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Back to Ethics: Investment Banking & the Moral Compass

This week in Alrroya Aleqtissadiya, the United Arab Emirates (UAE) business and financial daily, I argue that while the law may not be technically breached, once companies start to play in an ethical gray area, they open themselves up to all sorts of reputation-damaging charges.

In hindsight, the adulteration of ethics in investment banking may be the great lesson of the last decade. Everywhere we turn, we find conflicted agents who exploited the trust ascribed to them to profit at their principals’ expense. Occupants of a Martian spaceship visiting our planet could be forgiven for thinking that ‘investment banker’ is a synonym for greed and excess. For a profession that once prided itself on raising the capital companies and governments needed to build the economic muscle of nations, investment banking is now identified with outrageous bonuses, abuse of trust and selfish interests. From grace to gutter easily comes to mind.

It is not inappropriate that investment bankers and their culture are at the vortex of the contemporary debate on how to fix markets. Indeed, while there is universal concurrence that the investment banks’ faulty models, aggressive products pricing and extreme risk-taking amplified the radioactive fallout from the crash, those were not the only fission materials used to create the meltdown missile. Limiting the problems to the calibration errors of Ph.Ds in econophysics, mathematics and other esoteric fields who worked at these banks misses the point that the crisis was fuelled by age-old ethical imperfections in human character, which assumed gargantuan proportions when given massive amounts of capital.

Recent revelations by regulators and journalists have exposed the widespread ethical lapses that underlaid many segments of the investment banks’ business during the boom years. Most disturbing of all, these acts of moral misjudgment do not seem to have been confined to minions. If first readings prove correct, these actions were tacitly supported by executive managements at some of the world’s preeminent financial institutions. For an extra buck, share price boost and notch up the league tables, their leaderships had few qualms compromising their values.

Unfortunately, there is a real risk that the search for solutions on repairing trust and values in the market could deteriorate to partisan skirmishes between those who trace the origins of the crisis to purely impersonal factors like low interest rates, inflation, arcane products and flawed risk models, on the one hand, and those who identify it as the product of character failures. The two views have elements of truth but neither has a monopoly of it. Here, I will to focus on the character side.

The civil charges recently filed by the US Securities & Exchange Commission (SEC) against Goldman Sachs (GS & Co), the investment bank, and Fabrice Tourre, one of its executives, ‘for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (CDO) the bank structured and marketed to investors’ has raised the profile of the debate afresh.

The investment bank is accused of misleading investors in the CDO by failing to disclose that the residential mortgages backed securities (RMBS) in it were selected by John Paulson, who had ‘economic interests directly adverse to [these] investors.’ Paulson, the principal of Paulson & Co, a hedge fund, subsequently ’shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with GS & Co to buy protection on specific layers of the CDO’s capital structure.’

The bank’s refusal to reveal Paulson’s role in the structuring of the CDO to investors and its insistence that there was nothing improper in non-disclosure has heightened tensions that banks often have subterranean agendas which place them in competition or conflict with clients’ interests. Goldman’s admission that it lost $90 million in that CDO is a poor alibi. The release of emails sent by Tourre, the embattled executive, has proven to be singularly damaging. In one email, Tourre, who the SEC says ‘devised the transaction, prepared the marketing materials and communicated directly with investors’ refers to the CDOs as ‘monstrousities.’ Worse, he confesses that he hardly understood their implications.

The ethics of confidently selling investments one barely understands, in addition to withholding material facts, would be surreal if it were not borderline criminal.

Only a few months ago, there was a furore over the skulduggery of defunct Lehman Brothers’ use of Repo 105 and before that the public outcry about the insensitivity of paying huge bonuses at institutions receiving government support. Can it get any worse? Honestly, we have reached the point where all these institutions which trumpet trust as their core foundational value need to introspect on their sincerity to it.

Trust is not a marketing buzzword. To lay claim to it, investment banks need to hold themselves up to the highest ethical standards. Fees are good for business, but if they come at cost of riding roughshod over the faith of clients, then they are unsustainable. Profits without values are the biggest risk faced by investment banking today. Whatever the outcome of the SEC suits against the banks and hedge funds, they must not forget that the appearance of impropriety is sufficient to ruin a reputation. Once upon a time, capital was the key element for the future survival and competitiveness of these institutions. Today, it is the moral compass. Without it they are lost. Literally.

The original article may be read here on the Alrroya Aleqtissadiya website.

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