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Ethical Challenges in the Financial Sector-II
Arindam Banerrji
THE METAMORPHOSIS OF FINANCIAL INSTITUTIONS
Looking at financial services as a sector and why ethical standards are important in this sector in particular, it comes to two or three fundamental things that are shaping things for us in India. The first is their changing portfolio. The traditional function of a bank was to take a deposit and give a loan, but now, it is increasingly becoming a less important function of any financial institution's portfolio. Financial institutions are making money on risk arbitrage and on information arbitrage. They live on hugely leveraged balance sheets, much higher standards than corporate institutions are used to and, therefore, the financial health or the financial practices, the ethical practices in a bank or a financial institution impacts a large part of the society. It is not just a corporate impact, it has many more interests involved. In such situations, how do you make sure that the risk arbitrage, which we are involved in, is careful about taking risk appropriately and in a controlled manner?
FINANCIAL INSTITUTIONS NEED TO DO THEIR BUSINESS ETHICALLY
How do you ensure that the information arbitrage that we are doing is rightfully obtained information? This is an important question, because you could have information that is not rightfully obtained and that basically means insider trading. So all of these controls and the policies, whether you look at them from the top or from the ground level of understanding, you will realize that these are important for a financial institution to be successful in the long run. I would start with a couple of questions. How many of you have been approached by bankers explaining a product to you, trying really hard to sell and giving you all the positives without pointing out the negatives? We come across this every day. I get five calls a day for different credit cards. So, if you expedite a transaction for a client who really does not have an understanding of investment products and a mix of high-risk equity options, and if you do not educate him regarding all the possible loopholes, then on a scale of 1 to 5, where would you put that? If 5 is most unethical and 1 is absolutely ethical, then how would you rate this behaviour as being ethical or unethical? I actually think it should be rated 5 because when we, as a financial institution, are selling products to people, it is our obligation to ensure that the clients have complete understanding of the risks involved. If they do not, then we are not taking a balanced position in the transaction. You could debate about this, but if you go into the basic long-term philosophy, you will understand what I mean. For the financial institutions, if they stick to this philosophy, it pays in the long term because your client starts trusting you. If you go in with a view that it is fine for an institution to be rated at 3, and try and sell a deficient product to a person who does not really understand interest rate caps, you may sell the products, but you have lost the future with the client because he just hasn't understood the transaction.
THE IMPORTANCE OF AVOIDING CONFLICT OF INTERESTS IN FINANCIAL BUSINESS
Let us take another example—giving tickets at a sporting event. All of the banks are good at sponsoring different sporting events, such as Wimbledon, US Open and Deutsche Bank Golf tournaments. When I am in the middle of a transaction or a client deal and I basically give a complimentary ticket to this event, I do not want to take a poll again, but the answer is 5. If I am transacting with someone—if I am looking at someone with a client or an immediate perspective—I should make sure that I am not giving any inducement which is there in the case above. If I am investing in a security issuance, say, the Indian Bank IPO, and that is a Deutsche Bank client, and I have met Mr Sundara Rajan, I have gone back and got my preclearance and I do the market trade at a market executed rate. Am I being ethical or unethical? I think I am being ethical, because I have gone through everything that needs to be done to make sure that I do not have a conflict of interest. I think these are the definitions. The point I am making is that in a financial institution you have to constantly have these debates—whether I am in any way conflicted, whether in any way I have information that others do not have and which I am taking an advantage of—you constantly look at these things and evaluate yourself. As long as you do things within the ethical and compliance norms set by the institutions, you would be safe and the institution would be safe in the future.
Ethics are standards of right and wrong. These are well-grounded standards, rights, obligations, and benefits to the society. There are other aspects to it and these are one's own ethical standards as well as one's institution's. So, the institutions need to help shape and live up to the standards that are reasonable and solidly based. These are the basic definitions of ethical standards—and I think Mr Sundara Rajan and I refer to pretty much the same book. However, I think moral behaviour and legal behaviour are getting confused. How many times do you hear from different people that this is legal, the law permits it but actually you should not be going ahead with a particular transaction because it is against the basic ethical principles? I want to mention the point that professional duty can come into conflict with company demands a little bit more, because in any large financial institution what you now see is a conglomeration of multiple businesses on the buy side and the sell side. Financial institutions today by structure are prone to conflicts. You are serving multiple tiers of clients whether you are buying or selling, whether you are on the fiduciary responsibility side or you are a custodian, sometimes you are a broker/dealer, sometimes you are an asset management firm, all of these by nature bring a situation of conflict within a financial institution very often. The conflict of interest is inbuilt into the institution, and, therefore, how you manage that conflict of interest is important. You need to be able to confidently assure yourself, your shareholders, employees and clients of the fact that you are managing that conflict of interests. I think this is another sort of chart that talks about ethical, legal and economic responsibility. The moral of the story is that if you are ethical, legal and economic, you are in the golden zone and you will basically collect everything. On all of the others, you really need to look at the proceedings pretty cautiously with due diligence.
