Back to the basics in business: Ethics

The Coffee Shop
1

We all know that businesses exist to provide a good or service to customers and to make money for themselves and others (shareholders, employees etc). That is capitalism at its finest and most of the time it works great. Also, people usually act ethically and in the best interests of their companies, their shareholders and their customers every day and still make healthy profits.

While a certain amount of greed has and always will be a part of human nature, I think in the case of many of the banks and insurance companies excessive greed became paramount to the basic principles of capitalism.

While developing and spreading the use of “creative financial instruments,” did these people and companies ever stop to ask, "Should we be doing this?” Probably not. They were making too much money to even consider if it was right or wrong.

There is a concept called moral agency, which says that ethics is not possible at the organizational level, but ethical behavior relies on the individual. I believe behaving ethically relies on both the individual and the organization.

2

An excellent and timely post.

“While a certain amount of greed has and always will be a part of human nature, I think in the case of many of the banks and insurance companies excessive greed became paramount to the basic principles of capitalism.”

The word “greed” is one of those “package deal” words that refer to some mixture of good and bad qualities, without providing any means for distinguishing between them. For that reason, I try to avoid the word. I would say that the pursuit of rational self-interest is promoted by capitalism, while exploitation is discouraged by that system and aggression against others (by fraud, for instance) is prohibited. Under capitalism, one is encouraged to seek to maximize one’s values, most often by providing values to others. When people complain about “excessive greed,” what they are normally talking about isn’t the pursuit of rational self-interest–which is never “excessive,” because it works for the good of everyone–but rather about exploitative or short-sighted behavior that ultimately works against one’s own self-interest as well. If I may borrow MattinSF’s metaphor from a recent post, gorging on a “huge plate of cookies” is not an expression of rational self-interest at all.

“There is a concept called moral agency, which says that ethics is not possible at the organizational level, but ethical behavior relies on the individual. I believe behaving ethically relies on both the individual and the organization.”

Only individuals can make choices, so only individuals can be moral agents. At the same time, the culture of an organization may tend to encourage individuals to make either good or bad choices; in this manner, although the organization does not make moral choices, it does exert moral influence. The same principle obtains if we think of a society, particularly with regard to its political system, as an “organization.” Is the system structured in such a way as to incline people toward responsible or irresponsible behavior? Does it encourage people to pursue their rational self-interest, or does it lead them to believe that they can only obtain values by exploiting others? Note that in a system where exploitation and other short-sighted behaviors are accepted in the public sector, it becomes increasingly likely that they will be practiced in the private sector as well.

3

Actually, this was largely not a problem of individual behavior. This was a problem of systemic lack of or relaxing of controls which then transcending a series of organizations, all of whom had no ties to the other with respect to ownerships structure but relied on the next in line for its profits. Unfortunately, it was death by 1000 cuts. Think of it as the game of telephone you played as a child. If everyone makes a small mistake, what you hear on the other end in no way resembles what was initially stated. You can’t blame the creator of a financial instrument if someone was willing to buy that instrument and you can blame the warehouser for buying it and bundling it if someone was willing to syndicate it and you can’t blame the party responsible for syndicating it if the rating agency was willing to misgrade it. Hopefully you get the point. In my opinion there is an systemic moral agency problem that regulations should have goverened. That does not however, releive parties from company or individual responsibility.

Where I did see material ethical lapses was in the individual origination of loans where people were underwritten who were not financially viable. Lying or material misstatement of fact to garner a profit, whether excessive or otherwise, is a moral agency problem.

4

I think that ethics in business is a nice concept but it doesn’t play well in Capitalism. If not for the hated Govt. would workers have any kind of protection if it was up to business? The same for the consumer. Individuals may or may not be ethical, again it depends on the individual.

When it comes to Wall St how often does someone serve time for a crime? Usually the big guys pay fines WITHOUT admitting guilt. Bernie appears to be the exception to that rule. Why should we expect Wall St to be “ethical” if they don’t have too? What’s their incentive?

