Financial Services: Ethical Pitfalls and the Role of Ethical Practices

Ethical Pitfalls and the Role of Ethical Practices
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Ethical Pitfalls and the Role of Ethical Practices
Introduction and Background
The financial sector is a complex mammoth system permeating local and global socioeconomic functions. In principle, the sector promotes and improves social and economic welfare by mobilising savings and distributing capital to worthy investments. Banks (commercial and investment) and insurance firms constitute financial intermediaries, providing the conduit through which capital flows between savers and borrowers (Hanley & Hoberg, 2019). According to Yu et al. (2021), these activities facilitate economic growth, create employment, and reduce societal poverty (p. 4). In addition, the financial sector provides the bedrock for the growth of healthy markets and resilient economies. For instance, it provides liquidity, allows the development of risk management strategies, and reduces inefficiencies and costs of doing business.
In practice, the financial sector taps into businesses, households, and other institutions (including governments and local authorities) to mobilise savings that it then avails to borrowers through loans and investments. As a result, it supports innovation, entrepreneurship, and sustainable development by financing projects that generate social and environmental benefits alongside financial returns (Bayar et al., 2018). It also provides a collection of efficient and reliable instruments (financial services) to individuals, businesses, and governments to aid their socioeconomic empowerment. Further, the sector creates various assets like currencies, derivatives, and stocks, which economic agents can trade (Hanley & Hoberg, 2019). Finally, the financial sector maintains the stability of local and global economies and guarantees consumer protection by ensuring compliance with regulations, conducting due diligence, and providing transparency and disclosure of information.
The debate over the specific factors behind the financial crisis of 2007-2008 rages on even today. Experts agree that the increasing complexity of financial products was among the fundamental causes of the crisis. Financial institutions created and marketed increasingly complex financial products such as mortgage-backed securities, collateralised debt obligations, and credit default swaps (Ogg, 2022). According to Ogg (2022), these products comprised multiple layers of risk and lacked transparency, making it difficult for investors to fully understand the risks involved. In addition, regulators did not adequately understand the complexity of these products and their potential impact on the financial system. This lack of understanding and transparency led to a mispricing of risk, with investors taking on more risk than they realised, ultimately leading to the collapse of the housing market and the subsequent financial crisis.
The increased complexity of financial products also contributed to the financial crisis of 2007-2008 due to the interconnectedness of financial institutions and their exposure to these products. Financial institutions held large amounts of these complex financial products on their balance sheets, and many institutions were highly interconnected through their exposure to these products. When the housing market collapsed, and these products began to fail, it had a domino effect on the financial system, with institutions facing significant losses and even insolvency. Furthermore, the complexity of these products made it difficult for institutions to accurately assess their exposure and risk, leading to a lack of trust and confidence in the financial system. This ultimately led to a freeze in credit markets, exacerbating the financial crisis and its impact on the broader economy.
The discussion on the debate around the financial crisis ends here for now to avoid the danger of going too far beyond the scope of this paper. Other important culprits worth mentioning included excessive leveraging by primary economic agents and lax oversight by regulators. However, this discussion shines a light on a deeper problem that lay beneath the factors behind the financial crisis of 2007-2008: a lack of transparency. This problem points to an even deeper issue that most experts agree was the operant cause of the crisis: an ethical one. Dobson’s (2005) and Bogle’s (2017) analyses of business and economic activities observed that sound ethical practices comprise the most effective defence against potential economic crises like the one precipitated by the financial crisis of 2007-2008. In other words, ethical practices prevent unethical actions from occurring in the first place and promote honesty and integrity within organisations. Furthermore, ethical practices create trust and confidence in and among organisations, promoting economic and social stability. The lack of transparency and ethical practices that went along with it were the fundamental problems at the heart of the financial crisis. This paper explores such issues, including the contributing ethical pitfalls, the role of ethics in the financial sector, as well as the costs and benefits.
