Ethics in Banking
I am grateful to the Governor of the Bangladesh Bank, Dr. Salehuddin Ahmed, and the Bangladesh Institute of Bank Management for inviting me to deliver the Seventh Nurul Matin Memorial Lecture. The lecture, as you all know, is in honour of a great banker, a distinguished public servant and a former Deputy Governor of Bangladesh Bank. As a fitting tribute to his contributions to banking as well as central banking, this series of lectures in his honour was launched by Bangladesh Institute of Bank Management in1998 with the blessings of the then President of Bangladesh. This series of lectures is titled "Ethics in Banking". All the previous lectures, as well as this one, deal with this particular subject only. The decision of the Institute to confine all lectures in this series to a single area, which is of great importance for the development of the financial sector, is quite unusual and deserves our fulsome praise. Many banking institutions all over the world, including central banks, have a variety of annual lectures, but very seldom are they confined to one identified area of such great importance as "Ethics in Banking".
When I was asked by Dr. Ahmed to deliver a lecture on this topic, I was a little intrigued but extremely pleased to avail of the opportunity to share some thoughts with you. All of us in India have followed developments in Bangladesh closely since its liberation. As perhaps many of you know, Bangladesh and India are both in the same constituency in international financial institutions like the International Monetary Fund (IMF) and the World Bank. As it happened, I had the privilege of representing this constituency on the Boards of both these institutions, and had the benefit of working closely with the Ministry of Finance and Bangladesh Bank over the years. Our two countries are also, of course, members of the SAARC. Both our countries have taken strong initiatives to further strengthen the SAARC framework and to promote economic co-operation among countries in our region.
Given this close association, I particularly welcome the opportunity to visit Dhaka again. A parallel reason for my gratitude for your kind invitation to deliver this lecture is simply that Bangladesh is also the home of Grameen Bank, which is a universally recognised landmark in the history of banking. Growth of micro-finance and delivery of credit to disadvantaged persons through self-help groups in many developing countries, including my own, are primarily the result of the example set by the Grameen Bank in Bangladesh. You would be glad to know that, in India, the number of self-help groups, which are availing of bank loans, has now reached nearly 3 million. The total number of beneficiaries is 41 million, and this number is rising significantly every year. Bangladesh would always enjoy a special place in the promotion of development banking in our countries.
On the subject of "Ethics and Banking", after reading the previous six lectures which were delivered by highly distinguished persons from different professions—including a former President, a former Finance Minister, a retired Chief Justice, a Professor of Economics, and two eminent leaders of economic think tanks here and in Washington—I have hardly anything of significance or importance to add. Personally, I have learned a great deal from what has already been said, and I hope that the Bangladesh Institute will publish a volume of previous lectures for the benefit of the entire banking community all over the world. Since I have nothing much to add to what has already been said, in this particular lecture I will take a somewhat different tack. I propose to make a few broad points on legal and institutional reforms in banking, which may promote ethical behaviour and make banks more accountable for what they do and how they do it.
Although the subject of ethics in banking is relatively new, a vast academic literature is available on the wider subject of ethics, public policy and economics. Ranging from John Locke, Jeremy Bentham, John Stuart Mill and Immanuel Kant in the 18th and 19th century to A.C. Pigou, Amartya Sen, and John Rawls in the 20th century, there is hardly any well-known economist or philosopher who has not deliberated on the choices involved in making an ethical judgment on public policy issues, and on the meaning of the commonly used word "ethics". Those of you who are interested in this literature may like to look up a slim recent volume by a well-known welfare economist I.M.D. Little "Ethics, Economics and Politics", published by Oxford University Press, U.K., in 2002. Little's book provides a concise summary of the literature spread over nearly three centuries, and also his own views on what exactly is meant by ethical behaviour in economics and politics.
Having gone through this literature, which has been enormously beneficial and intellectually exciting, the central message that I carry is that what may be considered to be ethical or unethical depends largely on the circumstances, and the broader economic and political environment where a particular policy or operational decision is taken. As far as I can see, there are only three definitive conclusions emerging from this vast literature which are independent of the context: -
These principles, as principles, are entirely appropriate. However, it is interesting that even these are not fully applicable in autocratic or non-democratic regimes. This was, for example, the case during our independence struggle. In fact, it was the non-violent defiance of law rather than adherence to law as laid down by the British (for example, during the salt march) which is generally regarded as having been ethical and profoundly inspirational for the people.
On the whole, it seems to me that, in practical terms it is not necessary to look for a unique or universally valid definition of what is ethical and what is not, particularly in areas of business, banking or economics. When there are conflicting policy choices involved, there can be no unique answer to the question whether a particular choice is ethical. At the same time, while a unique definition of "ethics" is not feasible, it is also true that whether a particular action or practice is ethical (or otherwise), is easy to recognise – when we see it. Let me give you an example to illustrate the point.
