Finance can be ethical

Ethics are, at last, big business. There has been a four-fold increase in ethical investment in the UK in the last decade, rising from £2.4bn in 1999, to £9.5bn by 2009. Where there were 20 or so ethical investment funds at the turn of the millennium, now there are well over a hundred.

Consumers are, generally, much more concerned about the morality of the businesses they use. A survey conducted for EIRIS – the Ethical Investment Research Service – found that nearly half of consumers in Britain want to know about the ethical credentials of the businesses that supply their goods or services and three quarters of these consumers intend to take those factors into account when making choices, including in investments.

Mark Robertson of EIRIS explains: “It’s clear that increasing numbers of consumers are turning to those financial institutions which offer financial products that make money whilst making a positive difference to the world. The world is changing fast and many of the issues targeted by green and ethical investment funds – such as the need to tackle ageing populations, reduce levels of obesity, address the global power shortage, tackle water scarcity and climate change – are creating attractive business opportunities, which in turn are creating great investment opportunities which consumers can take advantage of.”

The strength of the ethical sector is demonstrated most starkly by the phenomenal growth experienced by the Fairtrade Foundation. Sales have risen exponentially – increasing by a factor of 30 in 10 years. In 1999, turnover was £22m, by 2009 it had grown to £635m and last year it probably exceeded £1bn for the first time. According to a survey conducted for The Co-operative Bank, the total value of the ethical marketplace was worth £36bn in 2008 (the latest year for which statistics are available), against £13.5bn in 1999.

It is not merely that consumers and investors want a clear conscience. There are hard headed reasons why ethics can affect investors’ returns. A prime example is the crisis that hit BP, with its Gulf of Mexico oil spill. An official report for the US federal government concluded that the spill resulted from ‘management errors’ at BP and two of its contractors. At one point, the crisis wiped-out half of BP’s share value, though it has since partially recovered.

The damage from the spill is not restricted to the physical beauty of the Gulf of Mexico, its wildlife and the welfare of residents earning their incomes from fishing or tourism. Investors have also felt a severe impact – which could get worse if BP is eventually found to have been negligent in failing to prevent the spill and then faces severe penalties. The long-term affect on BP’s reputation and future sales is unclear, but will be substantial.

There are equally striking demonstrations of the value of ethical approaches within the financial services sector. The Bank of England, the Financial Services Authority and various international financial regulators have concluded that the payment of bonuses to bankers contributed to banks taking excessive risks – and consequently to the global economic crisis. So the traditional, conservative approach to the banking sector would probably have protected us from economic calamity.

That conservative approach to financial management was exemplified by the traditional building society. The society was content to take members’ savings and use those to finance mortgage lending to other members. It was a simple system that worked very well for over 150 years.

Sadly, though, some people got greedy. A few of the societies’ directors started dreaming of the salaries and fees they would get if they were on the boards of PLC banks instead. Various members (the ‘carpet-baggers’) thought of the reserves the societies had built-up – which should have protected them in bad times – and they wanted these for themselves. Together the greedy members and directors built-up a momentum and achieved a steady flow of society demutualisations. They got their windfalls and higher directors’ salaries – but at a substantial cost.

Since then, those demutualised building societies have hit serious problems. Northern Rock became effectively bankrupt and was rescued by the Government. Halifax was in not much better shape when Lloyds was persuaded to rescue it. Bradford & Bingley also collapsed, and its business is now operated by the Spanish banking giant, along with the other former building societies Abbey and Alliance & Leicester. It is a similar story with all the other former building societies: none has survived as an independent bank.

Nor have customers benefited. According to independent analysis – by the Association of Chartered Certified Accountants for the All Party Parliamentary Group for Building Societies and Financial Mutuals – consumers have lost out badly. PLC banks charge on average an extra 0.21% on mortgage loans to finance shareholders’ dividends. Over a 25 year period of a loan, that might add £3,000 to £10,000 on the cost of a home loan. That is significantly more than the average £2,260 windfall received by a Northern Rock former member.

But an even bigger loss has been suffered by taxpayers, who have had to prop-up several failed banks – including the former Halifax and Northern Rock building societies, and part of Bradford & Bingley. These three businesses were not mere business failures, they were also ethical failures. The banks (along with RBS) became so focused on growth, profit and executive bonuses that they lost sight of their core purpose – to be a safe place in which to put money and to lend that money on in a responsible fashion. Instead their actions were central to the worst economic boom and bust since the 1930s.

The pressing question now is how financial services can be reformed into a more ethical and sustainable operating sector. Yet there is no simple answer. Part of any solution has to be better and stronger regulation. There is acceptance by governments around the world that this is necessary. It will only work, though, if there is effective international co-operation – including by those countries that host ‘offshore financial centres’.

Regulation on its own will not solve the problem, anyway. Several of the banks that failed around the world used accounting devices to hide their problems from regulators. So we also need more transparency in the way banks report their profits, losses and exposure to possible future liabilities. Those new accounting standards are being adopted as a matter of urgency.

Meanwhile, banks are being forced into holding much higher reserves to protect themselves from future losses. This has some unintended and unfortunate effects. While this measure may help to protect taxpayers and customers from the unwise actions of the largest banks, it discriminates against smaller mutual banks. These institutions do not have outside shareholders and so are restricted in building-up larger reserves. In fact, many of the surviving building societies ran down their reserves as they tried to prevent ‘carpet-baggers’ from demutualising their businesses. Ironically, a new generation of building society demutualisations and mergers is being triggered by the need to greatly expand reserves.

With very substantial bonuses again being paid, the main PLC banks seem not to be moving to a more ethical or sustainable operating model. In this they are showing an independence of attitude that veers on contempt for their customers’ clear preference for morality in business and politicians’ call for financial restraint. This stubborn approach could many more ethically-concerned consumers move their accouns from the big banks to competitors that better demonstrate their commitment to sound ethics.

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