Ethics in banking: Part-I

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A series of financial crisis that jolted the world economy over the past fifteen years or so has raised serious concerns about unethical conduct in banking operations. Regulatory authorities around the world are struggling to formulate reform measures to prevent recurrence of such malaise. Any discussion on the subject of ethics in banking inevitably requires some elaboration of what is understood by ethics, what are the functions of a bank and the interface between them.
Meaning of ethics in the present context: Ethics has been defined as the study and philosophy of man with emphasis on the determination of right and wrong and also as the basic principles of right action, moral principles, moral philosophy etc. The word ethical has been variously interpreted as morally correct, honourable, decent, fair, good, honest, just, noble, principled, righteous, upright, virtuous and so on. This brief taxonomy suggests that it is not easy to precisely delineate the scope of ethics.
Academicians have written volumes on the interpretation of ethics espoused by great philosophers as Aristotle, Kant, Bentham, Mill etc. I am inclined towards Jeremy Bentham's and John Stuart Mill's utilitarian view of ethics. Simply put, this implies the greatest good for the greatest number. It is from this perspective that I will try to deal with the issue of interface between ethics and banking.
Principal functions of banks: Banks perform four principal conventional functions. The first relates to intermediation. Banks serve as intermediaries between savers and investors. They mobilise savings from the members of the public in the form of deposits and make these savings available to those who are willing and able to make investment in the real sectors of the economy or to engage in trade which serves as the conduit for distribution of the produced goods and services to consumers and users of these goods and services. The second function involves maturity transformation. The banks accept deposits, a large part of which have to be returned immediately on demand or at short notice. But they use these deposits for giving loans and advances for investments which have longer gestation periods. The third function has to do with credit allocation. In granting loans and advances, banks determine allocation of credit by sectors, regions and groups of populations. The fourth function relates to facilitating payments flows, for example, between exporters and importers as well as between buyers and sellers of goods and services that are produced and consumed domestically. It is obvious that a modern and increasingly globalised economy could not operate if there were no banks to provide these services.
In addition to these conventional functions, there has been a phenomenal growth of new products and services offered by banks. These involved, inter alia, complicated derivatives and underwriting foreign debt. Paul Volcker, the former chairman of the United States Federal Reserve System, labelled the emergence of these new products and services as "bright new financial system."
Why is ethics in banking important? There are several considerations which underlie the importance of ethics in banking. Banking sector activities are characterised by pervasive asymmetry of information. On the liability side the depositors are not fully aware of the liquidity and asset quality of the banks in which they keep their deposits. The depositors cannot be entirely sure about the safety of their deposits or of a fair return on the deposits. On the asset side, banks cannot be fully confident about the ability of the borrowers to repay in due time in spite of all the safeguards that may be put in place by way of collaterals and/or rigorous screening of loan proposals. Such asymmetry of information implies that banks can take depositors for a ride. The borrowers, on the other hand, can take the banks for a ride.
The banks could also deliberately engage in loose lending practices with a view to favouring particular parties connected to sponsors, directors, senior bureaucrats, political parties etc. or simply out of greed at the cost of basic principles of prudence. To a significant extent, therefore, the banking system is based on trust. Any persistent violation of trust by any party would have serious detrimental consequences for the banking system. And, of course, violation of trust would be considered unethical in any society.
The banking system in Bangladesh has not been entirely free from breach of trust. Some years ago there was the case of the Bank of Commerce and Investment which had attracted huge amount of deposits by advertising very high rates of interest. The bank collapsed within seven years of its establishment. More recently, Oriental Bank failed primarily due to connected lending. The operations of the bank had to be suspended in 2006. The central bank had to take over the bank and eventually sold it to a Malaysian group. It is now being operated by the purchasers, and renamed as ICB Islamic Bank. In the process, depositors had to suffer a lot as restrictions had to be imposed on withdrawal.
Another problem intrinsic to the banking system is moral hazard. The banks are prone to unethically risky practices and greedy pursuit of income and profits. In this misadventure they are fortified by the assumption and indeed experience that they will be salvaged by public authorities in order to save depositors and to mitigate negative externalities of bank failure.
Mahatma Gandhi said that mother earth could cater to everyone's need, but not even one person's greed. Many of the financial crises that have occurred from time to time in both developing and developed countries can be traced to greedy behaviour of banks. Prior to 1997-98 Asian crisis, banks connived to create severe asset bubble. Despite signs of impending troubles in the real economy, the local banks borrowed heavily from the international capital market, including foreign banks which did not hesitate to extend loans on an excessive scale. The borrowed funds were re-lent to domestic non-tradable sectors, particularly real estate. The prices of real estate as well as stocks reached unsustainably high levels. As these bubbles burst, non-performing loans soared. Moreover, borrowing in foreign currency to lend against activities which would yield income in local currency created currency mismatch, leading to drastic depreciation of exchange rate. The real economy became victim of serious negative externalities. Indonesia and Thailand, for example, suffered negative growth of 14% and 8% respectively in 1998.
Banks can be held accountable for the economic crisis in the developed countries during 2008-09 periods. Prior to the first signs of crisis in August 2007, the United States pursued loose monetary policy. This enabled banks to lend at low interest rates and without due regard for prudential norms. In consequence, consumers chose to live beyond their means and investors chose to buy assets at high prices with funds borrowed at low interest rates. Moreover, banks securitised their potential future receipts against loans to consumers and investors. These securitised assets were then pooled, dividend into risk tranches and sold to other institutions. The process was repeated several times, giving rise to a complicated set of debt products. Banks avoided capital and other regulatory requirements by treating securitised assets as off- balance sheet items. Eventually, many borrowers failed to meet their obligations, lending to fall in values of real assets (e.g. houses) as well as securitised assets and eventually credit squeeze. Hundreds of billions of dollars of public money had to be poured in to buy up toxic assets held by banks. The growth of output of advanced economies as a group decelerated from 2.8% in 2007 to only 0.1% in 2008 and -3.7% in 2009.
Banks cannot be also absolved of culpability in the most recent sovereign debt crisis in Europe. While the continent is still struggling to reach consensus to deal with debt problem of Greece, several other European countries, such as Spain, Portugal and Italy, are confronted with a similar problem. Some of these countries, such as Greece and Italy, were able to avoid European Union's ceilings on budget deficit and debt/GDP ratio by taking recourse to opaque and complex derivative instruments devised by internationally well-known banks. Despite the knowledge that the aforementioned countries were beset with problems, banks continued to buy and/or underwrite sovereign debt issues in order to fetch income from commission and other fees. Once again the banks' insatiable greed led to blatant breach of ethical standards in their decisions. According to International Monetary Fund's September 2011 projections, real GDP growth of Euro area will decelerate to 1% in 2012 and that of Italy, Portugal and Greece to 0.3%, -1.8% and -2% respectively. Greece experienced a negative growth of -4% in 2010 and the estimate for 2011 is -5%.

The author is a former Adviser to the Caretaker Government, Ministries of Finance and Planning.

(Part-II will appear tomorrow.)