It is well-known that the interest rate on micro-finance or credit to borrowers from self-help groups is likely to be higher than the interest rate charged by a scheduled bank for direct lending to its borrowers. At the same time, it is also true that a large number of smaller farmers and poor persons have easier access to micro-finance institutions than to the formal organised banking sector. The reasons for the interest rate being higher for loans by self-help groups is the higher cost of transactions and the need to reach a wider section of the people, particularly in rural areas. There is also no scope for cross subsidization among borrowers on any significant scale as the bulk of loans are to relatively less well-off persons or enterprises. In this situation, it is perhaps legitimate to take the view that higher interest rates, which may have been considered unethical if charged by a bank to the poor, are not per se unethical in the case of self-help groups. Precisely where the dividing line between right and wrong is to be drawn is obviously a matter of judgment, and may vary from case to case.
In addition to the definitional issue, another vital issue concerning ethics in banking—on which we should perhaps spend a couple of minutes is—whether banking can be separated from other sectors of the economy, or for that matter, from the standards of ethical conduct in the society as a whole? In other words, should the norms of ethical conduct in banking be different from, say, norms prevailing in stock markets, private corporate sector or government administration? Suppose unethical conduct, however defined, in manufacturing of, say, jute bags or investment in the infrastructure sector is tolerated and accepted, then can bankers who finance these activities be considered unethical? I am sure all of us would agree, in principle, with the observation made by Prof. Nurul Islam in last year's lecture that:
".....ethics in banking, economic transactions and in society in general, are all interrelated. The solution needs to cover all related areas, including the systematic political factors."
In principle, the above observation is entirely appropriate. However, in practice, there is a genuine difficulty in ensuring ethical behaviour in all sectors of the economy as well as politics. We are all familiar with various pulls and pressures in political life of most countries, including our countries. If rules of ethical behaviour in banking were to be intrinsically dependent on ethical behaviour in politics, or for that matter, in different segments of trade and commerce, then we are likely to be faced with an insoluble problem.
Against this background, is there anything further that can be said specifically about ethics in banking, which is the subject of our discussion today? I believe that, even after taking all the constraints into account, it is still possible to prescribe some rules of behaviour which will make banking more ethical in developing countries, particularly in those countries which have an independent judiciary and an accountable administration. Let me move on to some prescriptive suggestions for promotion of ethics in banking for further consideration by central banks, experts and public in general.
The foremost requirement, in my view, to make our businesses, including banking, more ethical is to insist on standards of accounting and auditing which conform to the best international standards and ensure full financial disclosure. Banks, in particular, deal with other people's money. They are intermediary institutions which have been set up and licensed to accept deposits from the public, most of which are small in magnitude. They then lend such deposits to other users and producers for carrying out their business activities, which in turn are expected to generate employment and growth for the country as a whole. This intermediary function places a special responsibility on the banking sector. It is of utmost importance to ensure that there is complete transparency in respect of the use of depositors' money and ensuring safety of funds.
As the sub-prime crisis in the US and the UK has recently demonstrated, non-transparency and non-disclosure of financial obligations is not confined to developing countries alone. For all our countries, in the light of recent experience, it has become doubly important to revisit the banking, auditing and accounting standards and lay down guidelines which would ensure full disclosures of all obligations, including "off-balance-sheet" items.
One important ingredient of the proposed review of disclosure and accounting standards is to eliminate excessive secrecy that now prevails in regard to banking operations in many of our countries. I do not know enough about the situation in Bangladesh, but I know that in India, banks enjoy considerable legal protection in respect of disclosing identity of borrowers as well as defaults and rescheduling of outstanding payments. This non-disclosure is further buttressed by the Official Secrets Act, 1923, which protects government ministries and departments from disclosing anything in respect of formal or informal directions given by them to banks, regulatory authorities and other financial institutions. I see no reason why names and amounts lent by banks to individual borrowers should not be disclosed, and why even defaulters should enjoy the benefits of secrecy provisions.
The rationale for reducing the scope of secrecy provisions is to ensure that actions taken by banks conform to the normally accepted banking and regulatory guidelines, and are not unethical—at least on the face of it. Public disclosure would also ensure some exercise of caution by banks in their lending operations, and in granting benefits to borrowers by way of rescheduling and so on. All such operations should not only be reasonable but also perceived to be so by the general public.
In respect of the responsibility of the Board of Directors for ensuring ethical conduct, the United Kingdom has recently amended its Companies Act (with effect from 1 October 2007). In line with similar amendments made in the United States (under the Sarbanes Oxley Act), the Companies Act in the U.K. now specifically lays down the following seven statutory duties of directors of companies:
Similar principles of conduct are also implied in various provisions contained in company laws or contract laws in our countries. However, in practice, observance of these principles is generally neglected as duties of directors are considered to be essentially confined to papers put up by the management. In our countries also, it is desirable to make a distinction between independent responsibility of directors as distinguished from those of management. Such a move, along the lines of recent amendments carried out in the U.K., would go a long way in ensuring ethical conduct by banks and accountability for decisions taken by them.