ETHICAL ISSUES MAY ARISE IN ALL ORGANIZATIONS, BIG OR SMALL
You know what happens when ethics are compromised. Many of you are aware of these big examples such as Enron, Barings, Sumitomo. You have a few big examples in India as well, luckily not many in the last six years. All of these cases have different aspects about them, but what is important in these cases is the fact that they were the big press issues. These come out in the press as these are the multi-billion, multi-hundred million scandals. But what's also important is that the small offences matter as well. When you are in an institution like Deutsche Bank which has 70,000 employees, you need to make sure that none of your employees in anyway is involved in insider trading and is not using key information for personal gains. Information is there, the point is that very often on our desk we do get information that we can use for personal gain. How do you set in place compliance policies that mitigate that risk? So, trading in advance customer orders—I can give you an example of what we do in my business process securities. When I process the information, the clients are all US- and UK-based Foreign Institutional Investors (FIIs). When they come in, they will say buy a 100,000 Indian Bank IPOs, I know there is a big order out there from a client, I have the information with me, I could as well personally gain from it straightaway by placing an equivalent order. So, how do you make sure the bank's employees are not doing that? What are the systems, controls and processes that you keep in place? Information which is a second sort of environment change has happened previously or it is only a limited sector of people. The people working in groups in the securities broker-dealer in India, need to know the information.
GLOBALIZATION BRINGS IN MULTIPLE ETHICAL ISSUES
Now, with the nature of global operations that we have, the scenario is very different. It is going to be extremely challenging in this environment to control this because we are a global economy, we are processing trades in New York, Hong Kong and India. When the order comes from the client abroad, we probably know before the sales person in India knows, and, therefore, how do I put in the controls? Today, ethical standards are not just about Indian regulations. Within the next three months, I may have to comply with the regulations of the German Regulator, the British Regulator, the US Regulator and the New York Stock Exchange. So, ethical standard is a global standard now. It is not about how it is defined locally because I need to defend my institution to the regulators and its clients. If you work in the corporate world, forwarding e-mails with confidential data is a very common occurrence you come across, what controls do you put in place? I can bet you it is 40 per cent—and we have actually done this statistically, it is 40–50 per cent—of those who leave an organization, actually channellize information out before they leave. How often do you come across investment bankers, and I have had one instance, where somebody was actually fired. He comes in—a very fine candidate, second day on the job—and says, ‘I actually know about this transaction that I actually dealt with in my previous job with another investment bank, and I sat on the other side of the sell side of the transaction and I can help you on the buy side.’ An immediate answer to him was, ‘Sorry, you have to leave because you are not supposed to have that information. You came into a conflict straightaway. You cannot carry information from institution to institution.’ The institutions need to be extremely stringent in the norms around this and how they react. Gifts-buy from vendors is a known fact; an employee's declaration of current holding investments, is it proportionate to his income? Is it in line with or in conflict with any transaction that he has done? There may be other sources of income, but how do you make sure that the bank he is dealing with is focused only on the job that they are supposed to be doing?
WHAT WENT WRONG WITH WORLDCOM?
I take an example of WorldCom which I dealt with fairly closely during my tenure with my previous bank. On one hand, risk and controls failed because they were almost deliberately violated and on the other, when you go into some of the case studies it is a comedy of errors. People who should have been checking it did not catch it. That is why I call it a comedy of errors and why did it happen in the case of WorldCom over a period of ten years? They were $40 billion from about $7 billion profit, but basically book keeping was sloppy, accounting was bad. People from the financial controllers to the auditors to the bankers, everybody made a mess of it. We all take information as given, but sometimes you need to go beyond that and two principal reasons to that acquisitions were overvalued, so blame the banking community because the investment bankers and accountants would have been the ones who have certified the valuation. Similarly, a profit understatement, a profit swing of $5 billion, how does that happen without the auditors and controllers being fully aware of their responsibility? So, if you look through the fact, it is poor governance, greedy senior managements. We all want our shares to be valued at our levels, by which our own personal holdings will become multiple.
