As a student in a public high school in Los Angeles, I had some wonderful teachers and opportunities. These included the bus ride from the San Fernando Valley into downtown Los Angeles to see plays performed by television and movie actors who performed MacBeth, The Tempest, and Jean Anouilh’s Antigone, among other plays. Our teacher of world civilization, Gert Wossner, was an intellectual presence in the lives of many students over many years. He introduced us to Henrik Ibsen’s Enemy of the People, a play that described the outrage of townspeople against one Dr. Thomas Stockmann, who threatened the 19th-century town’s nascent tourism industry when he called attention to the contamination of its thermal waters, caused by the local tannery. The play pits the individual against the masses, which Stockmann decries for its ethical failings. Favoring the heroism of the doctor against the cowardly immorality of the people, the play teetered between a Randian Hollywood individualism and the precocious anti-democratic sentiments that darkened the first half of the next century. This is great stuff for high school debate.
The debate around the ethics of the financial crisis shares much of the hysteria but little of the plot. The popular press has been eager to plaster the news with pictures of rich CEOs before Congress, though the causal link suggested by level of salary is far from finding a leather belt floating in the waters of the local spa. But if the strident tones of Ibsen’s masses often appear misdirected, we should note that the leaders of our financial institutions were no Dr. Stockmanns. Surprisingly few corporate leaders publicly condemned the mortgage origination rapacity or the hollow shells of synthetic assets. Surely, some were smarter than others, such as those who shorted the market and egged others to reassess it at more sensible valuations — but asking the market to fall after you have shorted it is a business strategy, not an ethical stake in the ground.
It is tempting to throw up one’s hands and declare that we should move quickly on while markets appear to be buoyant. The simple phrasing of this perspective is: “The crisis had nothing to do with ethics.” Or, “If it is legal, it is ethical,” and no one has been convicted, except by the proxy of the press, for violations of the law. Here is what I am willing to say:
•On the consumer finance side, the granting of mortgages to owners through consistently flawed methodologies to assign credit risk was promoted by overly powerful incentives and woeful managerial complicity. However flawed they were, government-sponsored enterprises (GSEs) did not force mortgage originators and other financial institutions to finance bad consumer credit risk. “Lead us not into temptation” is not a good title for a code of business ethics.
•On the institutional financial market side, the serial transformation of bad mortgage assets into asset-backed securities and into pure synthetics led to the illiquidity of markets but more importantly led to careless proliferation of inherent uncertainty — because risk could not be properly measured. This illiquidity did not grow simply out of opacity in true values and counterparty risk, but also because of the deterioration of trust between financial institutions due to violations of normative expectations that support seller-client relations. Laws, wrote Emile Durkheim sometime ago, are never sufficient to provide the basis for the function of markets; trust based on norms of behavior is always the foundation — the etymology of the word credit is to trust and once trust stops, credit stops.
•Boards and top executives failed miserably in their fiduciary duties to correct for the undervaluation of tail risk and, contrarily, approved compensation practices inside firms and for executives that encouraged excessive risk positions. The structure of pay (that is, monetary incentives through options and bonuses) was too aggressive and encouraged extreme risk. No matter if the assumption of too much risk was done by traders or middle managers, boards and CEOs are paid to set the compensation policies in their companies and they are responsible — if they are not responsible, then who is?
The academic research on the moral and business practice failings behind the crisis is well under way. Behavioral strategy and economics highlights the questionable practices that hide fees and often lure unsophisticated consumers to pay too much. Financial illiteracy appears to be harder to eradicate than thought and suggests the need for consumer financial protection. The structure of compensation contributed to too much risk taking. (For some examples, see the related links at right.)
Businesses, too, are learning from the crisis. Credit Suisse is taking bold steps to redesign compensation packages. Goldman Sachs employed outside consultants to improve client relation practices and non-monetary incentives for their employees to strengthen new business strategies. And government agencies have come to commit to greater supervision and oversight of financial institutions as well as to build a new architecture to handle systemic risk.
No one is naïve enough to think all the right lessons were learned. But it’s hard to see how it does anyone much good to say the last crisis was a technical blip caused by too much leverage and too much temptation. There were ethical failings, stunning examples of poor governance, and many badly designed business practices. Our job at the Business School is to do the research and teaching that updates theory and lessons on the basis of new data. I suppose the hopeful title of this play is Friend of Better Business. While unlikely to be a Broadway hit, it is no minor contribution. And, as the importance of ethics for lowering the risk of the next crisis eludes consensus and public endorsement, it is also apparently great stuff for public debate.
Bruce Kogut is the Sanford C. Bernstein & Co. Professor of Leadership and Ethics in the Management Division and the director of the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School.