StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

Ethical dilemmas are everywhere in finance - Research Paper Example

Cite this document
Summary
Ethics are important in any field of life. However, it assumes greater importance in finance because finance touches our daily lives. Be it every day finance for buying daily grocery or investing ones money in the capital markets with an aim of earning maximum profits, finance touches us in various forms…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER92.8% of users find it useful
Ethical dilemmas are everywhere in finance
Read Text Preview

Extract of sample "Ethical dilemmas are everywhere in finance"

?Ethical dilemmas are everywhere in finance Introduction Ethics are important in any field of life. However, it assumes greater importance in financebecause finance touches our daily lives. Be it every day finance for buying daily grocery or investing ones money in the capital markets with an aim of earning maximum profits, finance touches us in various forms. Boatright (1999) divides organized finance under three broad categories in life – financial markets, financial services companies and non-financial organizations. Ethical dilemmas in finance surely impact us the most and hence the choice of this topic. Importance of ethics in Finance An interesting aspect of this dilemma is to understand what is considered ethical and what is not. Finance by its very nature propagates the theory of maximization of profits. Why would anyone culminate a financial transaction if there was nothing to gain out of it? Now to decide how much to earn and by what means to earn is the most interesting facet of this dilemma. In theory, an organization is considered to be an entity that works for the benefit of its shareholders. The employees of the firm are thus assumed to be the representatives of this entity. They work on the various financial models to look for avenues which have minimum risk and maximum return. The financial theory also states that people are averse to taking risk. Hence, an investment in a risky proposition would mean that the investor is expecting an above average return. Riskier the proposition, higher the return expected. But the amount of risk to be taken is something that the investor needs to understand. Another concept in financial management is that of the Net Present Value (NPV). A firm should invest only in those assets or projects which have a positive NPV. All these concepts are interlinked with the fact that ethical dilemmas will continue to haunt the stakeholders at all points of decision making while running an organization. The various theories of finance can tell what the best options to maximize returns are, but ethics relate to the means that are used to achieve those ends. This is the most important aspect of this topic. The figures used in finance require an ethical basis to produce positive and sustainable results. Let us see how this dilemma exists in the present market. Discussion of Financial irregularities that lead to the recent global crisis (Kolb 2010) One of the stark examples of financial irregularity and unethical activities can be seen in the recent financial crisis of 2008 which is considered to be the biggest financial depression since the depression of 1930’s. This has been attributed to the emergence of complicated financial instruments called CDOs which are traded through investment banks. Investment banks, unlike the normal banks which give out loans and have adequate deposits to cover them, do not need to keep any deposits. They collect all the mortgage backed securities (MBS) and sell them to investors after securitization. Kolb (2010) explains the process of lending that takes place in the mortgage market in the figure below. The figure shows the origin to distribute model (OTD) which was being applied in the industry before the financial crisis occurred. As per this model, the originators of the loans were not there holders unlike in the normal banking loans scenario. Ethical dilemmas at borrower level (Kolb 2010 and Stich n.d) Kolb (2010) observed that most of the borrowers never had any intentions of paying their principal amounts. Ethical issues cropped at all the links in the model. The first level of unethical financial dealing started at the borrowers level itself. In a normal banking scenario a borrower has access to only those loans and interest rates which are commensurate with the risk he has been associated with by the lender ( the banker in this case). However, in the OTD model, the originator of the loan gives the borrower options of varied interest rates and EMI payments by overlooking their actual credit worthiness because the originator is not at a risk of default. The originator knows that it will be further securitized and sold off to an investor down the line. US witnessed a growth in real estate prices and a reduction in interest rates in the beginning of the 21st century. Thus, borrowers first started getting loans for houses to live in. But as the availability of credit became easier and the property prices kept growing at obnoxious rates, they started over leveraging themselves and buying second or even 3rd house as an investment to reap capital gains at a later stage. For getting these 2nd and 3rd properties they provided false documents or avoided disclosure of vital information regarding their leverage position to the originators. Another facility provided to the borrowers which prompted them to take risky positions was the ARM loans (Adjustable Rate Mortgages). These loans had a fixed low interest rate (called teaser rate) for an initial period followed by a higher floating rate. The borrowers paid the initial low rate and once this expired they took