Ethicalstandardsandculturalassimilationinﬁnancial services ·...

Ethical standards and cultural assimilation in financialservices

Alan Morrison1 John Thanassoulis2

1University of Oxford2University of Warwick

[email protected]

May 2016

Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 1 / 34

Introduction

The financial crisis of 2008–09 cast a harsh light upon a number ofpractices in the financial services sector:

Subprime mortgage lending;LIBOR fixing;Forex fixing;PPI (Payment Protection Insurance).

And even more recently:

Mis-selling passive investment vehicles as active fund management.

Widespread concern that the culture in Finance is bad

Supervisors note that they cannot rely solely upon formal regulations tomoderate such behaviour.⇒ cultural standards & “tone from the top” are critical.

Despite the focus, “cultural failure” seems to be an endemic feature ofbanking. [e.g. Dudley of NYFed, Pope Francis & Archbishop ofCanterbury]

A consensus that executive pay has contributed to problems in the financialsector; and this has led to substantive fines (Forex $10bn, LIBOR $9bn).

Behavioural problems seem specific to banking and linked to ‘moral failure’.(e.g. propensity to lie and experimental evidence).

Ethics are essentially contested

Despite ease with which commentators identify moral failings, philosophershave been arguing about what is right for more than two millennia.

Virtue (e.g., Aristotle (2009), MacIntyre (2007));

For Aristotle, virtue is inconsistent with many commercial activities.

Utilitarian tradition due initially to Jeremy Bentham (2007 [1789]).

For Bentham an action is right when it generates an increase in theaggregate level of individual well-being.

Kantian duty ethics, are duties which exist before we understand thecontext and do not depend upon that context (Kant (2012 [1785]).

An example is the duty to tell the truth.We interpret as a duty not to harm the customer.

Kant would never countenance lying; Bentham would accept its desirabilityin some situations.

Modelling Ethical Dilemmas

A principal employs two agents to provide a service to consumers.There exists a practice, P, which each agent can invoke and whichraises profits with some probability.

P may harm consumers a lot, or a little.E.g. fix LIBOR; or sell PPI.

The agents face a moral dilemma: whether or not to invoke P

Senior agents have better knowledge of the harm which can be causedby P.Junior agents can observe the adoption decision of their senior.The principal can use optimal remuneration contracts to sway theagents’ choices.Consumers can be sophisticated (maybe as in LIBOR fixing); or naïve(maybe as in PPI).

Behavioural norms may be passed from senior to junior ⇒ culture

Senior agents have better knowledge of the harm which can be causedby P.Junior agents can observe the adoption decision of their senior.

The principal can use optimal remuneration contracts to sway theagents’ choices.Consumers can be sophisticated (maybe as in LIBOR fixing); or naïve(maybe as in PPI).

Behavioural norms may be passed from senior to junior ⇒ culture

Senior agents have better knowledge of the harm which can be causedby P.Junior agents can observe the adoption decision of their senior.The principal can use optimal remuneration contracts to sway theagents’ choices.Consumers can be sophisticated (maybe as in LIBOR fixing); or naïve(maybe as in PPI).

Behavioural norms may be passed from senior to junior ⇒ cultureMorrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 5 / 34

We study moral agents who subscribe to two ethicaltraditions

1 An interpretation of Bentham’s act-utilitarianism;An agent is more ethical to the extent that he places a higher weightupon the Benthamite utilitarian welfare measure from the act, and alower weight upon his own concerns.

2 An interpretation of Kant’s duty ethics;An agent is more ethical to the extent that he places a higher weightupon avoiding harm to the customer, and a lower weight upon his ownconcerns.

We study moral agents who subscribe to two ethicaltraditions

1 An interpretation of Bentham’s act-utilitarianism;An agent is more ethical to the extent that he places a higher weightupon the Benthamite utilitarian welfare measure from the act, and alower weight upon his own concerns.

2 An interpretation of Kant’s duty ethics;An agent is more ethical to the extent that he places a higher weightupon avoiding harm to the customer, and a lower weight upon his ownconcerns.

Our rationale for modeling ethical choice in this way:

1 Easier to incorporate in an economic model in which actors maximisesomething.

2 Many modern economists accept Bentham’s ethical stance byidentifying welfare with aggregate surplus.

3 Several studies indicate that real-world managers use an act-utilitarianyardstick when resolving ethical dilemmas (e.g. Fritzsche and Becker(1984) and the literature which followed).

