. Abd Allah al-Muhaysini was designated a terrorist by the US Department of Treasury in 2016. See US Department of State, ‘Treasury designates key Al-Nusrah front leaders’ (10 November 2016), https://www.treasury.gov/presscenter/press-releases/Pages/jl0605.aspx. Accessed 18 September 2020. ANF has been described as representing al Qaeda in Syria and it has been designated a foreign terrorist organisation by virtue of the Immigration and Nationality Act 1965, Pub.L. 89–236, 79 Stat. 911, enacted 30 June 1968. 46 United States Department of Justice, ‘Maryland man sentenced to 20 years in prison for providing material support to ISIS and terrorism financing’ (30 March 2018), https://www.justice.gov/opa/pr/ maryland-man-sentenced-20-years-prison-providing-material-support-isis-and-terrorism. Accessed 18 September 2020.

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pleading guilty to attempting to provide material support to a designated foreign terrorist organisation. Here, law enforcement authorities were able to determine that Lepsky had used several social media platforms to plan his terrorist attack.47 In September 2019, the US Department of Treasury stated that ‘HAMAS solicit [ed] bitcoin donations via social media, using two Bitcoin addresses. As of late March 2019, those two known addressed had received at least $5,000 worth of bitcoin’.48 These instances illustrate that terrorism financiers are using several social media platforms in an attempt either to solicit donations or to transfer funds to proscribed terrorist groups. The evidence presented in this part of the paper highlights that terrorism financing continues to evolve at an unprecedented level. The use of both cryptoassets and social media platforms to obtain financing represents a new funding model that can thrive due to the anonymity provided by the Dark Web.

3 UK Counter-Financing Strategy Due to the ‘Troubles’ in Northern Ireland and other terrorist activities in mainland Britain, the UK has significant experience of tackling domestic acts of terrorism. Consequently, the evolution of its terrorist-related measures and policies can be traced back to its initial efforts to tackle terrorism in the early part of the twentieth century. The two central legislative pillars of the UK’s counter-terrorist efforts are therefore the Northern Ireland (Emergency Provisions) Act 1973 and the Prevention of Terrorism (Temporary Provisions) Act 1974. Since these formative Acts, subsequent pieces of legislation and the UK’s CTF policy have been heavily influenced by drug trafficking legislation. Donohue stated that the country’s: anti-terrorist finance regime has exhibited an almost symbiotic relationship between antidrug and anti-terrorist finance measures since the mid-1980s, leading to a steady expansion in the number and range of related offences, investigatory authorities, regulatory provisions, and powers of forfeiture. 49

For example, the Drug Trafficking Offences Act 1986 contained a series of statutory provisions that permitted the confiscation of the proceeds of drug trafficking offences. Moreover, the scope of a limited number of criminal offences covered by the Act was extended to all ‘non-drug’ indictable offences and specific summary offences by the Criminal Justice Act 1988. Further amendments were introduced by United States Department of Justice, ‘New Jersey man sentenced to 16 years in prison for attempting to provide material support to ISIS’ (1 March 2019), https://www.justice.gov/opa/pr/ new-jersey-man-sentenced-16-years-prison-attempting-provide-material-support-isis. Accessed 18 September 2020. 48 United States Department of Treasury, ‘Under Secretary Mandelker remarks at the 19th Annual International Conference on Counterterrorism’ (11 September 2019), https://home.treasury.gov/ news/press-releases/sm773. Accessed 18 September 2020. 49 L. Donohue, The Cost of Counterterrorism: Power, Politics and Liberty (Cambridge University Press, 2008), 123. 47

