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Ethics in Finance
tribute to social stability. In the process of social evolu- ble for as little work as possible, and the store owner wants
tion, we have developed not only an instinct to care for as much work from the manager for as little pay as possi-
ourselves but also a conscience to care for others. There ble. This theory is value-free because it does not pass judg-
may arise situations in which the need to care for ourselves ment on whether the maximization behavior is good or
runs into conflict with the need to care for others. In such bad and is not concerned with what a just pay for the
situations, ethical norms are needed to guide our behav- manager might be. It drops the ideas of honesty and loy-
ior. As Demsey (1999) puts it: “Ethics represents the alty from the agency relationship because of their incom-
attempt to resolve the conflict between selfishness and patibility with the fundamental assumption of rational
selflessness; between our material needs and our con- maximization. “The job of agency theory is to help devise
science.” techniques for describing the conflict inherent in the prin-
Ethical dilemmas and ethical violations in finance can cipal-agent relationship and controlling the situations so
be attributed to an inconsistency in the conceptual frame- that the agent, acting from self-interest, does as little harm
work of modern financial-economic theory and the wide- as possible to the principal’s interest” (DeGeorge, 1992).
spread use of a principal-agent model of relationship in The agency theory turns the traditional concept of agency
financial transactions. The financial-economic theory that relationship into a structured (contractual) relationship in
underlies the modern capitalist system is based on the which the principal can influence the actions of agents
rational-maximizer paradigm, which holds that individu- through incentives, motivations, and punishment
als are self-seeking (egoistic) and that they behave ration- schemes. The principal essentially uses monetary rewards,
ally when they seek to maximize their own interests. The punishments, and the agency laws to command loyalty
principal-agent model of relationships refers to an from the agent.
arrangement whereby one party, acting as an agent for Most of our needs for financial services—manage-
another, carries out certain functions on behalf of that ment of retirement savings, stock and bond investing, and
other. Such arrangements are an integral part of the mod- protection against unforeseen events, to name a few—are
ern economic and financial system, and it is difficult to such that they are better entrusted to others because we
imagine it functioning without them. have neither the ability nor the time to carry them out
The behavioral assumption of the modern financial- effectively. The corporate device of contractualization of
economic theory runs counter to the ideas of trustworthi- the agency relationship is, however, too difficult to apply
ness, loyalty, fidelity, stewardship, and concern for others to the multitude of financial dealings between individuals
that underlie the traditional principal-agent relationship. and institutions that take place in the financial market
The traditional concept of agency is based on moral val- every day. Individuals are not as well organized as stock-
ues. However, if human beings are rational maximizers, holders, and they are often unaware of the agency prob-
then agency on behalf of others in the traditional sense is lem. Lack of information also limits their ability to
impossible. As Duska (1992) explains it: “To do some- monitor an agent’s behavior. Therefore, what we have in
thing for another in a system geared to maximize self- our complex modern economic system is a paradoxical sit-
interest is foolish. Such an answer, though, points out an uation: the ever-increasing need for getting things done by
inconsistency at the heart of the system, for a system that others on the one hand, and the description of human
has rules requiring agents to look out for others while nature that emphasizes selfish behavior on the other. This
encouraging individuals to look out only for themselves, paradoxical situation, or the inconsistency in the founda-
destroys the practice of looking out for others” (p. 61). tion of the modern capitalist system, can explain most of
the ethical problems and declining morality in the mod-
The ethical dilemma presented by the problem of
ern business and finance arena.
conflicting interests has been addressed in some areas of
finance, such as corporate governance, by converting the
agency relationship into a purely contractual relationship ETHICAL VIOLATIONS
that uses a carrot-and-stick approach to ensure ethical The most frequently occurring ethical violations in
behavior by agents. In corporate governance, the problem finance relate to insider trading, stakeholder interest ver-
of conflict between management (agent) and stockholders sus stockholder interest, investment management, and
(principal) is described as an agency problem. Economists campaign financing. Businesses in general and financial
have developed an agency theory to deal with this prob- markets in particular are replete with examples of viola-
lem. The agency theory assumes that both the agent and tions of trust and loyalty in both public and private deal-
the principal are self-interested and aim to maximize their ings. Fraudulent financial dealings, influence peddling
gain in their relationship. A simple example would be the and corruption in governments, brokers not maintaining
case of a store manager acting as an agent for the owner of proper records of customer trading, cheating customers of
the store. The store manager wants as much pay as possi- their trading profits, unauthorized transactions, insider
ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 267