What does good financial reform look like? And where is it today?

My vote for the best financial reform ever goes to the system of mandated disclosure introduced in 1934 as the centerpiece of the SEC. In response to the worst stock market crash in the nation’s history, lawmakers made a bold and inspiring decision to require full disclosure from publicly listed companies. It was a stroke of genius. Instead of burdening companies with endless rules about how they should or shouldn’t operate, the law required firms to tell the public what they were doing. That way, investors could decide for themselves whether to invest or not. It was a powerful way to rebuild trust in the stock market at a time when it had been broken and it has underpinned trust in the market for decades.

The principle of full disclosure is something that we can all understand. Over time though, that simple and powerful principle has been distorted. The agency itself has gummed up the system of disclosure by introducing rule upon rule of how companies should disclose things and what they need to include and so on. I understand the impulse to clarify but this approach has actually been counterproductive. By introducing endless details in the rules, companies have sought out the help of technicians to make sure they’re in compliance. That can result in situations like AIG where the insurer seems to have complied with GAAP and everything else but it did not disclose the one thing that would have made a huge difference to investors and the market—the fact that it had created an incredibly risky structure that could come tumbling down at any point.

Unfortunately, I believe we’re going to see more cases like AIG if the current financial reform package is any guide. Instead of simple and powerful principles everyone can understand we’re getting lots of technical rules that can be run around. Encouraging good behavior isn’t easy but it starts with the introduction of simple, clear rules that make sense. Once you do that you can hold people accountable to those principles. Anything else just seems to make matters worse.

Interview on promoting integrity and trust

Here's an interview Barbara Kimmel did with me on her blog Trust Across America

Where’s the Integrity in Financial Reform?

It’s hard to believe in the integrity of the financial reform package now almost certain to pass into law. That’s not to say there aren’t some positives in the legislation. But without an honest, straightforward approach the reform isn’t likely to do much good. Here are five gaping holes which spell trouble for the future:

1. The root cause of the financial crisis hasn’t been addressed.
In fact, it hasn’t even been acknowledged! While there were plenty of contributing factors to the financial crisis, the central cause of all the panic was the incredible risk financial players were taking with other people’s money. Reasonable limits on risk remain an absolute necessity. Until we take this on, the financial system will remain vulnerable.

2. Solutions are put off until later.
The main effect of the financial reform bill is to give unspecified powers to untested regulators who may—or may not—create effective rules. Rather than taking on and debating the rules, congress has kicked the can down the road to a new group of Washington mandarins. It may all turn out well but we won’t know for some time. In the meantime, the approach isn’t exactly a profile in courage.

3. The temptation to further complexity appears irresistible.
Finance is already an overly complex area of the economy. The proposed legislation does nothing to cut through the fog and clarify the workings of the system. In fact, it seems designed to create an even more complicated matrix of products and rules. That’s not what we need. We lacked clear information about the outrageous risk taking that led up to the financial crisis. Instead we were bombarded with gobbledygook dreamed up by risk takers and echoed by their regulators. If the past is any guide, the industry should be pretty sanguine about continuing to enjoy lax regulation, and more confident than ever that the taxpayer will pay if things go wrong.

4. Politicians are obfuscating the issue.
Congress and the Obama administration are in universal agreement that financial reform is vital to our economy. But they haven’t exactly tripped over themselves rushing to put reform in place. The time to negotiate reform with the entrenched interests of the financial community was when banks and markets were in desperate need of help from the public. That time is long past, and with its passing the opportunity for strong and effective financial reforms has all but disappeared. So when politicians crow about how great this legislation is, or will be when its effects are ultimately able to be seen, keep in mind that the package appears to be designed to have minimal effects.

5. Financial leaders are morally bankrupt.
After so few take so much from so many, mightn’t it be time for a little humility? The enormous risk in the system was no accident. It was knowingly and intentionally created for the short term gain of a relatively small group of financial leaders. But instead of acknowledging the absurdity of continuing these practices, bankers have been spending their time and energy blocking reform.

Is it really too much to ask for all involved—bankers, politicians and the public—to work together for real reform with the main purpose in mind of making the financial system better for everyone?

A Big Thank You to Readers of the Economics of Integrity!

