Corporate Finance and Original Sin

The unique characteristics of the financial services industry present practitioners with challenging ethical demands. Of these, the potential for extraordinary monetary gain and the moral anesthesia resulting from the inward-looking nature of the profession conspire to hamstring effective regulation by industry insiders. Effective control of the industry must come from outside the industry. The choice is between regulation by a private entity and regulation by a governmental body.Recent articles in the Financial Analysts Journal have made a powerful case for a self-regulatory approach to the conflicts of interest revealed by recent corporate scandals. The authors argued that in the long run, ethical behavior is both morally and economically satisfying and that a robust industry-derived educational and institutional ethical framework should prove adequate to the task.I disagree. The probability of ethical failure is affected by several factors, prime among which are the amount of remuneration involved, the emotional reinforcement provided by peers, and the length of time participants have been exposed to industry norms. The larger the amount of compensation involved, the more the practitioner is inappropriately reassured of the rectitude of his unethical behavior, and the longer the practitioner has been exposed to such behavior, the higher the likelihood of an unethical outcome.Unfortunately, all three factors conspire against the financial services industry. The amount of compensation is so high that it not only induces unethical behavior but also actually serves to attract unethical players to the field. Moreover, the hothouse atmosphere of the financial services industry produces a moral anesthesia that blinds participants to conflicts obvious to outsiders; the longer such activities are deemed acceptable, the more likely they are to occur in the future and become the norm.Because of these factors, ethical reform of the financial services industry must come primarily from outside the industry. Furthermore, examination of other professions, as well as the dismal recent records of the National Association of Securities Dealers and NYSE board of directors, argues for a substantial governmental role in the process of reform and oversight.