A difficult and somewhat thorny issue in regard to regulation and management of the banking sector is the role of politics in determining outcomes. In most developing countries, there is a strong view that banking and financial operations should be conducted to promote growth with equity, and special attention should be given to the poorer sections of the people in granting access to bank loans. In several countries, there are specific provisions in regard to quantum of lending that should be directed to persons below poverty line and certain other categories of borrowers. Since these provisions are meant to serve the interests of the people, peoples' representatives in Parliament and ministries claim to have a direct role in ensuring that banking operations conform to governmental priorities.
This view has substantial validity and must be respected as an important aspect of democratic accountability in developing countries. However, while ensuring public accountability for banking operations, it is equally important to ensure that political affiliations do not become the primary criterion for selection of top management or directors of banks. The objective of political neutrality in appointment of top management and directors can be met if the same processes are put in place for such selection as is presently the case for initial appointment of members in different civil services.
In several countries, civil servants are normally appointed through an open competitive examination process which is conducted by an independent institution, such as the Union Public Service Commission. There is no reason why a similar mechanism, at arm's length from the political executive, cannot be set up for the choice of top management and boards of directors in public sector banks. Selections can be made by an independent statutory Commission by inviting applications from qualified professionals and/or through appropriate search committees. The process for selection should be open and well advertised. So far as private sector banks and other financial institutions are concerned, it is desirable for the government not to have any role in the selection process.
The point is simply that while financial priorities and banking policy may be decided at the political level, with due accountability, the political executive should not have any direct operational role in the choice of persons to run banks and other financial institutions. Such a process should ensure that, while there would always be some exceptions, the management and boards of banks are independent in their functioning and are not beholden to the changing political leadership for their appointments.
In India, a new law has recently been enacted which grants inalienable rights to the public to seek information from any ministry or public institution on decisions taken by them. This is the Right to Information Act adopted in 2005. This is a momentous step to open the governmental decision-making process to public scrutiny. The Right to Information Act will, over time, lead to greater accountability for ethical conduct in the banking and other sectors of the economy. There is a strong case for adoption of similar measures to grant legal rights of information to public in all countries, particularly where governments have a substantial administrative role in the conduct of financial operations.
The sanctity of contracts and redressal of consumer grievances are essential components of a financial system, which encourages ethical behaviour by participants. This requires a speedy judicial system where people can go for alleged breach of contract and redressal of their grievances as borrowers or depositors. Unfortunately, in many of our countries, while there is abundance of legislation, there are enormous delays in getting judicial verdicts even in most blatant cases of breach of contract or illegal behaviour by one of the parties involved. With a huge backlog of cases in courts at different levels, it often takes more than a decade to get even an initial verdict. In recent yeas, some initiatives have been taken to encourage settlement of cases by mutual agreement. However, actual progress in reducing backlog of cases by using the settlement route has been relatively slow. It goes without saying that, for most ordinary people, justice delayed is justice denied. An important priority in our countries—and it goes well beyond the financial sector—is the reform of the judicial system and introduction of measures to reduce delays in multi-layer framework of judicial hearings.
Finally, there can be hardly any doubt that an effective and efficient regulatory system, at the level of the central bank and other supervisory authorities, is essential for furthering the cause of ethics in banking. All countries have central banks, and some countries also have additional financial supervisory authorities with designated functions. These agencies are responsible for ensuring compliance with their rules and regulations, and thereby encouraging ethical behaviour in dealings between banks and their borrowers and depositors. While rules and regulations as well as periodic inspections are necessary parts of the regulatory framework, I believe that the supervisory system in many of our countries has become overloaded. It is also highly bureaucratic and discretionary. A discretionary and inspection-focussed system in turn encourages favour-seeking, corruption and other malpractices at the ground level. Rather than relying on inspectors, it will be much more effective if management of banks, including their board of directors, are made responsible for certifying compliance with applicable rules and regulations. Self-certification, along with statutory obligations of directors for ethical conduct, should ensure that the responsibility for unethical practices cannot be shifted to other agencies or regulators.
I have already taken a lot of your time. There is, of course, much more to be said on ethics in banking, but let me stop here and leave it to subsequent speakers in this series of lectures to further deliberate on the issues involved. Today, what I have tried to do is to mention a few broad principles which can encourage and promote ethical behaviour in banking. I believe that these measures are practical—and "doable". These are also capable of being introduced in the financial sector specifically, even if there are problems in introducing similar principles in non-financial sectors or the economy as a whole.