5

I would say that the pursuit of rational self-interest is promoted by capitalism, while exploitation is discouraged by that system and aggression against others (by fraud, for instance) is prohibited. I would totally agree with that from an academic standpoint. In reality, though, there really isn’t one “free market.” The U.S. economy is made of thousands of interconnected markets. Some of them are fantastically efficient, like the markets for most commodity goods. I would argue that some parts of our financial system, far from being efficient, met the conditions for several types of market failure. One of several is informational assymetry, where one party in a financial transaction has more information than another and withholds that information,. This occurred at many levels, but most obviously at the level of the mortgage broker. The mortgage broker accepts little risk (except eventually losing their job) for initiating bad mortgages. So they shield the buyer from the information that the mortgage is probably too big for their income level, and they shield the bank from information that that the loan is risky. Another example is at a higher level . I suspect that there are some within AIG - and other institutions - that knew that the mortgage-backed securities were riskier than their market valuation. Yet they kept quiet about the market valuation because their institutional and personal income benefited in the short term (short term being ~10 years or so). That is, again, a market inefficiency due to informational assymetry. It’s possible this was informational incompetence, and not, moral hazard, but I’m skeptical.
Now normally this isn’t news. The bad company just melts away, and is replaced by more efficient ones. Not the case currently because huge financial institutions are quasi-governmental in their power. Getting rid of them is like trying to fire the rogue IT manager who can take down the entire company mainframe before he goes. We’re being held hostage. Some here claim it’s fear mongering to say that. I doubt it. These companies, collectively, really can take down the economy to a 1929-like level.
Note that in a system where exploitation and other short-sighted behaviors are accepted in the public sector, it becomes increasingly likely that they will be practiced in the private sector as well. ** I would argue the opposite. The private sector culture has infiltrated* *the public sector regulatory institutions. Many who work for the SEC are grooming themselves for more lucrative private industry jobs, and therefore have little motivation to upset the status quo. In addition, the private industry has more, and smarter people than the public sector. Many of whom are lobbyists. So there’s a failure of the regulatory mechanism. Which leads to governmental failure to magnify the market failure. Some, of course, say the governmental failure caused the market failure, but from what I’ve seen that’s pushing it. Enabled it, certainly, caused no. The solution? Don’t know. I don’t think we can ever let individual instituations get that powerful, though. ** **

6

When people complain about “excessive greed,” what they are normally talking about isn’t the pursuit of rational self-interest–which is never “excessive,” because it works for the good of everyone–but rather about exploitative or short-sighted behavior that ultimately works against one’s own self-interest as well. If I may borrow MattinSF’s metaphor from a recent post, gorging on a “huge plate of cookies” is not an expression of rational self-interest at all.

Acting against rational self-interest with “exploitative or short-sighted behavior” is a good way to describe their behavior.
**
Only individuals can make choices, so only individuals can be moral agents. At the same time, the culture of an organization may tend to encourage individuals to make either good or bad choices; in this manner, although the organization does not make moral choices, it does exert moral influence.

The culture of an organization can make a big difference on the moral choices individuals make. I wonder if the culture of these types of institutions can “excert moral influence” that encourages risky behavior? Or were these simply a small group of rouge agents engaging in these activities without knowledge of senior management? Either way, there is a problem.

7

*In my opinion there is an systemic moral agency problem that regulations should have goverened. That does not however, releive parties from company or individual responsibility. *
**
Laws and regulations can only go so far to influence individual or organizational behavior. Some say there are already too many regulations and others say there aren’t enough.
Would more regulations and oversight have been able to prevent the risky behavior? Probably not, but could have reduced its impact in the long term.

8

*Why should we expect Wall St to be “ethical” if they don’t have too? What’s their incentive? *
**
Those are two very good questions. For most on Wall Street and elsewhere in the corporate world, the incentives to act ethically result in profitable companies that create shareholder value, employ people and provide a good or service to customers. At the same time, they don’t engage in high risk behaviors that threaten the continued success of the company in the short and long term, or in behaviors that could ultimately threaten the economy as a whole.

