Finance and Morality

A few weeks ago I wrote about Ignazio Visco, Governor of the Bank of Italy, and his lecture on the Financial Sector After the Crisis. This week he gave the opening remarks at the Islamic Financial Services Board forum on "The European Challenge."

The main prescriptions relating to financial transactions in accordance with Islamic religious law are the ban on paying interest and the prohibition of excessive uncertainty and speculation in contractual arrangements. This is predicated on the principle that profits should be generated from fully sharing in the business risk of an investment (the so called “profit and loss sharing principle”). The asset-backing requirement complements these prescriptions, providing for the link between each financial transaction and an identifiable underlying asset. 

A few weeks ago I gave a lecture on the financial sector after the crisis. On that occasion, it occurred to me that the renowned economist and philosopher – and eventually Nobel laureate – Amartya Sen had given in these same rooms the first of our scholarly lectures entitled to the memory of our late governor Paolo Baffi. Sen’s lecture was on “Money and Value: on the Ethics and Economics of Finance”. It is of course an interesting and good read in these difficult days. But what I was most intrigued by was Sen’s question: “How is it possible that an activity that is so useful has been viewed as morally so dubious?” 

There are indeed a good finance and a bad finance. While we may have some differences in ideas and perceptions on the goods and the bads, I think that what is most important is really to focus on the link between financial transactions and underlying assets, to conclude, with Sen, that “finance plays an important part in the prosperity and well-being of nations”. Indeed, it is crucial for sharing and allocating risk, especially for poorer societies and people. It is crucial for transferring resources over time and removing liquidity constraints. It is very important for fostering innovation and promoting economic growth. 

But it has to be certainly “ethical” and certainly transparent.

Many religious traditions have long recognized the moral and ethical challenges of finance and provide at least some guidance to their followers on the issue of finance. Ignazio Visco is not himself Muslim (as far as I know), but he is sympathetic with some of the moral sentiment behind Islamic religious law about finance. What I think we are seeing recently, and will see more of, as a result of the financial crisis is a wider-spread emphasis on morality in finance.

Not that this is entirely new. Via Nathan Tankus, here's a quote from The Economist, November 2, 1907 (after a major banking panic):

The financial crisis in America is really a moral crisis, caused by the series of proofs which the American public has received that the leading financiers who control banks, trust companies, and industrial corporations are often imprudent, and not seldom dishonest. They have mismanaged trust funds, and used them freely for speculative purposes. Hence the alarm of depositors, and a general collapse of credit.

What can a secular society do about a moral crisis? Can regulatory reform (like Admati and Hellwig's proposals in "The Bankers' New Clothes," for example) make the financial system as a whole more "moral" seeming, even if individuals within the system are not moral? Can economists treat morality as something that can be incentivized? I need to keep this post brief today since I am preparing for a presentation tomorrow, but I'd love to hear readers' thoughts on these questions, or for people to post links to good readings on this topic.