On Sunday, The Economics of Integrity hit the best seller list in Singapore at number 7! It’s very exciting seeing the book resonate with people around the world. What’s more it’s great to hear from readers about the interesting and important work they’re doing in relation to integrity and trust. I just wanted to mention a few from various exotic corners of the world:

John who is an American, working in China, is developing business initiatives to enhance integrity in commercial dealings between US and Chinese firms.

David Rea, a social scientist in New Zealand, has been working on policy ideas for the New Zealand government to foster greater integrity.

Johanna in Amsterdam has her own business consulting firm and is working on issues like integrity and trust to help her clients prosper.

Carlos who is Spanish and living in Bucharest has been working on taxation policy and is interested in incorporating greater integrity into the tax system.

Thanks to everyone who has gotten in touch with me so far. I really enjoy hearing what you’re working on and sharing ideas!

The Sweet Spot of our Market Economy

Here are two statements:

Following your own self interest benefits everyone. (Adam Smith)

Acting with integrity benefits everyone. (Conventional morality)

The conventional view is that these two statements are mutually exclusive.
The truth is there is a place where those statements intersect. That place is the economics of integrity and it’s the sweet spot of our economy.

When acting with integrity is in our self interest we get a double payoff: economic growth and societal benefits. This opportunity often exists in the short run but it’s always there in the long run. The only way to create lasting wealth is to act with integrity.

Will Health Care Reform create more integrity?

Recently I found myself trying to escape from reality by watching a marathon session of Grey’s Anatomy reruns. One episode was so shocking in it’s depiction of our health care system it’s worth mentioning.

A seemingly prosperous man in his late 50s or early 60s is raced to the emergency room after being in a car crash. Unbeknownst to his wife, he lost his job some months back and their health insurance is due to expire at midnight that very day. It turns out the man needs very expensive surgery to save his life. A resident uncovers the health insurance issue and pleads with the chief of surgeons to undertake this mans surgery before the stroke of midnight otherwise the costs could bankrupt the couple. After refusing to put the man ahead of her other patients who were more in need of help, the chief of surgeons turns to operate on him at a few minutes past midnight. But before she starts she asks the resident, who will record the time of operation for official records, to change the clock in the operating room to one minute before midnight.

The audience has a feel good moment and is relived that the Chief of Surgeons turns out to be on the side of the public against health insurers. While I also found myself being sympathetic I wondered what my reaction would be if I worked for a health insurance firm. How would I feel to see doctors cheating health insurers and that practice being legitimized on mainstream TV? What does it tell us when our health care system is portrayed, in a matter of fact way, as so broken that the only humane response is to cheat?

It made me wonder whether health reform enacted by the Obama Administration will do anything to change that. I’m skeptical. But then with so much of the reform set to be decided in the future, the only fair answer to that question is that no one really knows yet.
Up next: a few things we do know about Obama’s health care reform.

Creating a Culture of Integrity in the Corporate World

Only a few of us will ever lead a big company or wield considerable influence over corporate decision making. But we don’t have to wait for others to promote a culture of integrity, we can do it ourselves, now!
Here are five ideas:

1. Do the right thing in a situation where there’s a temptation not to.
My husband told me a story from his law firm days. Working with a team of lawyers to close a deal, he was in a conference room as they phoned around to all the parties involved. When the call had ended with the opposing counsel it became obvious that the other side hadn’t hung up and my husband’s team could hear their private discussion. The senior partner in the room moved swiftly to hang up the line saying “They’re not aware we can hear them. We shouldn’t be listening.”
Nothing speaks louder than being a model of personal integrity and people remember you for it.

2. Show people you trust them
Give people extra responsibilities or information they might not have as a way to build a relationship of trust. Remember the words of Henry Stimson, the American secretary of war during WWII, “The only way to make a man trustworthy is to trust him.”

3. Tackle problems as soon as they arise.
Remember the old adage “There’s never been a problem that can’t be fixed; unless it remains hidden.” If you can’t fix the problem yourself get help from others.

4. Admit mistakes
No one likes to admit mistakes but grimly hanging on and denying the mistake is not a good look either. Neither is finding clever ways to weasel out of it. Face up to what you did wrong and work swiftly to correct it.

