This is the fourth of the 5-part essay that attempts to answer the question: Is it good for society if the financial services sector is motivated by greed?. (READ: Greed is Good, Greed and Society, Greed is Good, Or is it?). This section discusses the special role of financial services industry and is a prelude to the conclusion that given the special role financial services sector plays in the economy, and ultimately society, it is not good if this sector is motivated by greed.
One of the factors that make financial services industry unique is the extent to which financial products, contracts and services are different from any other goods and services (Llewellyn, 1999). For example, Llewellyn (1999) explains that many financial transactions involve incomplete contracts, since their value is largely determined by the behaviour of the supplier after the contract has been entered into. In addition, Boatright (2008) points out that participants in the financial markets often engage in long-term relationships. All these mean that financial institutions and professionals are bound by fiduciary or agency responsibilities. Thus, while it may be beneficial to be motivated by greed in market conduct for proprietary transactions; fiduciary duty requires the subordination of self-interest. Being motivated by greed may result in breach of this duty. Due to these special relationships, financial institutions and finance professionals are not only bound to the firms’ shareholders but are likewise bound by their duties to their clients. Much of the relationships in financial services industry are based on trust and confidence and pursuing self-interest may undermine confidence in financial markets. Boatright (2008) cited Robert H. Frank’s argument that “economic life requires commitment and trust and that the single-minded pursuit of self-interest is ultimately self-defeating. Much of what want requires the cooperation of others, and we cannot gain the benefits of cooperation without honouring commitments, being trustworthy, and in general having the kinds of feelings that have evolved to make mutually beneficial interaction possible.”
In addition to shareholders and their clients, financial institutions, one can argue, likewise have responsibilities to other stakeholders, including the general public. This is because financial market transactions usually have third-party effects (or externalities), which means that market players need to take into consideration social impact of their activities. Llewellyn (1999) cites potential systemic problems associated with externalities. Specifically for banks, there are social costs of failure and to the extent that these social costs are not incorporated into the decision-making for the firm, particularly if motivated by greed, banks may be induced into more risky behaviour. The externality is that failure of an insolvent bank can cause depositors of other banks to withdraw deposits which can cause a solvent bank to become insolvent since a significant proportion of its assets are not easily marketable (Llewellyn 1999). Clearly, banks play a crucial role in the economy and the system is inherently fragile primarily due to its role in maturity transformation and the adverse selection and moral hazard associated with safety-net arrangements such as deposit insurance and lender-of-last-resort schemes. Banks’ assets are typically worth less in liquidation than on going concern basis and problems such as bank runs, can lead to insolvency.
The liquidity crisis experienced by banks (and “shadow banks”) that was triggered by the sub-prime crisis and the subsequent financial crisis and economic recession illustrate how the contagion effect can spill-over from Wall Street to the main street. Due to the systemic nature of some financial institutions, we cannot leave the proper functioning of the market up to the “invisible hand”. Self-interest sometimes morphs into greed and selfishness, and players can act at the expense of others. This greed becomes an accumulation fever and the focus shifts from the long-term to the short-term, with particular emphasis on profit maximization (Duska & Clarke, 2002) . This in turn may lead to excessive risk-taking and to the failure of a financial institution, which can have systemic implications.
The nature of the financial services industry, as discussed above, shows that conflicts of interests abound. In such instances, financial services providers are often forced to prioritise and choose among competing interests which makes it more difficult to accept at face value the concept that it is good if the financial services industry is motivated by greed. If such were the case, firms and professionals will make decisions for their own benefits, at the detriment of their clients. Various cases and scandals illustrate how acting on self-interests can harm society. For instance, Boatright (2008) reports that in 2003, ten major investment firms paid US$ 1.4 billion to settle charges that their “analysis of securities had been slanted in order to curry favor with client companies”. These firms’ analysts issued favourable reports on companies such as Worldcom and Global Crossing which subsequently collapsed. These analysts were compensated for their ability to bring in investment banking business, which clearly violated their duties to issue objective analysis/evaluation of these companies, Boatright (2008) noted. Specific professionals were fined and banned from the securities industry for their roles in giving favourable reports on companies that they knew were in trouble. Investors relied on their reports; bubbles were created and eventually burst, leaving millions of investors holding the empty bag.
Occurrence of actual conflicts of interest can be avoided if one follows the stakeholder theory. Stakeholder theory asserts that managers have a duty, not only to shareholders, but also parties who contribute the firms’ wealth-creating capacity and activities (Smith, 2003). Thus, managers have responsibilities to ensure no rights of stakeholders are violated and to balance the legitimate interests of stakeholders. Boatright (2008) also suggests various strategies for managing conflicts of interests. Specifically, he writes that actual conflicts can be minimised by relatively effective preventive strategies that include regulation of the financial services industry and accepted industry practices on the areas of competition, disclosure, rules and policies and structural changes, including separation of conflicting functions.
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