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the Drug Trafficking Act 1994 and the Proceeds of Crime Act 1995. Despite the enactment of such progressive and wide-ranging pieces of legislation, terrorist financing continued, which led Tony Blair’s Labour government to review the UK’s confiscation regime.50 The subsequent report recommended that an ‘Asset Confiscation Agency’ should be created and that the money laundering and confiscation regimes should be consolidated under one piece of legislation. These recommendations were eventually enacted via the Proceeds of Crime Act 2002. The existing drug-related mechanisms also influenced the CTF provisions in the Prevention of Terrorism Act 1989. 51 For example, under Part 3, it introduced specific provisions to criminalise the financing of terrorism and the control of terrorist finances and imposed forfeiture and criminal penalties on those found guilty of this offence. The UK has achieved some success against the Irish Republican Army (IRA) in Northern Ireland by virtue of the offences created in this legislation. However, the Act’s effectiveness was still questioned, which led to a review of the UK’s anti-terrorism policy by the Home Office in 1998.52 The resulting consultation paper highlighted several weaknesses in the terrorist financing provisions, including the fact that there were only four terrorist financing convictions between 1978 and 1989.53 The Home Office thus recommended that the scope of the terrorist financing provisions should be extended to fundraising for all terrorist purposes. Following the review by the Home Office, the UK signed and ratified the 1999 UN Convention on the Suppression of the Financing of Terrorism prior to 9/11 (on 10 January 2000 and 7 March 2001, respectively). Shortly after the UN Convention, the UK government enacted the Terrorism Act 2000, which became, and remains, the cornerstone of the country’s CTF strategy. Part 3 of this Act significantly extends provisions relating to terrorism to include international terrorism and persons residing outside the UK. This was done in response to allegations that earlier UK legislation focused too heavily on Northern Ireland and other parts of the UK. The provisions therefore include, as noted above, offences of fundraising and money laundering, and cover the issues of restraint orders and penalties of forfeiture and compensation, if convicted. Accordingly, the UK is one of the few countries which has properly separated CTF legislation, which means it is also one of the most advanced in the application of financial weapons against terrorist organisations. In 2002 HM Treasury published a report which outlined the important contribution made by the UK government towards targeting the sources of terrorist financing.54 Building on this leadership, in 2007, the

50

Cabinet Office, Recovering the Proceeds of Crime—A Performance and Innovation Unit Report (London: Cabinet Office, 2000). 51 For a more detailed discussion, see B. Rider, ‘Taking money launderers to the cleaners: Part 2’ (1996), Private Client Business, 3, 201–210, at 205–206. 52 Home Office Legislation against Terrorism—A consultation paper (1998) para 6.14. 53 See R Bell, ‘The confiscation, forfeiture and disruption of terrorist finances’ (2003) 7(2) Journal of Money Laundering Control 105, 113 54 HM Treasury Combating the financing of terrorism. A report on UK action (2002).

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government published its Financial Challenge to Crime and Terrorism, which ‘sets out for the first time how the public and private sector would come together to deter terrorists from using the financial system, detect them when they did, and use financial tools to disrupt them’.55 In 2018, the FATF reviewed over 100 countries’ anti-money laundering and CTF regimes and rated the UK’s as the best in the world.56 In addition to such external evaluations, HM Treasury and the Home Office are obliged to carry out annual National Risk Assessments in relation to money laundering and terrorist financing. The most recent of these (at the time of writing), published in December 2020, recognises the accolade from the FAFT but insists that more can always be done.57 It was this attitude that led to 2019’s Economic Crime Plan, which outlines seven strategic priorities and 52 action points,58 building on commitments made in the UK’s Anti-Money Laundering and Counter-Terrorist Financing Action Plan 2016.59 These legislative and policy measures have largely addressed the shortfalls identified in previous FATF Mutual Evaluation Reports, they are the principal reason why the UK has been rated so highly. In terms of CTF legislation, then, the UK is undoubtedly a world leader.

4 CTF and Technology The FATF acknowledges cryptoassets as an emerging technology and defines ‘virtual asset’ as a ‘. . .digital representation of value that can be digitally traded, or transferred, and can be used for payment or investment purposes’.60 However, despite the fourth Mutual Evaluation Report signing praises of the UK’s approach to tackling money laundering and terrorism financing, it fails to consider new technologies and cryptoassets. Of the 573,085 SARs raised in 2019/20 in the UK, most of which were raised by FinTech companies, only 430 were reviewed concerning CTF, suggesting an increase in suspicious cryptocurrency-related activities.61 While the figures may at first seem promising, statistics alone are not an appropriate measure of effectiveness. As it is impossible to ascertain how many of those were in relation to crypto-related transactions owing to such not being a

HM Treasury The financial challenge to crime and terrorism (2007). See Financial Action Task Force above, n 2 at 5. 57 HM Government National risk assessment of money laundering and terrorist financing 2020 (HM Government: 2020). 58 HM Government Economic Crime Plan 2019-2022 (HM Government, 2019). 59 HM Government Anti-money laundering and counter-terrorist finance: legislative proposals (HM Government: 2016). 60 Financial Action Task Force Glossary (Financial Action Task Force: n.d.). 61 National Crime Agency UK Financial Intelligence Unit Suspicious Activity Reports Annual Report 2020 (National Crime Agency: 2021) 55 56