5. Point out what’s working well
Make sure you look for what others in the firm are doing well. Discuss it, learn from it and replicate it.

Tapping into the Power of Social Contagion

Friends from Australia who recently moved to New York City were horrified when their name appeared on a list of donors to the private school their son attended. While it can be daunting to those unaccustomed to the practice, the main purpose of publicly acknowledging donors is to encourage others to give. Charities have found that if they publish the identity of donors, it encourages others to donate, either to be associated with those already on the list or as a way to fit in.

There are times though when we see other people breaking the rules and it makes it a lot easier for us to do the same. Think of driving. When everyone else on the freeway is travelling above the speed limit, chances are we will too. Why? No one really believes in the speed limit. That is, we don’t really accept the speed limit as the law. Plus we don’t often get caught and when we do it’s not that big of a deal.

So how do we encourage the contagion of good behavior?
These three ideas, used together, are a good place to start:
1. Allow behavior to be open and visible
2. Establish well understood norms
3. Insist on accountability

Coming up next:
You really can create a culture of integrity in your own corner of the corporate world. Here’s how.

Integrity is Contagious

Here’s an interesting experiment. David Rea, a social scientist in Wellington, New Zealand recently conducted a test on his students. He presented 28 university students with five ethical dilemmas. The students were split into two groups, given a questionnaire about the dilemmas and asked how they would respond in each case. The questionnaires were identical except that each group received different information about how others had responded to the same dilemma. For example one dilemma about paying taxes was presented to the first group Rea called the ‘ethical group environment’ as:

A very small number of tertiary students use accounting firms to file their tax returns. They do this to access a soon to be closed legal loophole that gives them a refund of $1000 on their student fees. Would you pay $40 to an accounting firm to access this refund?

While the ‘unethical group environment’ was presented with the following:

Almost all tertiary students use accounting firms to file their tax returns. They do this to access a soon to be closed legal loophole that gives them a refund of $1000 on their student fees. Would you pay $40 to an accounting firm to access this refund?

The results were significant. Individuals in the ‘ethical group environment’ acted ethically on average 58 per cent of the time while those in the ‘unethical group environment’ acted ethically only 38 per cent of the time.

Rea’s experiment is important because it provides valuable insight into our own behavior. Human beings have a deep need to fit in. When we see others doing the right thing we tend to follow. But the reverse is also true. If we see others cheating, it tends to encourage us to do the same. Rea’s work also builds on experiments by other social scientists. In one previous experiment, social scientists found that people were less likely to litter if they saw other people throwing garbage in the trash can.

Can you think of an instance when seeing other people’s behavior has affected your own? I’ve noticed it when I leave the grocery store, usually with a cart full of groceries, my children on the verge of a tantrum, and in the middle of a sudden downpour. After I load up the car, I look around and notice where other carts have been left. If I see carts strewn around in parking spaces, higgledy piggeldy, I find it much harder to force myself to trudge over to where you’re supposed to return your cart. But if I see carts neatly stacked at the entrance to the grocery store, I make the effort.

Knowing that people’s actions can be influenced by other people’s behavior is an empowering realization. Importantly, it means that we can create corporate and economic cultures where integrity is internalized and becomes the norm. (Yes even in finance!) Not by adopting onerous and restrictive rules though, but by taping into human nature and fostering self reinforcing integrity systems. It’s an exciting possibility at our fingertips! Stay tuned to find out more.

Does Goldman Sachs offer its customers a satisfaction guarantee?

Think about that for a moment. When a business offers a satisfaction guarantee it communicates trust and a bond of trust with customers is extremely valuable. Not only does a guarantee show a business trusts its own products and services but it also trusts customers to treat its products and services fairly. It’s a critical question every business needs to ask. “Can I offer a satisfaction guarantee?” If not, a firm needs to think long and hard about why it’s ok for customers not to be satisfied with what they’re getting. Whatever the costs of a satisfaction guarantee, the benefits are large. For one thing, it’s an incredibly useful way for companies to get feedback from customers about how products and services can be improved. In the investment business, guarantees are certainly not the norm. But moving toward some form of satisfaction guarantee could be a big step banks take in rebuilding trust.