Home Banking Investing in Managerial Honesty: Opportunities and Challenges for Banks and Regulators

Investing in Managerial Honesty: Opportunities and Challenges for Banks and Regulators

by internationalbanker

By Dr. Alexander Wagner, Swiss Finance Institute Associate Professor of Finance, University of Zurich

 

 

 

Trust is a key pillar of banking and of the financial and economic system overall. This article argues that by incorporating new insights on drivers and consequences of managerial honesty and deception, and on investor preferences regarding values of managers, banks can more effectively fulfil their function as intermediaries—and be more successful. The article first highlights the prevalence of both honesty and deception in financial markets. Then it presents insights—for banks and regulators—that can be gleaned from research on how investors respond to managerial (dis)honesty. Finally, it presents conclusions derived from this work.

Honesty and deception everywhere 

It is clear that when fraud occurs, this is extremely damaging to firms, shareholders, employees and all other stakeholders. But seemingly contradictory observations can be made regarding the prevalence and drivers of managerial honesty. On the one hand, from the Enron scandal to the subprime crisis to the Bernie Madoff scam, corporate fraud and managerial misconduct have rattled shareholder value and investors’ trust over recent decades. Dishonesty breeds distrust—which is particularly important for banks because their business models depend so much on trust. It was, therefore, doubly striking when the president of the American Finance Association, Luigi Zingales, noted in his Presidential Address: “I fear that in the financial sector, fraud has become a feature and not a bug”. Moreover, contrasting doctors and financial-service providers, he argued that “customers [of financial-service institutions] are often not seen as people to respect, but as counterparties to take to the cleaners”.

From 2005 to 2015, 7 percent of financial advisers in the United States have misconduct records, and this share reaches more than 15 percent at some of the largest advisory firms. Roughly one-third of advisers with misconduct are repeat offenders. Offenders get rehired (at less attractive conditions) at firms that have higher rates of prior misconduct themselves, suggesting that some firms indeed foster a culture of misconduct and dishonesty.

On the other hand, substantial honesty even in the face of incentives to the contrary can be observed in real life. Most firms and managers do remain honest. Some individuals clearly give up gains that could be realized from misreporting. Whistleblowers and journalists risk their careers and sometimes their lives to bring out the truth.

Seeking to explain this wide variation in human behaviour, fundamental research increasingly shows that people differ in their intrinsic preferences and lying costs. Incentives, when well-designed, can help sustain honest behaviour; but it has also become clear that poorly designed incentives can backfire. Deviating from the standard economic paradigm that only consequences matter, more recent research establishes the relevance of process. Research suggests that people differ in the extent to which they regard honesty as a “protected value”—that is, as a value for which they are willing to pay a price to uphold it. In short, not only the what but also the how matters to people.

An experiment on investor responses to managerial honesty 

While these fundamental insights are interesting, from an applied perspective, the question is: Can investors—and financial-service institutions—use insights regarding the drivers of behaviour to develop more suitable investment strategies and investment products? Also, is further regulation required to improve ethical management and promote honest corporate cultures? Or can investors influence managers by making investment decisions based on perceived managerial honesty?

New research sheds light on these questions and suggests great opportunities, but also some challenges, for banks and financial institutions more generally.

As an example of the ongoing research in this area, consider a recent paper that my co-authors Rajna Gibson, Matthias Sohn, Carmen Tanner and I have recently released (“Investing in managerial honesty”, Swiss Finance Institute working paper). We investigate whether investors form views about CEOs’ honesty based on the CEOs’ previous actions—and whether this affects investment decisions. To be concrete, we consider a situation in which investors see two CEOs, one who legally managed earnings to meet market expectations and one who did not do so. Consequently, the CEO who announced the earnings that the market expected received a higher bonus than the other.

We find three sets of striking results. First, although only legally acceptable practices of earnings management are considered, investors view a CEO who has resisted the temptation to manage earnings as substantially more honest on average. But there is great variation in the assessment of CEO honesty by investors, suggesting that matters such as earnings management are not easy to assess by investors, and also that investors do have different views on this matter.

Second, 60 percent of the participants in the experiment chose to invest with CEOs who did not engage in upwards earnings management and thus passed on the opportunity to earn a higher bonus. Strikingly, participants favored CEOs they perceived to be more committed to honesty, even if this implied lower promised returns. Further, the more a CEO is perceived to treat honesty as a protected value, the less investors tend to be sensitive to the relatively higher future returns claimed by CEOs perceived to be less honest.

Investors differ in their values

Third, there is important variation in how investors regard ethical decisions, and these differences have a substantial impact on investment choices. Specifically, some investors are “pro-self”, trying to maximize their investment returns. Others are “pro-social”, which in this context means that they also care about goals other than their own returns.

Pro-self investors optimize their risk-return profile: They seek higher returns as well as lower uncertainty about claimed returns, and they trade off the two factors against each other. In other words, to them managerial honesty is important because it mitigates deception risk. The rationale at work here is that CEOs with strong perceived commitment to truthful reporting are expected to announce more reliable information regarding investment returns. Prosocial investors, by contrast, seem to base their investment decisions directly on moral values and are largely insensitive to financial returns. They prefer to invest with the non-earnings management CEO when they themselves have strong protected values for honesty, or when he is perceived as the more honest CEO.

An expanded “know your client” approach for banks—and implications for regulators 

The key implication of this line of research for banks is that they should acknowledge the importance, to their clients, of managerial honesty. The “know your client” mantra of wealth managers and banks too often considers only issues such as risk tolerance, experience and competence, and financial goals of the investor. Occasionally, goals or preferences as regards environmental and social issues are considered. The present research suggests that this misses out on an important dimension of investor preferences, namely their broader ethical values and their concern for such values in individual CEOs. Applying these insights does not require banks or investors to have (hard or impossible to obtain) detailed data on the values of CEOs—what matters for investment decisions are the perceptions of investors. Transparent information regarding issues revealing managerial characteristics is required to enable investors to channel funds to firms they consider more honest. This is where policymakers and regulators have a key role to play in setting the right disclosure requirements.

In sum, from an overall financial-market perspective, managerial honesty may be an important factor that facilitates stock-market participation for a variety of investor types. From a prudential perspective, observing that broad types of investor clientele elect to invest with firms managed by honest CEOs, though for different reasons, suggests that, after all, market discipline may contribute towards curbing managerial unethical behaviours. Although we still know too little about these issues, and although more work needs to be done to make them concretely implementable, ultimately the consideration of managerial honesty will enhance the role the financial sector can play in channelling investments to where they are most effective.

 

References:
  • More information on the subject can be found at http://www.alex-wagner.com. 
  • Zingales, Luigi, 2015, Presidential Address: Does finance benefit society?, The Journal of Finance 70, 1327-1363.
  • Egan, Mark, Gregor Matvos and Amit Seru, 2017, The market for financial adviser misconduct, Journal of Political Economy forthcoming.
  • Gibson, Rajna, Carmen Tanner and Alexander F. Wagner, 2013, Preferences for truthfulness: Heterogeneity among and within individuals, American Economic Review 103, 532-548, available at http://bit.ly/AERTruth
  • Gibson, Rajna, Matthias Sohn, Carmen Tanner and Alexander F. Wagner, 2017, Investing in managerial honesty, Swiss Finance Institute Working paper available at http://bit.ly/InvHonesty

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