We cannot adjudicate between different conceptions of right ... but we cangenerate positive predictions about the real-world impact of managerialmorality.

Findings for sophisticated consumers – e.g. LIBOR

If agents resolve ethical dilemmas using act-utilitarian principles then:Principal incentivises cultural assimilation.Juniors copy adoption decision of the senior agent.Principal encourages senior ethical decision and so educates junior.

For agents who have a duty not to harm consumers then:Cultural outcomes are more diverse and depend on parameters:

1 Cultural assimilation implies senior bonused on own and junior’ssuccess.

2 Acceptance and rejection cultures both possible: junior incentvised toignore senior’s adoption or otherwise of P.

P is invoked insufficiently from a surplus-maximising regulator’s pointof view.

Findings for sophisticated consumers – e.g. LIBOR

If agents resolve ethical dilemmas using act-utilitarian principles then:Principal incentivises cultural assimilation.Juniors copy adoption decision of the senior agent.Principal encourages senior ethical decision and so educates junior.

For agents who have a duty not to harm consumers then:Cultural outcomes are more diverse and depend on parameters:

1 Cultural assimilation implies senior bonused on own and junior’ssuccess.

2 Acceptance and rejection cultures both possible: junior incentvised toignore senior’s adoption or otherwise of P.

P is invoked insufficiently from a surplus-maximising regulator’s pointof view.

Findings for naïve consumers – e.g. PPI

Whatever the ethical tradition followed by the agents,profits rise as the ethical scruples of the agents decline.

If agents resolve ethical dilemmas using act-utilitarian principles then:If the ethics of both agents are weak enough then adoption of P willexceed the aggregate surplus maximising level.

Bonuses for high profits grow.

Culture of acceptance of P can be dominant when ethics are weak.

For agents who have a duty not to harm consumers then:The full spectrum of cultural outcomes remains possible: culturalassimilation, rejection and acceptance.There can be too much or too little of P for an aggregate surplusmaximising regulator.

Findings for naïve consumers – e.g. PPI

Whatever the ethical tradition followed by the agents,profits rise as the ethical scruples of the agents decline.

If agents resolve ethical dilemmas using act-utilitarian principles then:If the ethics of both agents are weak enough then adoption of P willexceed the aggregate surplus maximising level.

Bonuses for high profits grow.

Culture of acceptance of P can be dominant when ethics are weak.

For agents who have a duty not to harm consumers then:The full spectrum of cultural outcomes remains possible: culturalassimilation, rejection and acceptance.There can be too much or too little of P for an aggregate surplusmaximising regulator.

Related Literature

To our knowledge we’re the first to embed philosophical ethics into a con-tracting model and so study the interaction of ethics, the profit motive,remuneration and culture.

Transmission of cultural norms: Schein (2004), Swidler (1986), andPatterson (2014)

Culture without compensation:Kreps (1990), Crémer (1993), Crémer,Garicano, and Prat (2004), Carillo and Gromb (1999, 2002), Van den Steen(2010a, 2010b)

Compensation without ethics: Inderst and Ottaviani (2009)

Compensation and financial stability: Thanassoulis (2012, 2013),Fahlenbrach and Stulz (2011), and Efing, Hau, Kampfkotter, andSteinbrecher (2015)

The model

A business run by a profit-maximising principal with a senior agent, s,and a junior agent, j, who provide a service to customers.The value v of the service to any customer is v ≡ N (v , 1/τv ); eachtime it provides the service, the business earns a profit π ∈ {π, π},where P [π = π] = p. We write ∆π = π − π.

There is a new practice P:Adoption of P raises the probability of high profit to p + ∆p < 1.P may be harmful: if so customer suffers c > 0.Ex ante probability that P is harmful is h > 0.

c > ∆p∆π , h ,∆p∆π

P is surplus reductive in expectation if h > h.

The model

c > ∆p∆π , h ,∆p∆π

P is surplus reductive in expectation if h > h.

The model

c > ∆p∆π , h ,∆p∆π

P is surplus reductive in expectation if h > h.Morrison and Thanassoulis (SBS & WBS) Ethics in Banking May 2016 11 / 34

Timings

At time t = 0, the practice P emerges, and the principal offers aremuneration scheme to the agents. The principal makes take-it-or-leave itfee offers φs and φj to the customers of the senior and junior agent,respectively. Each agent acquires one customer. The customer commits topay the fee.