9

I think you overestimate the individuals role or ability to influence. It takes an organization to change the way things are done, the individual, unless they are at the top, merely gets spit out the back. And yes, you can trace a lot of this behavior to a number of legislative actions which have laxed the rules on financial services companies, namely Gramm-Leach-Bliley. If i-banks had not been allowed to borrow against their equity at the same levels, some of this could certainly have been avoidable. Hell, blame the credit card companies if you like.

10

“I wonder if the culture of these types of institutions can “excert moral influence” that encourages risky behavior? Or were these simply a small group of rouge agents engaging in these activities without knowledge of senior management? Either way, there is a problem.”

Note, BTW, that the two alternatives are not mutually exclusive. Senior management may promote that kind of atmosphere, consciously or unconsciously, while not monitoring things well enough to recognize the risks that are actually being taken by the rogue agents.

“For most on Wall Street and elsewhere in the corporate world, the incentives to act ethically result in profitable companies that create shareholder value, employee people and provide a good or service to customers. At the same time, they don’t engage in high risk behaviors that threaten the continued success of the company in the short and long term, or in behaviors that could ultimately threaten the economy as a whole.”

In a free market, individuals who put their companies at undue risk would normally be fired promptly. Their reputation would then make it very difficult to them to assume similar responsibilities at other firms. In our current system, though, employers are reluctant to terminate miscreants for fear of legal action, and if those individuals leave, they are reluctant to provide frank opinions to future employers for the same reason. Consequently, from the employee’s point of view, the downside to taking a great risk is not that great, while the upside possibilities remain compelling. That’s just one of the ways in which the political/legal environment can influence moral behavior.

11

When it comes to Wall St how often does someone serve time for a crime?

I suspect any time the crime committed carries a sentence of jail time.

I’m also not sure what you mean by “Wall street” are you talking traders or CEO’s? We’ve seen plenty of CEO’s do the walk of shame over the last 4-5 years.

~Matt

12

One’s “Morals” and “Ethics” are often times tempered by the known consequences of ones actions.

As we can see today the known “Consequences” of screwing people over in the financial sector or pretty much any “Large enough” company is not “Failure”, the only consequence capitalism can deliver, but to the contrary “Reward”.

Return to basic business principles can only happen under conditions that businesses are operating in a “Basic” market. As long as the market is set up to not allow failure you won’t see a return to a more basic level of operation. “Risk takers” will increase to a level unsupported by the market, wages will increase to a level unsupported by the market and so on until it all crumbles again, but someone will pick up the pieces, well until the “piece picker upper” crumbles.

If you want “Ethics and morals” you have to rely on the individual. Those individuals have to suffer the consequences of their actions. Those individuals when grouped and understand the consequences of their actions will be more moral as a group.

We really are talking a societal “mindset shift” here more than a lack of regulation, although we need more of the RIGHT kind of that as well, IMHO.

~Matt

13

In a free market, individuals who put their companies at undue risk would normally be fired promptly.

The funny thing with this whole deal is that the eventual risk was obvious, but so was the short-term gain. These companies seem to plan for short term gain only… and they reward their management accordingly.

Maybe they didn’t care about the future? Make your fortune now while you can. Many MLMs prosper under this philosophy. Maybe they planned on getting bailed out all along? Maybe they knew that their political influence was enough to save them… or maybe they just figured that when the crisis hit, there’d be little or no chance that the government would allow the world financial system to collapse.

One thing for sure… if they thought they’d be able to run this scam forever, then they were truly stupid.

14

In a free market, individuals who put their companies at undue risk would normally be fired promptly.

The funny thing with this whole deal is that the eventual risk was obvious, but so was the short-term gain. These companies seem to plan for short term gain only… and they reward their management accordingly.

Maybe they didn’t care about the future? Make your fortune now while you can. Many MLMs prosper under this philosophy. Maybe they planned on getting bailed out all along? Maybe they knew that their political influence was enough to save them… or maybe they just figured that when the crisis hit, there’d be little or no chance that the government would allow the world financial system to collapse.