another loan of a similar nature. Kolb (2010) observes that when they had exhausted all possibilities of refinancing, they would usually default. Thus, the borrowers always had unethical intentions when they took a loan in the first place. The originators never bothered about the quality and final fate of the loans because they had already passed on the risk to the investors (some of them being completely naive investors) through securitization root. Stich (n.d.) observed that there was another way in which people defrauded lenders. Many people who had good creditworthiness sold their identities to those who were not eligible for loans. They received monetary compensation from the buyers for hiding the true picture. Ethical dilemmas at the originator level (nexus of brokers and lenders) (Kolb 2010 and Stich n.d) Kolb (2010) says that they lenders and brokers tweaked the 80:20 rule of lending which says that 20% of the financing should be done by the borrowers themselves to keep leverage low. The next thread in the link is that of the loan originator. The main problem with the subprime mortgages was that they were not very credit worthy loans but they provided high interest rates to the lenders for taking the higher risk. Hence, the originators (who were mostly banks and brokers) pushed for these loans as they would provide them with better returns after securitization and hence had a great demand from the institutional investors like the pension fund schemes and insurance companies. A higher return for a risk which was never theirs was a great incentive for the originators to sell such loans. The brokers wooed the borrowers by providing alternative ways of getting 20% of financing done through refinancing options rather than through own equity route. Hence these loans were 100% leveraged. The originators even had the incentive of guiding the borrowers in different ways of flaunting rules. The financial lenders also displayed unethical behavior by charging exorbitant rates to the borrowers when they knew that subprime borrowers did not have the capacity to continue making payments at such high rates. Another aspect which motivated lenders to specifically sell big ticket loans was the fact that higher principal balance on the mortgage would fetch a higher price for it. Thus, all these aspects motivated the lender to sell big loans irrespective of the paying capacity of thse borrowers and to ignore the down payment criteria thus making the loan very risky. Coupled with this was the fact that the mortgage broker connived with the banks to woo the naive borrower with unfavorable loans on one side while on the other side showed the borrower ways of deceiving the lenders when they did not meet the requisite borrowing criteria. The brokers were minting fees and incentives from both sides. Stich( n.d.) says that one of the evidences of public misguidance can be seen from the fact that by beginning 2006, most of the insiders of Wall street had started realizing that there was a problem with the subprime mortgage and the related securities were losing value, but they still kept pushing their customers to buy ARSs (Auction Rate Securities). Most of the big financial houses (Wachovia, Merrill Lynch & CO., UBS securities etc.), which were trusted blindly by the public, had miss-sold the ARSs to the client by pushing them as cash equivalents. When the funds dried out and clients started asking for their money back, these banks started shirking their responsibility. However, various enquiries into the alleged malpractices revealed the truth and hence they were forced by regulators to buy back the ARSs sold to the naive customers. But by then it was too late and there was no liquidity in the system. This worsened the situation. The nexus between the brokers and the employees of the lending institutes was so strong that lien documents were taken out from the lending institute. Stich (n.d) quotes that “the lien documents were forged and then recorded at the recording office as lien satisfied”. This could now be used to get another loan. Stich (n.d) also notes in his article that selling of false income statements; employee payroll stubs and income tax statements were rampant. Ethical dilemmas of securitizers (Kolb 2010) Kolb (2010) observed that the employees of investment banks ignored all due diligence rules as there was a conflict of interest. Securitization is the next source of incentive collection. “Securitizers” bought the individual mortgages from the lenders and through financial re-engineering converted them into CDOs which were traded in the market. In an ideal situation, the securitizer would be keen to perform due diligence to ensure that the mortgages are worth the value they are being purchased for. However, the employees of the securitizers were always under pressure to buy more so that their respective organizations could earn the maximum. Their incentives were thus linked to the volume of business they generated. This prompted them to resort to all possible means to churn out short term gains by overlooking long term implications Unethical behavior by Credit rating agencies (Kolb 2010) Kolb 2010 says that the rating agency was earning from two sides – one for guiding the securitizer and other for giving the rating itself. Once these “bad” securities passed the hurdle of second level due diligence the next step was to obtain credit ratings for them from independent credit rating agencies. The rating provided the securitized assets the opportunity to earn maximum price in the market. Higher the rating provided by the credit rating agencies like S&P and Moody’s, higher was the price earned by the security. Here again conflict of interest came into play. The securitizer wanted a high rating