At time t = 1, the senior agent receives her private signal σ of thepractice’s type, and makes her private invocation decision Is . The junioragent observes Is .

At time t = 2, the junior agent makes his private invocation decision Ij .

At time t = 3, customer benefits and business profits are realised. Thetime 0 remuneration contracts are executed.

Agent knowledge and contracts

The senior agent s receives a private signal σ ∈ [0, 1] about P; juniordoes not.High signals σ are suggestive of a harmful practice:

σ drawn from FH(·) if the practice is harmful, and FL(·) if it is not.Assume fH(σ)/fL(σ) is strictly monotonically increasing in σ.Assume that fL(1) = 0 = fH(0), so extreme signals reveal type withcertainty.

Contract variablesProfits are verifiable, customer benefits are not.

The junior agent moves after the senior agent and cannot affect herprofits. His contract is therefore (w j ,wj).

Senior agent’s contract is a four-tuple: (w sj ,w sj ,w

js ,wsj).

Agent knowledge and contracts

The senior agent s receives a private signal σ ∈ [0, 1] about P; juniordoes not.High signals σ are suggestive of a harmful practice:

σ drawn from FH(·) if the practice is harmful, and FL(·) if it is not.Assume fH(σ)/fL(σ) is strictly monotonically increasing in σ.Assume that fL(1) = 0 = fH(0), so extreme signals reveal type withcertainty.

Contract variablesProfits are verifiable, customer benefits are not.

The junior agent moves after the senior agent and cannot affect herprofits. His contract is therefore (w j ,wj).

Senior agent’s contract is a four-tuple: (w sj ,w sj ,w

js ,wsj).

Agents’ Objective functions and ethical standards

u = (1− ε)w + εe(w , v). (2)

Parameter ε ∈ [0, 1] is agent’s ethical commitment;Function e is agent’s ethical standard:

1 For an act utilitarian evaluating P

eAct , E [surplus due to act]= E [surplus accruing to bank]− E [cost to customer] .

2 For an agent with a duty-based ethical standard to evaluate P

eDuty , −E [harm to the customer] .

results

u = (1− ε)w + εe(w , v). (2)

results

u = (1− ε)w + εe(w , v). (2)

results

Equilibrium definition

An equilibrium of the model comprises:

1 Remuneration contracts(w j ,wj

(w sj ,w s

j ,wjs ,wsj

)between the

principal and the agents;2 A strategy θs (σ) for the senior agent that depends upon her private

signal σ;

3 Strategies θ1j and θ0

j for the junior agent in the respective cases wherethe senior agent does and does not invoke P;

Such that each agent’s strategy is optimal given the other’s, and theremuneration contracts maximize the principal’s expected income given theagents’ strategies.

Preliminaries

We solve the game by backwards induction.

LemmaFor any level εs of ethical commitment, the senior agent’s posteriorassessment η(σ) of the probability that P is harmful is increasing in σ.

A consequence of the monotonicity of fH(σ)/fL(σ): a higher signalrenders the senior agent more confident that P is harmful.

Senior agent expects P to increase aggregate surplus precisely whenη(σ) ≤ h. (Equivalently σ ≤ σ , η−1(h)).

PropositionThe senior agent adopts a cut-off strategy, under which she adopts P ifσ < σ∗R and rejects P if σ > σ∗R .

Preliminaries

We solve the game by backwards induction.

LemmaFor any level εs of ethical commitment, the senior agent’s posteriorassessment η(σ) of the probability that P is harmful is increasing in σ.

A consequence of the monotonicity of fH(σ)/fL(σ): a higher signalrenders the senior agent more confident that P is harmful.Senior agent expects P to increase aggregate surplus precisely whenη(σ) ≤ h. (Equivalently σ ≤ σ , η−1(h)).

PropositionThe senior agent adopts a cut-off strategy, under which she adopts P ifσ < σ∗R and rejects P if σ > σ∗R .

Further preliminaries

The junior has posterior belief as to the harmfulness of P given by hIj .

PropositionThe junior agent adopts a cut-off strategy, under which he adopts P ifhIj < h∗j ,R , and rejects P if hI

j > h∗j ,R where

h∗j ,R , hR +1− εjεj

c(w j − wj). (3)

{0, R = Duty ,h, R = Act.

