Measuring Integrity in Financial Markets
Everyone is keen on promoting the need for integrity in the financial markets – and much has been written on this topic over the years, normally when scandals occur. Then there is usually a regulatory investigation – and/or a criminal investigation by the authorities about what went wrong, and what the root cause of the failure was. And so lessons are supposedly learned and measures are put in place to ensure that the whole system is tightened up so that the risks of such a failure occurring again are considerably lessened.
Everyone is keen on promoting the need for integrity in the financial markets – and much has been written on this topic over the years, normally when scandals occur. Then there is usually a regulatory investigation – and/or a criminal investigation by the authorities about what went wrong, and what the root cause of the failure was. And so lessons are supposedly learned and measures are put in place to ensure that the whole system is tightened up so that the risks of such a failure occurring again are considerably lessened.
But perhaps what we do not do enough of – either on an institutional basis or a marketwise basis – is try and measure integrity. ‘What is integrity?’ is the key question here; everyone has their own idea and definition thereof. But there is a compelling case to say that ‘Integrity’ equates for this purpose to ‘trust’. Because without integrity, an institution will not be trusted, and if you have earned the trust of the market, you have earned the right to be deemed to have integrity.
On the world financial state, there are unregulated actors – for example, Sovereign Wealth Funds, governmental bodies and major investors who do not act on others’ behalf and can therefore avoid the need for regulatory oversight. For these organisations to be credible participants on the world stage they need to be trusted. And in order to be trusted, an institution needs to demonstrate and promote itself as adhering to the rule of law and to the rules of the market – and to manage its own affairs in an orderly manner and in compliance with proper governance rules. There is a commercial benefit here also – from an overall markets’ perspective, those with good governance – and trust – will generally have lower rates of capital than those without.
So the question becomes – how do we measure trust?
This can be achieved on a bottom-up basis and a top-down basis.
From a bottom-up perspective, ie at institutional level, there are many incidents that can happen and dent a reputation. And, of course, it is important to remember that sometimes it’s not what actually happened that’s important, but what the stakeholders – in this case other market participants – think what the case is. Hence a PR Department in any credible institution will have lots of tools to measure what the press and commentators think. They – and top management – are concerned about ‘Reputation’, but of course that word covers many aspects – for example, adverse media comment vs positive media comment, surveys conducted of interested stakeholders, as well as internally known issues relating to Sanctions breaches, insider trading propensity, market manipulation allegations, bribery and corruption investigations, and regulatory compliance issues, to name but a few. And ‘Reputation’ – say in an investment institution – also covers factors such as investment performance, employee contentment, vendor relations (including prompt payment history!), as well as market conduct, bribery and corruption and compliance.
But Boards do not need a chapter and verse on each of these issues – so the best way is surely to create an ‘Integrity Index’, and track how this moves. This avoids having to get too granular in reportage, but a weighted composition of incidents and investigations known about internally, together with external reputation scores, can construct such an index. It doesn’t need to be scientifically accurate to the last delta, the important measure from the institution’s perspective is how the index moves over time. Some examples of what can go into this index could be past incidents of integrity failures, both at employee level and at institutional level, reputational profile (including Board and C-Suite personnel), current internal ongoing issues, whistleblowing incidents, and governance failings at the institution itself and at those investments which it controls.
From a top down perspective, there is no reason why such similar indices cannot be constructed by the regulatory community across markets. We can then compare integrity across marketplaces, applying a factor to take into account the nature, size and complexity of whichever market is considered.
So, assuming that we can do all the above at institutional and market level, we end up with some indices and some comparisons across institutions and markets. But of course the key question is to understand what is the norm? Viz, how do we decide what is an acceptable level of integrity? Arguably, this doesn’t really matter – just being able to compare markets, or institutions, would be really helpful and let market participants make their own mind up. As we all do at present, but on the basis of what we might call ‘anecdotal evidence’ rather than ‘empirical evidence’ scientifically analysed.
We’ve all been where we think ‘Not sure about dealing with x’; and if we have to, and can do so, we put in more safeguards than normal. The anonymity of the current market can hide matters – we’re a long way from the old days of the London Stock Exchange, for example, when if you saw, say, an individual from a low quality firm with a dodgy reputation wending their way towards you, you’d know instantly to widen your prices significantly. Similar antics happen in all markets today – just more discreetly, away from the public eye.
It all comes down to people at the end of the day – and their own integrity. But we need to bear in mind the Rumsfeldian quotation about ‘known knowns’, ‘known unknowns’ and ‘unknown unknowns’. We can’t do anything about the ‘unknown unknowns’ – and as far as the ‘known knowns’ are concerned, the above index concept can cope with that. However, the prime issue of a ‘known unknown’ here is the base integrity of people.
Are we all fundamentally honest? Or do we comply only when there are checks and balances in a system which strongly encourage us to comply? Generally, surveys about people’s honesty tend to find that individuals seek mostly to avoid a dishonest action that would bring about demonstrable harm to another individual. However, that is not so much the case where, rather than individuals, it is only institutions that might be damaged – and a prime example here is making a false insurance claim if a person thinks they can get away with it. Another example would include the ‘black economy’ – significant in most economies – and non-disclosure of income for tax purposes. There may indeed be lots of checks and balances designed to ensure that people are not tempted to act dishonestly, but the fact is that the base integrity index across the entire population of the world may be quite low. This leaves aside the whole issue that behaviour demonstrating integrity in one jurisdiction may not be judged the same in another – as the old saying goes, ‘Different markets, different customs!’
Lastly, a thought about whether the markets will have more integrity in the years to come – or less? Transparency can be a blessing and a curse here – for example, more transparency occurs because of the rise of social media, the increasing speed of information delivery and assimilation – and this leads to there being less places for miscreants to hide. But there are also examples of less transparency – for example, the anonymity of the internet, and the increasing complexity of some transactions. But whilst there are integrity-challenged people out there in the world, we will always need to look for ways of determining where the integrity is, who has it and to what extent and who doesn’t, and the above might be a way to start measuring this consistently and analytically.