to earn the maximum, so it had to go to the rating agency and understand how that could be done. The agency in turn was paid hefty consultation charges for the guidance it gave. Thus, at this level, where an external agency should have conducted a credit worthiness analysis of the security, it was actually guiding the securitizer ways of planning the security in a way that could fetch it the best rating. Thus the interests of the investor were recklessly ignored. These agencies completely disregarded the very purpose of their existence – to check the risk involved in a security and show the investor the true picture of what they are going for by investing in these securities. Irresponsible behavior of financial engineers (Kolb 2010) Another source of the financial distress was the “growth of structured finance” (Kolb 2010). As stated earlier, structured finance allows the various loans to be structured into securities and then sold to the investors. In their enthusiasm or greed to earn more, the financial engineers created such complex instrument which they themselves could not understand. This was again thoughtless ignorance of the risk they were putting an investor into. There was no need to increase the complexity of the instruments when everyone knew that even a slight change creates unmanageable complexity. Unethical behavior by lobbyists, politicians and regulatory agencies (Stich n.d) Stich (n.d) notes that these institutes were insanely leveraged at a ratio of 27:1.The supervisory mechanism of the financial markets was also not very foolproof. The investment banks, who were actually the intermediaries, were being monitored only by the SEC. There was no supervisor for these firms. They kept doing what they liked. He also points to the fact that there was no obligation on them to disclose the “off-balance sheet risk” and neither did some of them understand it. The big institutes, Freddie Mac and Fannie Mae who were supposed to monitor risks were more like sleeping giants. There was a nexus between the politicians and the lobbyists to overlook any signs of impending crisis. One such instance came out in the investigations done later. Senator McCain is alleged to have kept his eyes closed due to the influence of the lobbyists. In his study Stich (n.d) has observed that Freddie Mac is supposed to have paid $15,000 every month to a Rick Davis who was the “senator’s campaign advisor for president” just to keep close ties with the senator. The financial institutes had full control over the politicians. Stich (n.d) notes that Freddie Mac for example “paid a republican firm $2million to kill legislation that would have regulated and trimmed the mortgage finance giant” along with Fannie Mae. The lobbyists did not stop at this. They were all out after the Congress to persuade them to pass bills to bail them out of the financial crisis. They were unconcerned about the fact that they were actually asking for money for their reckless behavior which had caused so much distress to the very public through whom they wanted to get bailed out. Indifference shown by corporate to public woes (Stich n.d) Stich (n.d) quotes that Merrill Lynch paid its CEO $150 million golden parachute despite suffering losses of $30 billion under him. He has also observed that Freddie Mac and Fannie Mae were also not behind in showering bonuses amounting to $100 million to its top executives despite the financial losses.The losses suffered by the American public and the world as a whole did not deter the companies from paying hefty bonuses to their top leadership cadre. This shows an irresponsible behavior on part of the coporates. Conclusion Looking at the above discussion, we can conclude that financial dilemmas exist at all points of transactions in the world of finance. The basic premise of economics is to earn profits. In that sense the financial institutes, brokers and credit rating agencies were not doing anything wrong as every entity should be profitable at the end of the day. However, since financial mangers (not just those working for organizations but those who are facilitating the functioning of a financial transaction like government agencies and politicians etc.) influence our lives to such a great extent that it is imperative that they understand the thin line between ethical action and a legal action. An unethical action may not always come under the legal jurisdiction, but the person involved should understand its implications on others. The over-rated junk bonds did not only impact the American public, but the entire world suffered huge losses because they had invested heavily in those securities trusting the AAA ratings given by the various credit rating agencies. Thus a financial manager’s responsibility goes beyond just maximizing profits but to understand the implication of the actions involved (in earning that profit) on the society. References Boatright, J.R (1999) Ethics in finance – Volume 1 of Foundations of business ethics, Wiley-Blackwell Kolb, R.W (2010) Lessons from Financial Crisis: Causes, consequences and our economic future, John Wiley and Sons Stich, R (n.d) America’s Housing and Financial Frauds, Silverpeak Enterprises Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(“Ethical dilemmas are everywhere in finance Research Paper”, n.d.)
Retrieved de https://studentshare.org/finance-accounting/1390585-ethical-dilemmas-are-everywhere-in-finance
(Ethical Dilemmas Are Everywhere in Finance Research Paper)
https://studentshare.org/finance-accounting/1390585-ethical-dilemmas-are-everywhere-in-finance.
“Ethical Dilemmas Are Everywhere in Finance Research Paper”, n.d. https://studentshare.org/finance-accounting/1390585-ethical-dilemmas-are-everywhere-in-finance.
  • Cited: 1 times