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category on the SAR form, it would be inaccurate of FATF to present the UK as one of ‘the best in the world’ in terms of AML/CTF regime. Seeing as failure to submit a SAR is a criminal offence under POCA 2002 and TA 2000, financial institutions may be inclined to ‘preventative’ or ‘defensive reporting’ to avoid a personal criminal liability for a money laundering offence or failure to disclose information.62 Preventative reporting would support the increase in the number of SARs submitted, which, to an extent, defeats the perceived success of the UK’s CTF regime namely in relation to the use of SARs. With the nature and scale of the cryptoasset market evolving, complexity advances within the cryptoasset ecosystem, and with it the scope to use it for illegitimate purposes. While in 2015 Bitcoin accounted for 40% of all identified criminal transactions, this number is likely to grow.63 As the discussion in this chapter had shown, terrorists have, to date, adapted to modern technology and the perks it bears, thus, arguably, there is a scope that terrorist networks could abuse the existing digital infrastructure and prospectively use cryptoassets as a means of evading sanctions. In support of this, Islamic law allows for the use of cryptocurrencies to fund terrorists and the FBI recognises that Bitcoin can be used by countries such as Iran or Pakistan to transfer large amounts of cash to groups such as Hamas, offering safe havens for terrorists by being passive supporters by virtue of their inaction.64 Furthermore, the Cuban government’s decision to regulate Bitcoin could help Cuba circumvent the US sanctions regime. While it is agreeable that in theory, cryptoassets can be used to evade sanctions, in practice experts believe the risk of such to be low owing to the cryptoasset market not being ‘large enough’. Despite these claims, the US DoJ acted fast in response to the Russia-Ukraine conflict and launched Task Force KleptoCapture dedicated to enforcing sanctions in cases where the use of cryptoassets is specifically targeted to evade US sanctions.65 At the time of writing, there is no known evidence of cryptoassets being used to dodge counter-terrorism sanctions, though the possibility should not be overlooked and appropriate measures be considered to tackle CTF in any event. Distributed Ledger Technology (DLT) provides a basis for blockchain, a foundation upon which Bitcoin operates. Initially introduced in 2008 by Satoshi Nakamoto, the main purpose behind Bitcoin was to operate on a cryptographic proof-based system, within which a network of users are enabled to communicate with one another.66 Within the bitcoin network, each electronic coin comprises chain 62 See generally Law Commission Anti-money laundering: the SARs regime (Law Commission, 2019). 63 Europol, ‘The internet organised crime threat assessment’ (September 2015) p 46. 64 V Markovic, ‘Fighting a losing battle? Countering terrorism financing in Nigeria and Somalia’ (2021) South African Journal of International Affairs 28 (2): 167, 169. 65 US Department of Justice, ‘Attorney General Merrick B. Garland Announces Launch of Task Force KleptoCapture’ (2 March 2022) https://www.justice.gov/opa/pr/attorney-general-merrick-bgarland-announces-launch-task-force-kleptocapture. Accessed 26 June 2022. 66 H Vranekn, ‘Sustainability of bitcoin and blockchains’ (2017) Current Opinion in Environmental Sustainability 28, 1.