The Ethical Pitfalls that Contributed to the Collapse of the Financial Sector
The subprime mortgage crisis of 2007-2008 was precipitated by a cascade of unethical practices by financial institutions, rating agencies, and individual investors. These unethical practices led to a mispricing of risk, with investors taking on more risk than they realised, ultimately leading to the collapse of the housing market and the subsequent financial crisis. According to Schoen (2017), the zeitgeist of the financial sector before the financial crisis entailed an atmosphere characterised by serious moral deficiencies and a lack of transparency. Financial institutions failed to disclose the true nature of their dealings, leading to a lack of transparency in the market. For instance, banks packaged subprime mortgages into complex securities (mortgage-backed securities) and sold them to investors without adequate disclosures or due diligence. Investors were also misled by the rating agencies, which gave AAA ratings to securities that were likely to default. For instance, Moody’s Investors Service downgraded some mortgage-backed securities’ credit ratings, creating a false sense of security among investors (Omstedt, 2020). Consequently, these unethical practices led to a mispricing of risk and the housing market’s collapse.
Another ethical failing that contributed to the financial crisis was the reckless gambling by individual investors. For example, during the housing boom of the early 2000s, many investors became overexcited and began to purchase securities based on short-term price movements rather than sound investment principles. This led to a bubble in the stock market, which ultimately burst in 2007-2008. As a result, many individual investors lost their life savings and were left to bear the financial burden of the crisis. The lack of transparency in the financial sector also undermined investors’ trust in financial institutions. According to Schoen (2017), when investors cannot trust their financial institutions, they are less likely to invest in these institutions, which exacerbates the financial crisis.
Furthermore, the deregulation of the financial sector played a significant role in the subprime mortgage crisis. For instance, Congress passed legislation in the late 1990s encouraging banks to engage in risky trading practices. This legislation, known as the Gramm-Leach-Bliley Act, allowed banks to merge with other financial institutions, which made it more difficult for regulators to monitor these banks (Ghosh, 2020; Schoen, 2017). As a result, banks could engage in risky trading practices without fear of retribution. This deregulation also led to a lack of transparency in the market, as banks were not required to disclose their dealings to investors. The inadequate regulatory mandates by oversight authorities and the exponential technological developments sweeping through the financial sector made it easier for financial institutions to carry on risky behaviour without notice. Regulators did not have the necessary tools or resources to monitor and enforce compliance with the rules (Ghosh, 2020). Consequently, they failed to prevent financial institutions from engaging in risky and illegal practices, such as predatory lending and market manipulation.
Conflicts of interest were also some of the unethical practices that contributed to the financial crisis and maintained the undercurrent of lack of transparency that characterised the industry. Investment bankers had a conflict of interest when underwriting securities, as they were incentivised to recommend investments that would generate commissions for their clients, regardless of their quality (Schoen, 2017). Furthermore, many Wall Street firms were owned by the same financiers who operated as investment bankers. As a result, these firms had a vested interest in promoting their clients’ stocks, even if these were not in the public’s best interests (Schoen, 2017). This conflict of interest and lack of transparency led to widespread financial fraud and concealed the actual risks of many investments.
Another factor (ethical pitfall) that contributed to the financial crisis was banks and other financial institutions’ excessive use of leverage (Schoen, 2017). Leverage is using borrowed money to increase the amount of money a company or investor can invest. When used excessively, leverage can lead to financial instability and a collapse of the value of an investment. For example, when Lehman Brothers failed in 2008, its liabilities exceeded its assets by nearly $600 billion (Abreu, 2020). This significant shortfall was because Lehman Brothers had used much leverage to invest in risky securities. Leverage caused the company to become vulnerable to a sudden loss of money, which led to its bankruptcy (Abreu, 2020).
There were also gaping risk-management failures that showed a marked lack of ethics and professional responsibility by many bankers and financiers. For example, in 2007, Goldman Sachs warned its clients about the risks posed by mortgage...