One thing for sure… if they thought they’d be able to run this scam forever, then they were truly stupid.

You have a point. In which case this is also a shareholder failure. I.e. the shareholders of, for example, AIG, did not adequately gauge the long-term risks the management was assuming and either punish AIG in the stock market or force a management turnover. This shareholder failure could have many causes -

1)The shareholders, like the management, were only interested in short-term gain.
2)The shareholders were not given sufficient information to judge the risks. (assymetrical information causing market failure, as my post above).
3)The shareholders were given fraudulent information.
4)The shareholders are collectively incompetent, and think the P-E ratio and quarterly profit are everything. This leads them into “local maxima” i.e. seeking short-term peaks while ignoring unsustainable practices.

I kind of think it’s #2. The information on these mortgage backed securities and derivatives is incredibly complex. And hotshot analysts started using correlation-based formulas to measure their risk. These formulas turned out to be fatally flawed. The rating’s agencies looked at the outputs of these formulas, and gave out AAA ratings. Which is what shareholders looked at and accepted as gospel.

So the shareholders were not able to serve as a the market-correction force they’re supposed to.

15

“Maybe they planned on getting bailed out all along? Maybe they knew that their political influence was enough to save them… or maybe they just figured that when the crisis hit, there’d be little or no chance that the government would allow the world financial system to collapse.”

I wouldn’t go so far as to say that they were planning to fail, because I think they were still hoping to make big bucks if their risk-taking paid off. But I think you’re right that they felt insulated from the downside of the risk by the expectation of a likely bailout, especially if they pulled the right political strings. It’s what economists call “moral hazard.”

EDIT TO ADD (after seeing trail’s post): To a certain extent, the same argument would apply to shareholders (or potential shareholders), since there was undoubtedly some perception among the latter that stocks in certain firms might be less risky–specifically, those firms that the government considered essential to keep afloat.

16

Bad ethics can creep into any business - even this business, the tri/bike business. There is a tendency to over-promise and under deliver. Not sure why that is and why it has become the norm. However, business/sales -101 teaches the opposite - under promise and over deliver. This approach while sometimes painful, will earn you more respect, amongst your customers and in the long run more business.

17

In a free market, individuals who put their companies at undue risk would normally be fired promptly.

The funny thing with this whole deal is that the eventual risk was obvious, but so was the short-term gain. These companies seem to plan for short term gain only… and they reward their management accordingly.

Maybe they didn’t care about the future? Make your fortune now while you can. Many MLMs prosper under this philosophy. Maybe they planned on getting bailed out all along? Maybe they knew that their political influence was enough to save them… or maybe they just figured that when the crisis hit, there’d be little or no chance that the government would allow the world financial system to collapse.

One thing for sure… if they thought they’d be able to run this scam forever, then they were truly stupid.

You have a point. In which case this is also a shareholder failure. I.e. the shareholders of, for example, AIG, did not adequately gauge the long-term risks the management was assuming and either punish AIG in the stock market or force a management turnover. This shareholder failure could have many causes -

1)The shareholders, like the management, were only interested in short-term gain.
2)The shareholders were not given sufficient information to judge the risks. (assymetrical information causing market failure, as my post above).
3)The shareholders were given fraudulent information.
4)The shareholders are collectively incompetent, and think the P-E ratio and quarterly profit are everything. This leads them into “local maxima” i.e. seeking short-term peaks while ignoring unsustainable practices.

I kind of think it’s #2. The information on these mortgage backed securities and derivatives is incredibly complex. And hotshot analysts started using correlation-based formulas to measure their risk. These formulas turned out to be* fatally flawed*. The rating’s agencies looked at the outputs of these formulas, and gave out AAA ratings. Which is what shareholders looked at and accepted as gospel.