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of digital signatures, all of which are publicly stored on a distributed ledger with a purpose of circumventing a central authority. Operating in a decentralised system, DLT offers a set of technologies which enable a coherent representation of data across multiple nodes. In other words, it allows a distributed record (or a ledger) to store transactions in a permanent, immutable manner. Each transaction is stored in a node, with multiple nodes generating a block of transactions. Each block is connected through a hash, which in effect provides a timestamp on that transaction. This forms a basis of data authentication. Each block then stores the hash of the preceding block, connecting the transactions through blocks thus creating the blockchain. In order to add a transaction to said chain, it must be validated,67 relying upon a proof-of-work process. A block cannot be changed without redoing the work, thus an attacker would have to redo the proof of work of that block and all blocks thereafter in order to surpass the system. By not relying upon an intermediary to validate a transaction, a role of which a bank would play to a central regulator, the costs of the transaction process are thereby significantly reduced.68 The use of DLTs could have the potential of being used to regulate crypto-transactions. Given that the underlying technology in blockchain empowers record-keeping which would be beneficial given any bank’s or money transmitter’s know your customer (KYC) requirements. It is evident that the use of such is conceivable as shown in Project Maison, although its application has not been previously discussed in terms of its use within CTF. A collaboration between two global banks and a blockchain software developer, along with the FCA, Project Maison was introduced to pilot a system that would reduce costs and difficulty of regulatory reporting.69 Its permission-based structure70 allows the FCA to access all the data across the system, whereas each bank’s nodes are only shared with the FCA but not its competitors thus the banks do not have access to one another’s data. The use of DLT within this structure provides near realtime data feed to the regulator. The current regulatory reporting structure encounters inconsistencies with the available data; where modifications are made at the start of a mortgage cycle, the current system prevents adjustments from being made at a later stage. In addition to the lack of system flexibility, many companies must also employ compliance managers with FCA knowledge, accumulating additional costs, whereas the use of DLT within regulatory technology (RegTech) has the potential to eliminate human error as well as facilitate the reduction in transaction costs and time of

67 An algorithm is applied to a given transaction in order to validate it. Once a transaction is approved, it is then bundled into a block of approved transactions send across to all nodes within the distributed network that will validate the new block. See A Banafa, Secure and Smart Internet of Things (IoT): using blockchain and artificial intelligence (AI) 86. 68 R Girasa, Regulation of cryptocurrencies and blockchain technologies: national and international perspectives (2018) 14. 69 D Gozman, J Liebenau, T Aste, ‘A Case Study of Using Blockchain Technology in Regulatory Technology’ (2020) MIS Quarterly Executive 19 (1): 22. 70 As discussed above, the structure behind Bitcoin is permissionless.

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reporting, which would be of particular benefit in relation to SAR. Furthermore, the FCA agrees that cross-sector collaboration within DLTs could, in fact, be beneficial. DLT can also be used for data-collecting purposes, with Insurwave being one of prime examples of its success within nuclear security. The blockchain-based platform facilitates transactions between shipping brokers and insurers, including identification of risk exposure, which is enabled through data gathered over time, yet another capability of a DLT. The above-discussed examples illustrate that the use of DLT in RegTech is, undeniably, achievable. The same blockchain principles can be applied to CTF— to SARs in particular. The current, man-led process takes 5–7 working days to process a SAR, which can be drastically minimised by removing the manual oversight. In a similar manner to Insurwave, a DLT-based platform in the early lifecycle of a SAR (or pre-SAR) would collect data from numerous transactions of any given payee (fulfilling the KYC requirement) in order to identify the level of threat from the payee.71 Each piece of data stored would be accessible to the FCA, similarly to Project Maison, all information of which would be stored across a distributed ledger and thus, continuously validated in near real-time basis. Where a suspicious transaction occurs, it would automatically be shared with the regulator, thus cutting out the need to identify a transaction as ‘suspicious’ in the first place. In an effort to organise and segregate transaction data based on characteristics to build a model of what a ‘suspicious’ transaction entails, a public–private sector relationship would be of benefit, allowing CTF and technology experts to work with regulatory bodies. Donovan acknowledges some of the weaknesses of a centralised system, including its susceptibility to failure owing to the ‘manual intervention’ and thus, the undesirable impact it has on efficiency.72 Given that there is a lack of monitoring of financial activity in its present state, increasing the level of reporting requirements on financial institutions will not circumvent terrorist financing, and so measures beyond regulatory reporting must be taken. Irwin and Milad stipulate that if Bitcoin had been used for the 9/11 attacks, it would have been ‘extremely easy’ to hide, owing to the unfeasibility of law enforcement to examine every transaction that occurs through blockchain, the consequence of which could be eliminated through the use of a decentralised system, as discussed above.73 However, while beneficial in many settings, Gschossmann et al. (2022) concluded that some cryptocurrencies such as

M Umayam, ‘Possibilities of blockchain technology for nuclear security’ in C Vestergaard, Blockchain for international security: the potential of distributed ledger technology for non-proliferation and export controls (eds Springer 2021) 67. 72 Donovan, A. 2019. Blockchain: Developing Regulatory Approaches for the Use of Technology in Legal Services Legal Services Board available from https://www.legalservicesboard.org.uk/wpcontent/uploads/2019/10/Blockchain-Developing-Regulatory-Approaches-for-the-Use-of-Technol ogy-in-Legal-Services.pdf. Accessed 10 October 2021. 73 Irwin, A.S.M. Milad, G. 2016. The use of crypto-currencies in funding violent jihad. Journal of Money Laundering Control 19 (4): 407–425. 71