CHECK THESE SAMPLES OF Ethical dilemmas are everywhere in finance

Qatar Leadership Centre's programme

In the face of globalisation and internationalisation, there is the need for strong leadership in finance to enable businesses and nations to grow.... The next five years, the researcher desires to acquire more experience in financial management and lecturing, further his education in finance and accounting and also build a socially responsible career.... … The paper tells that the global imperative makes it vital for finance professionals to build international leadership competencies to enable them to meet their challenges of new trends....
4 Pages (1000 words) Essay

Code of Ethics

Free competition The banking and finance industry believes that free and fair competition is the basis of the free market economic system and avoids collusive, anti-competitive discussions and/or agreements with competitors.... hellip; The author states that individuals encounter moral dilemmas frequently in their working lives and are likely to find them very difficult....
4 Pages (1000 words) Assignment

Role of Religious Ethics in Prevailing Business Framework

United with contemporary skills and technologies, they progressively form the thoughts and actions of people and influence increasingly… Consequently, the larger is their impact, the larger is the necessity and importance to certify that they build up “in the correct path,” if they are not to Management for business and economics should come from both aspects of “external” and “internal....
13 Pages (3250 words) Essay

An analysis of ethics in the 21st Century

I hereby confirm that this assignment, to the best of my knowledge, is the candidates own work and they have not collaborated in the production of this assignment with any other person.... I also confirm that I have a record of this candidate's progress tutorial/s. The following… report includes the discussion about what Ethics, types of ethics, business ethics and importance of business ethics, Ethics in 21st century and finally the conclusion of overall report....
7 Pages (1750 words) Research Paper

Management Is a Highly Debatable Issue

The term management is used is used in almost all our day-to-day activities and our lives.... It used in a variety of ways depending on the context although some theorists tend to present it a dominating… For example, it can be used in organizations to mean planning, organizing and control but it can also be used in social setting such as in situations where people are advised to manage their affairs well or finances or when one says ‘ I can manage' to mean he/she There are also various terms associated with management such as scientific management, human resource management, knowledge management among others....
9 Pages (2250 words) Essay

Ethics in Hospice Care

The legality of the actions is another issue of concern that contributes to increased ethical dilemmas.... Euthanasia can be voluntary or involuntary, both raises ethical controversies.... Physician-assisted suicide is a huge ethical issue in the United States (Friend, 2011)....
16 Pages (4000 words) Essay

The Efforts of the Personal Finance Education Group

The paper "The Efforts of the Personal finance Education Group" discusses that the Financial Services Authority (FSA), the ifs School of finance, and the newly formed Office for Standards in Education, Children's Services and Skills (Ofsted), among others, have their own individual campaigns....
13 Pages (3250 words) Case Study

Personal Ethics - Life Balance Goals

believe that the ethical issues for business today include fraud, access to healthcare, opportunities for advancement, downsizing and crime.... This paper "Personal Ethics - Life Balance Goals" focuses on the fact that ethics are an important aspect of everyone's life because they help an individual understand the difference between right and wrong....
8 Pages (2000 words) Assignment
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us