Lemmah1j (σ∗) ≤ η(σ∗) ≤ h0

j (σ∗)senior rejection is bad news about P.

j > h∗j ,R where

c(w j − wj). (3)

j > h∗j ,R where

c(w j − wj). (3)

h∗j ,R

σ0 σ∗

Acceptance

CulturalAssimilation

Rejection

Figure: Junior agent strategy regions.

Optimal contract for junior

Principal selects remuneration contracts (w j ,wj) and (w sj ,w sj ,w

js ,wsj) to

implement cut-off values h∗j and σ∗.

These choices determine the organisation’s culture.

Assume w j ≥ wj , w sj ≥ w js , w s

j ≥ wsj .

LemmaFor R ∈ {Act,Duty}, the principal can implement any h∗j ,R ∈ [hR , 1].The cheapest way is to set wj = 0 and

w j = w jR(h∗j ,R) ,

εj1− εj

(h∗j − hR). (5)

Bonus pay can be used to mitigate an agent’s moral objections to P.

But wages rising in profits⇒ pay must expand beliefs for which P adopted.

js ,wsj) to

j ≥ wsj .

εj1− εj

(h∗j − hR). (5)

js ,wsj) to

j ≥ wsj .

εj1− εj

(h∗j − hR). (5)

Optimal contract for senior

The principal can incentivise any cutoff σ∗ ≥ σR ,

{0, if R = Duty ;σ, if R = Act.

If incentivising j cultural assimilation

Bonus on team success: w sj = w j

s = wsj = 0 with

w sj =εs

1− εsc

∆p(η(σ∗)− hR)

12p + ∆p

If incentivising j acceptance

Bonus on senior success: w js = wsj = 0. And w sj , w s

j satisfy:

(p + ∆p)w sj + (1− p −∆p)w sj =

εs1− εs

(η(σ∗)− hR) .

s = wsj = 0 with

w sj =εs

1− εsc

∆p(η(σ∗)− hR)

12p + ∆p

j satisfy:

(p + ∆p)w sj + (1− p −∆p)w sj =

εs1− εs

(η(σ∗)− hR) .

s = wsj = 0 with

w sj =εs

1− εsc

∆p(η(σ∗)− hR)

12p + ∆p

j satisfy:

(p + ∆p)w sj + (1− p −∆p)w sj =

εs1− εs

(η(σ∗)− hR) .

If incentivising j rejection

Bonus on senior success: w js = wsj = 0. And w sj ,w s

j satisfy:

pw sj + (1− p) w sj =

εs1− εs

(η (σ∗)− hR)

Equilibrium with sophisticated investors

Definition of Sophisticated InvestorsCustomers are sophisticated if they correctly anticipate the equilibrium ofthe game and are prepared to pay the expected value of their services inthat equilibrium.

PropositionWhen the firm’s customers are sophisticated and agents are actutilitarians, the principal sets wages equal to the outside option ofzero, irrespective of the state of the world. Then σ∗ = σ and the junioragent’s investment decision is culturally determined: cultural assimilation.

intuition

Equilibrium with sophisticated investors

Definition of Sophisticated InvestorsCustomers are sophisticated if they correctly anticipate the equilibrium ofthe game and are prepared to pay the expected value of their services inthat equilibrium.

PropositionWhen the firm’s customers are sophisticated and agents are actutilitarians, the principal sets wages equal to the outside option ofzero, irrespective of the state of the world. Then σ∗ = σ and the junioragent’s investment decision is culturally determined: cultural assimilation.

intuition

Sketch proof

Consider optimal contracting if incentivising cultural assimilation.The surplus which can be extracted is:

S Ass = 2(π + v + (p + ∆pFh(σ∗))∆π − hcFH(σ∗))

Note that ∂S Ass

∂σ∗ is positive for σ∗ < σ, and negative for σ∗ > σ.

Next determine wage payments. Show W Asss,R is increasing in σ∗ for σ∗ > σ,

and declining in σ∗ for σ∗ < σ.

As W Assj ,Act = 0 it follows that, conditional on opting for the cultural

assimilation region, ΠAss is maximised at σ∗ = σ

Finally repeat for acceptance and rejection regions, and show profitsbounded above by those secured from cultural assimilation.