So the shareholders were not able to serve as a the market-correction force they’re supposed to.
I think there is some truth in all four of your scenarios, but #1 is a big factor. Many shareholders these days are not interested in the long term success of the company they invest in, but only want big returns in the short term. It’s also about “Wall Street expectations”. Companies are continually expected to do better quarter after quarter, which can lead some to take more risk to increase their profits in the short term, while sacrificing long term success.

18

Bad ethics can creep into any business - even this business, the tri/bike business. There is a tendency to over-promise and under deliver. Not sure why that is and why it has become the norm. However, business/sales -101 teaches the opposite - under promise and over deliver. This approach while sometimes painful, will earn you more respect, amongst your customers and in the long run more business.

That is only if your intention is to create a stable and respectable business. It is amazing how many people will lie in order to get business… and the number of people who believe those lies. Many successfully grow quite quickly, and don’t seem to care about their long term survival or reputation. These days (post industrial) when so many businesses require relatively little capital investment, it seems pretty common.

Is it just my (flawed) perception, or has there been an ever greater amount of “get rich quick” mentality in the last few decades? The rise of legal gambling and lottos is obvious… but also MLM ponzi schemes… and of course “finance”. Too many people seem to share the fallacy that wealth can be created out of thin air.

Or maybe it’s just that my father in law is a MLM junky…

19

It is amazing how many people will lie in order to get business… and the number of people who believe those lies.

It shouldn’t be. In business your in competition. If one person “Lies” and says I can deliver that in 8 weeks full well knowing it will take them 10, the next person pretty much has to promise the same thing or else loose the job.

In the perfect world no one else would lie the person that lied would never get another job due to late delivery and the people who quoted 10 weeks would get the next job. We don’t live in a perfect world.

Instead what happens is one of several things. In some cases the “Liar” actually gets the next job because they got their foot in the door and the customer knows them. the customer screams and yells for two weeks, but that just makes them all that much more familiar with the liar…who gets the next job.

What also happens is that on the next job the customer thinks “Well that last guy told us he could do it in 8 weeks rather than 10 so someone has to actually be able to do it in 8 weeks”. So rather than giving the guy who quoted 10 weeks a shot they actually go searching for the next “Liar”…and the cycle continues.

Eventually the guy who is not lying has a choice, keep loosing out on bids, or join the liars. Multiple this on every aspect of the job, Price, delivery, quality etc and sooner or later people are telling some level of lie on something.

These days (post industrial) when so many businesses require relatively little capital investment, it seems pretty common.

What is this “Post industrial” age you speak of? Sure we might call ourselves in the “Technology age” but what do you think all that technology is used for…you guessed it, industry.

It’s an easy formula, make things, sell things. Everything else pretty much supports that. The only exceptions to this rule that I can think of would be entertainment and health care (Potentially some government services could be in there as well although I don’t consider them part of the economy in the same sense as the other groups). Even housing is manufacturing…you make houses.

~Matt

20

Eventually the guy who is not lying has a choice, keep loosing out on bids, or join the liars. Multiple this on every aspect of the job, Price, delivery, quality etc and sooner or later people are telling some level of lie on something.

Matt,

I agree with you to a certain degree, and in highly commoditized businesses with many competitors this is very likely the case. However, I can tell you that this approach in a micro/niche business with a small number of competitors is doomed for failure - or looked at the other way the honest straightforward guy, is often the last standing and will get the business and will get it again and again, based on the fact that he is honest and straight-forward about things and delivers and even over-delivers.

I started working at Sugoi in 1997. At the time delivery and availability was a huge negative issue with many customers and prospects in the running and bike specialty apparel business. Short story - few suppliers were delivering orders in-full and on time. Early on in 1997 we started to make a simple and straight-forward promise - we will deliver all orders in-full and on time. We started doing this with-out-fail. It took a bit of time to catch on. Some customers complained that we were more expensive. We said, “you can’t make money on what you don’t have in the store”! Eventually they caught on, that they could trust us, on availability and delivery. Sugoi 's business doubled duing the next four years going from about $10 million in sales to close to $20 million!!