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Bitcoin use a disproportionate amount of energy; the proof-of-work algorithm is very energy-demanding, requiring somewhere in the region of 100–500 MW, so it would be rational of officials to debate whether implementing a DLT for regulatory purposes would be economically and environmentally sustainable, despite it having a potential of reducing financial infrastructure costs.74 Ironically, proof-of-work blockchain is ‘energy-intensive by design’; it is owing to its high energy consumption that makes blockchain tamper-proof. For an attacker to successfully manipulate the system, he must use at least 25–50% of the total computing power used for mining in the first place. Nonetheless, in the sake of the nation’s security, should energy consumption be of primary concern?

5 Conclusion This chapter has demonstrated that terrorist organisations have expanded their funding mechanisms and continue to improve their financing strategies and successfully adapt to emerging technologies, as illustrated by the above-discussed examples of using cryptoassets to finance attacks. While the present difficulties in tracing crypto-related transactions pose drawbacks to regulatory bodies across the nations, they simultaneously offer a plethora of benefits to terrorists that not only extend to the concealment of the movement of the funds but also aid in the possibility of evading sanctions regimes by providing an alternative route of payment. The failure of SARs in detecting low-cost transactions (including crypto-transactions) that may relate to terrorism financing also raises doubts as to the effectiveness of the UK’s CTF strategy. The difficulties with regard to tracing cryptoasset transactions, viz. the perceived level of anonymity they offer, are worsened with the emergence of new cryptocurrencies together with the evolving ‘anonymity enhancers’ such as Dark Wallet or Bitcoin Fog which create a silver lining for terrorist financiers. The present lengthy SAR process needs to be eliminated, and prospects of using DLT in RegTech within CTF to identify suspicious transactions ought to be considered; DLT has the potential to improve efficiency and provide a more economically sustainable model of regulatory reporting. Until such is implemented, terrorist financiers and their host of safe havens and funding streams will continue to elude us in a torrent of meaningless triumphant affirmations of the country’s ‘leading’ approach.

74

Gschossmann, I. Kraaj, A. Benoit, P. Rocher, E. 2022. Mining the environment—is climate risk priced into cryptoassets? European Central Bank.

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List of References Legislation United States Arms Export and Control Act 1976 Export Administration Act 1979 Foreign Assistance Act

United Kingdom Criminal Justice Act 1988 Drug Trafficking Act 1986 Northern Ireland (Emergency Provisions) Act 1973 Prevention of Terrorism (Temporary Provisions) Act 1989 (repealed) Proceeds of Crime Act 1995 Proceeds of Crime Act 2002 Terrorism Act 2000

Cases US Ulbricht v. United States June 28 2018 United States v Shevelev 2014 WL 495393

UK A v HM Treasury [2010] UKSC 2 R v Da Silva [2006] EWCA Crim 1654 Shah v HSBC Private Bank (UK) Limited [2012] EWHC 1283

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Dominika Benton is a doctoral candidate in law at Cardiff University. Her thesis focuses on the use of cryptocurrencies as a means of financing terrorism and the ways in which Distributed Ledger Technology can be used in regulatory compliance within counter-terrorism financing, with a focus on its use within the suspicious activity reporting regime. Nicholas Ryder is professor in financial crime at Cardiff University, School of Law and Politics (UK). He has played advisory roles both nationally (Home Office, Law Commission, the Nationwide, Security Intelligence Services) and internationally (NATO, United Nations, CEPOL, EUROPOL, EUROMED Police, the Dutch Police, the France Telecom Group, and the Law Reform Commission of Ireland). His research has attracted funding from Innovate UK, Economic and Social Research Council (ESRC), LexisNexis Risk Solutions, the City of London Police Force, the Royal United Services Limited, ICT Wilmington Risk & Compliance, the France Telecom Group, and the European Social Fund. He was co-editor (with Lorenzo Pasculli) of Corruption, Integrity, and the Law: Global Regulatory Challenges (Routledge, 2020), and co-editor (with Alison Lui) of FinTech, Artificial Intelligence, and the Law: Regulation and Crime Prevention (Routledge, 2021).