Sketch proof

Note that ∂S Ass

Sketch proof

Note that ∂S Ass

Sketch proof

Note that ∂S Ass

Intuition

Sophisticated customers pay exactly their expected income from thefirm’s service.The principal earns the total expected surplus from service provision,less the expected value of any wages.The expected surplus is maximised if the senior agent invokes Pwhenever σ ≤ σ and the junior agent’s invocation decision is culturallydetermined.Because every agent has non-zero ethical commitment, the principalcan induce this behaviour by paying all agents a zero wage.Because this contract maximises surplus and minimises expected wagepayments, it is identified as optimal.

Equilibrium with sophisticated consumers

PropositionSuppose that the firm’s customers are sophisticated and that agents feel aduty not to harm the customer. Then σ∗Duty < σ withη(σ∗Duty ) < h/(1 + εs/2(1 + εs)), and the principal uses bonus contractswith wages above zero for agents whose ethical standards are low enough.Equilibria with junior agent cultural assimilation, acceptance, andrejection are all possible.

Sketch proof for Kantian duty ethics case:Consider each cultural region separately as above.Calculate S Ass, W Ass

s,Duty and W Assj ,Duty .

Now show wages are monotonic in σ∗.Demonstrate that each cultural region can dominate others for someparameter values.

Junior agent duty ethics sophisticated consumer example

Equilibrium with naïve investors

Definition of Naïve InvestorsCustomers are naïve if they do not appreciate the consequences of P, andalways pay v for the service.

LemmaHowever the agents resolve ethical dilemmas, the principal’s expectedprofits are declining in the strength of the ethical commitment of theagents.

Definition of Naïve InvestorsCustomers are naïve if they do not appreciate the consequences of P, andalways pay v for the service.

LemmaHowever the agents resolve ethical dilemmas, the principal’s expectedprofits are declining in the strength of the ethical commitment of theagents.

Act utilitarian agentsThe optimal σ∗Act > σ if the agents’ ethics are sufficiently limited.With sufficiently weak ethics, a culture of acceptance of P is dominant.

Duty ethic agentsThe principal uses bonus contracts with wages above zero for agents whoseethical standards are low enough. Equilibria with junior agent culturalassimilation, acceptance, and rejection are all possible.Any cutoff σ∗Duty ∈ [0, 1] is possible.

Junior agent duty ethics & naïve consumer e.g.

Conclusions

A contracting model in which morally aware agents decide whether or notto invoke a social practice which may harm customers.

Agents motivated by their compensation contract and their moralstandards.

Cultural assimilation, and so importance of tone from the top emerges natu-rally; it is the equilibrium outcome when ethical dilemmas resolved using actutilitarian principles and consumers are sophisticated.

With sophisticated customers, bonus pay is only needed when agents resolveethical dilemmas using Kantian duty ethics – such ethics would result inagents not maximising aggregate surplus if left to their own devices.

Naïve consumers offer no break on profitability – the principal uses pay toencourage agents to set aside their moral scruples – cultural assimilation canhappen, but it is perverse: senior encourages harmful social practices whenthey are sufficiently profitable.

Conclusions

PPI selling bonuses appear to be in sharp distinction to thosearising in optimal contracting which are designed to provide incentivesto overcome a moral hazard problem when managerial effort is not subjectto contract.

In our model such bonuses only undermine manager’s natural inclination todo the right thing.

We don’t claim performance pay is never justifiable – but the decision touse such payments should be weighed against the possible effectsthey can have on ethical decisions.

Bonuses in one UK Bank The Guardian 8 Nov 2012

“In my role as a customer adviser I had to sell 10 loans a week with seven or eighthaving PPI ... There was plenty of training in ’disturbance techniques’, making thecustomer feel anxious about their ability to repay the loan in the event of accident,sickness, unemployment or death ... If a customer refused to take PPI we had to explainto the manager the reasons given and which sales objections techniques we used.

Each quarter the branch had to achieve a certain amount of sales points ... Large loanswith PPI secured the most points. Our quarterly bonus depended on how many pointsthe branch as a whole achieved. I recall that hitting 120% of target meant our bonuswould be in a higher paying threshold.

We knew PPI was overly expensive, with some insurances costing £100 a month. Therewere plenty of other insurances on the market that could offer similar or more suitablecover at a much lower cost.”

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