Some egregious financial sector practices have come to light in recent years. For example, financial institutions in the United Kingdom have been pilloried for using high-pressure tactics to sell Payment Protection Insurance (PPI) to retail customers who neither understood nor required the product while, in the wholesale sector, the standard money market LIBOR benchmark was systematically manipulated for years. Some distinguished commentators have argued that these problems are symptoms of profound cultural and ethical problems in financial services, which will not be resolved by prosecuting a few obvious miscreants.
In this paper, John Thanassoulis and I examine an economic model in which actors are ethically concerned. We ask how a junior employee with ethical concerns copes with financial complexity when he has only an imperfect understanding of the effect of a new sales practice upon the well-being of customers who are themselves imperfectly informed. In our model, the junior employee can observe the actions of a senior employee who understands the consequences of the practice. If the junior employee believes the senior employee to have high enough moral standards, then the junior mimics the senior's actions. In other words, cultural assimilation is a rational response in our setting to poor information and moral concerns.
We examine the employment contracts that a pure profit-maximising employer employs in response to this effect. If the employer believes that employees' moral scruples reduce profits then it uses compensation contracts to overcome those scruples. Specifically, it pays employees to violate their ethical standards; the more they are paid, the more egregious the abuses they are prepared to perpetrate. And the more ethically committed the employees, the more expensive compensation becomes. Hence, we identify a relationship between compensation contracts, ethical standards, and social outcomes.
When cultural assimilation occurs, compensation contracts target senior employees, whose ethical choices are magnified throughout the organisation. In other words, the "tone from the top" with which most commentators are concerned may be rationally used to subvert cultural values and to encourage privately profitable but socially undesirable practices.
The scale of these effects has two determinants in our model. First, customer sophistication matters. When customers understand the effects outlined above then they charge the firm for ethical violations. The firm is thus dissuaded from ethical deviations of the type outlined above.
Second, the way that employees identify ethically right actions is important. Press comment frequently suggests that the ethically correct action is obvious in financial markets. A moment's introspection confirms that, in general, this is not the case: for example, reasonable people can disagree over the ethically correct level of expenditure against accidents on roads, or over the justification for minimum alcohol pricing. It is impossible to in an economic model to adjudicate between different visions of right, but it is possible to identify the consequences of those visions. (In performing this analysis we naturally choose to remain silent regarding the relevance of consequences in moral judgement.)
We present two stylised ethical standards. First, we consider classical Benthamite actors who are concerned with the effect of their actions upon aggregate welfare. Second, we examine a very simple duty-based (deontological) ethical standard, under which actors refuse to inflict any harm upon others. The two standards have different effects. In both cases, unsophisticated customers strictly prefer to deal with ethically committed actors, and employers prefer actors with low ethical standards, because they lead to lower compensation costs. In contrast, firms with sophisticated customers never attempt to subvert the ethical choices of Benthamite agents precisely because such agents dislike ethical subversion and reflect in their willingness to pay.
In each of the cases above, unsophisticated customers would prefer to deal with ethically committed employees and sophisticated customers are indifferent. When employees subscribe to a duty-based ethics we are able to show that sophisticated customers strictly prefer ethically uncommitted employees. The reason is that the employees may be unwilling for moral reasons to perform harmful actions to which the customer would be willing to sign up so as to reduce the overall cost of service. The sophisticated customer effectively baulks at the quasi-paternalism inherent in the employee's ethical stance, and prefers to look out for itself in dealings with a pure profit-maximising firm.
Our analysis identifies an incentive for firms in retail financial services sectors to recruit morally lax agents. Restrictions on pay levels will do nothing to attenuate this effect, since the incentive derives from a desire to minimise compensation costs. Effective policy in this field must deal with the structure of compensation. In particular, our work identifies a strong caveat against performance-related pay for people who deal with financially unsophisticated customers. This result does not apply when customers are sophisticated. In this case, performance bonuses may be an ineffective motivational tool or, in the case where employees subscribe to a duty-based ethic, they may be necessary to overcome paternalistic impulses that are not valued by customers.
Alan Morrison is Professor of Law and Finance at Saïd Business School, University of Oxford, and a Fellow of Merton College.