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ETHICAL DIMENSIONS OF ISLAMIC FINANCE – Book Sample

Ethics and Finance

Discussing the role of morals and ethics in economics and finance is not new but several developments can be attributed to a renewed interest in discussing the relevance of ethics to economics and finance.(()) (See Box 1.1). The financial crisis of 2007–2008 and its aftermath have led to a debate about the need to consider the role of ethics and morality in the economic and financial workings of contemporary capitalism.(( Hoepner and Wilson (2010) show that the annual number of publications indexed by Factiva for the search words ‘Bank’ and ‘Ethics’ increased by 357.9 percent from 4164 in the year 2000 to 19,069 in the year 2009.

This indicates a sudden increase in the topic in the post-financial crisis era)) Financial scandals, crimes, and unethical practices by financial institutions leading to financial repression are being noticed. For example, research into the growth of economic and financial crimes was focused on the impact of globalization and the resulting economic changes, but gradually attention is being paid to the most fundamental change—the erosion of morality.

 In addition, repeated failure of governance, regulations, and accountability are considered a sign of deteriorating ethics in financial markets. Finally, new evidence is emerging on a widening gap in income and wealth, and reduced opportunities for poor to share growth and prosperity, which raises serious ethical questions. All these developments call for a deeper understanding of the strong roots of ethics in finance, which has been mostly ignored or underplayed by mainstream research.

Box 1.1: Key Factors for Renewed Interest in Ethics and Finance

First, repeated financial crises and especially the financial crisis of 2007–2008 have raised the question if such crises could have been avoided if there were strong ethics embedded in financial transactions, public policy, regulations, governance, and business leader-ship. In addition, erosion of economic value and the social cost to the society and especially to the poor is getting serious.

Second, widening income and wealth disparity and diminishing opportunities for sharing growth and prosperity is viewed as an inherent outcome of capitalism when ethics are compromised.

Third, financial scandals (e.g., Enron, Worldcom, LIBOR), financial failures (e.g., Lehman Brothers), financial crises, and financial crimes have forced academia to question the very fundamental assumptions, such as self-interest and rational expectations, underly-ing modern economic thinking.

Fourth, while the issues relating to deficiencies in effective governance and regulations that govern financial intermediation and its links to the financial crises have been the focus of a global policy and academic debate, little has been done on the actual moral and ethical aspects of the problems and how to deal with challenges of unethical and immoral financial transactions that might be the seed of future global financial turbulences and meltdowns.

Fifth, increased complexity of financial transactions and financial markets, especially with the development of complex derivatives, has also raised ethical issues. The complexity has blurred the issue of eth-ics and has made it difficult to establish clear accountability for indi-vidual or corporate actions.

Sixth, ethics and morals are becoming part of investment decision- making for some groups of investors who are concerned about the negative impact of ignoring ethical practices. As a result, ethical investments or Socially Responsible Investments (SRIs) are growing. Preference for ethical investments could have an impact on corpo-rate behavior and on corporate stock prices, depending on actual or perceived ethical or nonethical behavior.

Finally, after the financial crisis of 2007–2008, leading business schools in the USA came under attack for producing top business executives whose academic training and thus business practices were void of ethical behavior. This has prompted these schools to embed discussion on ethics as a part of their curriculum. In addition, aca-demic resources devoted to the study of ethics have also increased in the last two decades.

Expropriation of Value and Fair Valuation

The integrity of a financial institution and its managers is a valuable asset. One example of integrity is that the institutions do not expropriate value from one class of capital providers to another (i.e., bond-holders versus shareholders or current shareholders versus future shareholders). Expropriation refers to the unwilling or unwitting transfer of value from one party to another, which is a fancy name for theft or, since in many cases it is legal, “theft-like.”

Other synonyms used by financial economists for this type of activity include predation, free-riding, market power, rent seeking, implicit compensation, tunneling, shirking, externalities, and sharking (Aragon 2014).

Jensen (2011) calls a system without integrity an incomplete system. Although the law does attempt to curb expropriation by imposing some explicit obligations to current and future bondholders and shareholders through disclosure rules and regulations, due to lack of integrity, the managers can still act improperly and make decisions to expropriate value.

Expectations play a critical role in economic valuation under uncertainty. Valuation models for pricing assets, equity in particular, are a function of expected cash flows, respective timing, and expected magnitude. Releasing of a signal or any information that would influence the expectations in one’s favor or create erroneous expectations about the future could be considered unethical.

In this respect, ethics have a subtle impact on the valuation of any security traded in the market. For example, knowingly overselling of future projects or creating marketing hype to raise expectations to increase the firm value to mislead investors, stakeholders, bondholders, and credit agencies would be considered unethical practices.

In a recent article, Professor Pablo Fernandez questions his fellow academia colleagues regarding the most common pricing model used for equities, i.e., Capital Assets Pricing Model (CAPM). Given the well- known and established shortcomings of CAPM, he makes the assertion that to continue to teach a model that does not truly represent the reality and is subject to serious criticism would amount to unethical.13 Although, CAPM has been under rigorous scrutiny in the last couple of decades but making an argument that continuing teaching such a model knowing that it does not explain much about risks and return of an asset should be con-sidered an ethical issue. Such an argument could have serious conse-quences on the way finance is taught or practiced today.

1.1.3 Corporate Governance

Corporate governance caught the attention of policymakers after the Asian crisis of 1997–1998, and the issues were highlighted to strengthen the governance and risk management framework. However, the current financial crisis showed that although governance and risk management frameworks were in place, they failed to deliver the promise of preventing a crisis before it erupted. Managers focused on short-term profit generation, and the boards neglected their task of asking probing, tough questions.

Although the role of the boards of financial institutions has increased dramatically over the last decade, they have been criticized for being too complacent and unable to prevent collapses. Weaknesses in safeguarding against excessive risk-taking behavior in a number of financial services companies were exposed during the subprime financial crisis. Again, the shareholders’ trust in governance mechanisms and the role of the boards suffered, and this had a negative impact on the value of equity.

Corporate governance brings in the ethical dimension of responsibility and accountability of each stakeholder in the governance framework. This is more critical in the financial industry, due to the trust placed on the managers, the board, and other stakeholders by individual investors in particular. A classic case of massive breach of trust is the case of Bernie Madoff, who cheated his investors by operating a Ponzi scheme and was able to hide the crime despite stronger controls imposed on the asset man-agement business.