ROLE OF AUDITORS
External auditors are not doing their job properly, and a lot of them such as Arthur Andersen don't exist today. But there are some other firms that originally start out as a chartered accountant and then morphs into a banker. This is a fact that the accounting, whether it's an ICAI or an ICSI institute, need to start recognizing. There is role and responsibility; and these are not regulated roles.
When we go in as auditors, when we go in as accountant into an institution, we have obligations that are not dictated by an institute, they are dictated by our ethical standards, and basically the way we look at it over here is when we are doing our business as a financial institution, how do we protect our integrity and reputation?
REGULATORY RISKS AND COST OF NON-COMPLIANCE
Advancing lawful and ethical business conduct in the interest of our clients and shareholders as well as preventing and detecting violations of the law through identifying and managing financial services’ regulatory risks and financial services is again very important. Regulatory risks are much higher here than most of the sectors in the industry, simply because of the risk that is carried on in these institutions and the cost of non-compliance is extremely high and because of this a regulator can walk in and stop you from doing business. As the SEBI chairman has put it, we all take them very seriously, a regulator walking in and finding out non-compliance, whether it is done unknowingly or by a rogue element within the firm, has serious implications for anybody and that can lead to loss of reputation, which itself has massive impact. An immediate business impact is low, but loss of business reputation is extremely high in the long run. Specifically, what we would put in place in the financial sector or personal account dealing is that we are not supposed to be trading in advance of customer bank orders, we are not supposed to be trading in advance of publishing research, we are not supposed to be short selling or naked short selling in particular, transactions at off market rates, transactions in own securities, unless you get the clearances and getting any priority treatment in IPOs. If you look at these, there have been a lot of case studies of people who have got penalized because of this and they did not have strong compliance standards around these. So as an institution, we need to look at these, from a personal-conduct perspective, professional standards, standards of fairness, and extremely important, complying with legal regulatory obligations. Going back to the point I made earlier, it is now no longer about just India, it is now multiple jurisdictions we look at when we are sitting and doing work over here. External activities not in conflict with the bank itself, adherence to the policy of which we have on gifts worthy of giving and taking and what you can and cannot do as normal courtesy versus extraordinary and making sure that we follow the policies in place.
INFORMATION ARBITRAGE AND ISSUES RELATING TO HANDLING INFORMATION
These are normally not noticed. I made the point earlier about information arbitrage but it is also equally important to make sure that the information is rightfully obtained and that we are dealing in a proper manner. The accuracy and intensity of the information and confidentiality, not trading on inside information, if you get to know appropriate external communication and compliance with retention policies are important. Going into them specifically and I guess within the current environment where e-mail is the primary form of communication in today's environment, there are some specific steps that we need to take. We need to be careful about these things, because the speed of today's communications age leads to carelessness. If you are not careful, you really need to be looking at things you could be at risk. You have to be careful about what you are sending to your client, an inappropriate e-mail will not do you any good. We have seen very often that the junior bankers, analysts who come in, do not quite appreciate what your client at the other end will comprehend out of that statement. So, you have to really put in a lot of effort in people around business communications much more than we had to do in the past because we no longer have the chance to review. You type and then you send and it's gone. A review process that was there when time to mark an external communication was three days is down to 30 seconds, is no longer there. So, be very careful that everyone is aware of this important aspect of communication. And it's about taking the newspaper test is that if I said something and it appeared how somebody else would react to it. Standards of communication need to be applied to make sure that information is balanced, accurate and truthful. Another important thing is that when you get enquiries from regulators, or from the market or financiers or any media or analyst, make sure that there are right people to deal with these enquiries. Very often, we tend to be reactive because we know only a certain part of it and we immediately pounce onto it even if we do not know the whole story. Communication standards are very important in terms of how we are going to do it.
E-MAIL RETENTION POLICIES AND RELATED ISSUES
Retention policies have been my single biggest headache in the last six months, because the US regulators say they want it this way, the German regulators say they want it that way, the Indian regulator says another way and the British regulator ends up saying another way. So, everything around e-mail retention from what is required if there is an investigative process to voice recordings that you need to keep about transactions and what you need to record, is becoming a huge challenge not just for the business, but also for our technology colleagues because you are trying to put in place a single global framework for what is a multiple jurisdiction business. As far as the importance of e-mails is concerned, if you look at all the cases that I mentioned earlier, the four collapse cases and the other things—every one of them—came to light through e-mail investigation processes. A lot of things came out not from formal documents but from e-mail. The regulators globally now look at this very carefully. Insider information is basically unpublished price sensitive—basically, you can't use it, and if you do it, it is a crime when you are dealing in securities or encouraging another person to deal in securities.
AVOIDING SPREAD OF INSIDE INFORMATION
In the early 1990s, during the height of the Harshad Mehta's scam, if you took a taxi or took a train ride in Mumbai, then by the time you finished the journey, there would be 10 people giving you an advice on what you should invest in next. Ninety-nine per cent of it was rumour. But sometimes, I would actually come across cases of people who were working in the finance departments of companies who had knowledge of what was going on and they were passing that information on. And this is not just about banking, it is not about financial sector, it is about a whole society having the information and misusing it. I think in case of any confidential information, whether it is related to finance or any other sector, the basic principle that you need to follow is to understand that this is confidential information and then communicate it on a need-to-know basis. It is only on that basis that you will be able to monitor and have a compliant framework. Chinese walls or firewalls are very important for mul-tibusiness investment banks. Basically, we do buy side and sell side, and how do you take people across the wall, how do you actually take the disciplinary sanctions is very important. So, the moment you come across an instance of non-compliance, the person has to be pulled up. There are no two questions about it that the person involved should be asked to leave immediately. And these are cases where once you build these practices—I would not say policies, everybody has policies within financial institutions—the long-term future is assured.
HANDLING CUSTOMERS IS BOTH TICKLISH AND IMPORTANT FOR SUCCESS
Are you confident that your Know-Your-Customer exercise has been adequately done? There are so many cases in our banks where the customer is not the person sitting in the front. You also need to know that behind this costumer who the actual transaction holders are. It is not a one-step process. It is extremely important in the banking environment to know that if there is a client shown as a Chennai Pvt. Ltd, it might be owned by a client out of the Bermuda and that in turn is then owned somewhere by the Russian mafia. I need to know a little more than just this Chennai Pvt. Ltd. I have to go beyond this face. It is very important in that situation that we act in the best interest of the customer. You cannot be a long-term sustainable banker to anybody, if you are only minding the short-term interests of the client. Look at the customer complaints just like you look at the employee complaints. When an employee complains the entire HR department is all over it and you need to do this, the vigilance process, grievance forums, and the like. But when the customers complain, in many places you will see that it does not go beyond a register that is kept for a regulatory reason. How seriously does the senior management look at that? Conflicts could arise because of the interests of different customers of the bank. How does a bank take all of the conflicts of interest in today's environment in investment banks is a very important matter. We have been at times in the sell side and buy side of the same merger. We have heard clients in the past with whom we had actually engaged in both the sides.....how do you manage conflicts like these? Many a time, the interests of the customer and the bank may come into conflict. Conflict could also arise between the bank and its staff many times. So, as long as we act in the best interest of the client complying with our fiduciary responsibility, executing at market rates, following up preclearance, I think we would avoid that situation. As bankers, we must understand that the core of values is basically trust. If the client is placing trust in us, we should also behave reliably, fairly and honestly. Some of the senior bankers I have worked with across the globe, have said that our aim is basically to earn, and re-earn, every day the trust of our customers and our fellow employees. It is not a one time affair; you just have to keep it going.
BUILDING A REPUTATION FOR ETHICAL BUSINESS
You must ask yourself questions. Are you a transparent, straight dealer? Are you accountable for your own decisions, outcomes and behaviour? Are you reliable? It is a very competitive industry and we play to win, but always obey the rules, and I think that's important. As Deutsche Bank, I will compete very hard with a Goldman Sachs or a Lehman Bros. But, I will do it within the rules. Lastly, it is quite important that we understand we all have a role to play in maintaining the reputation through our conduct. Furthermore, you manage the institution recognizing that a single individual can destroy your institution and reputation. You have to maintain your controls and processes keeping that in mind.