CHAPTER 1

INTRODUCTION

Financial intermediaries must keep to rules of law, industry standards and act ethically.
Dealt with is ethical. What does it mean to act ethical in financial services? Law and
industry standards are straightforward ethics an area for more interpretation. What is
considered ethical in financial services? Ethics towards the customer, (investor or
corporation looking for capital)? Ethics towards the employer/employee and ethics
towards the society? This paper will try to look at the ethical aspects of the financial
service industry towards Stakeholders. The Project covers standards of conduct in the
industry and explores stakeholders view on current conduct as well as trends. The paper
will cover a study of current behaviour and standards and research the literature available
the field. The outcome will cover the aspects of ethical behaviour in financial services.
What we have today and what is desired from stakeholders and not met by todays
standards as well as ideas for improvement. The implications may lead to suggestions for
the industry of how to deal with issues of loyalty and importance of firewalls between
departments as well as a more elaborated code of conduct. There is an opinion that greed
and unethical behaviour by market participants is a culprit for financial crises and
therefore it would be unwise to ignore the area of ethics and the requirements ethics put
on market participants. Financial intermediaries must keep to rules of law, industry
standards and act ethically. Dealing with ethics is not a side-line of the financial service
industry but should be a part of its core. The question that arises is what is ethical and
what is unethical? Are there any minimum requirements? Can certain intermediaries take
ethics to a higher level? Law and industry standards are far from straightforward, ethics is
an area for more interpretation.

The Indian financial services industry has undergone a metamorphosis since1990. Before
its emergence the commercial banks and other financial institutions dominated the field
and they met the financial needs of the Indian industry. It was only after the economic
liberalization that the financial service sector gained some prominence. Now this sector
has developed into an industry. In fact, one of the worlds largest industries today is the

1
financial services industry. Financial service is an essential segment of financial system.
Financial services are the foundation of a modern economy. The financial service sector
is indispensable for the prosperity of a nation.

Meaning of Financial Services

In general, all types of activities which are of financial nature may be regarded as
financial services. In a broad sense, the term financial services means mobilisation and
allocation of savings. Thus, it includes all activities involved in the transformation of
savings into investment. Financial services refer to services provided by the finance
industry. The finance industry consists of a broad range of organisations that deal with the
management of money. These organisations include banks, credit card companies,
insurance companies, consumer finance companies, stock brokers, investment funds and
some government sponsored enterprises. Financial services may be defined as the
products and services offered by financial institutions for the facilitation of various
financial transactions and other related activities. Financial services can also be called
financial intermediation. Financial intermediation is a process by which funds are
mobilised from a large number of savers and make them available to all those who are in
need of it and particularly to corporate customers. There are various institutions which
render financial services. Some of the institutions are banks, investment companies,
accounting firms, financial institutions, merchant banks, leasing companies, venture
capital companies, factoring companies, mutual funds etc. These institutions provide
variety of services to corporate enterprises. Such services are called financial services.
Thus, services rendered by financial service organisations to industrial enterprises and to
ultimate consumer markets are called financial services. These are the services and
facilities required for the smooth operation of the financial markets. In short, services
provided by financial intermediaries are called financial Services.

2
 CHAPTER 2

FUNCTION & NATURE OF FINANCIAL SERVICES

1. Facilitating transactions (exchange of goods and services) in the economy.

2. Mobilizing savings (for which the outlets would otherwise be much more limited).

3. Allocating capital funds (notably to finance productive investment).

4. Monitoring managers (so that the funds allocated will be spent as envisaged).

5. Transforming risk (reducing it through aggregation and enabling it to be carried by

those more willing to bear it).

Characteristics or Nature of Financial Services

From the following characteristics of financial services, we can understand their nature:

1. Intangibility: Financial services are intangible. Therefore, they cannot be

standardized or reproduced in the same form. The institutions supplying the financial
services should have a better image and confidence of the customers. Otherwise, they
may not succeed. They have to focus on quality and innovation of their services. Then
only they can build credibility and gain the trust of the customers.

2. Inseparability: Both production and supply of financial services have to be performed

simultaneously. Hence, there should be perfect understanding between the financial
service institutions and its customers.

3. Perishability: Like other services, financial services also require a match between
demand and supply. Services cannot be stored. They have to be supplied when customers
need them.

4. Variability: In order to cater a variety of financial and related needs of different

customers in different areas, financial service organisations have to offer a wide range of
products and services. This means the financial services have to be tailor-made to the

3
requirements of customers. The service institutions differentiate their services to develop
their individual identity.

5. Dominance of human element: Financial services are dominated by human element.

Thus, financial services are labour intensive. It requires competent and skilled personnel
to market the quality financial products. 6. Information based: Financial service industry
is an information based industry. It involves creation, dissemination and use of
information. Information is an essential component in the production of financial
services.

4
 CHAPTER 3

IMPORTANT OF FINANCIAL SERVICES

The successful functioning of any financial system depends upon the range of financial
services offered by financial service organisations. The importance of financial services
may be understood from the following points:

1. Economic growth: The financial service industry mobilises the savings of the people,
and channels them into productive investments by providing various services to people in
general and corporate enterprises in particular. In short, the economic growth of any
country depends upon these savings and investments.

2. Promotion of savings: The financial service industry mobilises the savings of the
people by providing transformation services. It provides liability, asset and size
transformation service by providing huge loan from small deposits collected from a large
number of people. In this way financial service industry promotes savings.

3. Capital formation: Financial service industry facilitates capital formation by

rendering various capital market intermediary services. Capital formation is the very
basis for economic growth.

4. Creation of employment opportunities: The financial service industry creates and

provides employment opportunities to millions of people all over the world.

5. Contribution to GNP: Recently the contribution of financial services to GNP has

been increasing year after year in almost countries.

6. Provision of liquidity: The financial service industry promotes liquidity in the

financial system by allocating and reallocating savings and investment into various
avenues of economic activity. It facilitates easy conversion of financial assets into liquid
cash. \

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 CHAPTER 4

TYPES OF FINANCIAL SERVICES

Financial service institutions render a wide variety of services to meet the requirements
of individual users. These services may be summarized as below:

1. Provision of funds:

(a) Venture capital

(b) Banking services

(c) Asset financing

(d) Trade financing

(e) Credit cards

(f) Factoring and forfaiting

2. Managing investible funds:

(a) Portfolio management

(b) Merchant banking

(c) Mutual and pension funds School of Distance Education Financial Services

3. Risk financing:

(a) Project preparatory services

(b) Insurance

(c) Export credit guarantee

4. Consultancy services:

(a) Project preparatory services

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(b) Project report preparation (

c) Project appraisal

(d) Rehabilitation of projects

(e) Business advisory services

(f) Valuation of investments

(g) Credit rating

(h) Merger, acquisition and reengineering

5. Market operations:

(a) Stock market operations

(b) Money market operations

(c) Asset management

(d) Registrar and share transfer agencies

(e) Trusteeship

(f) Retail market operation

(g) Futures, options and derivatives

6. Research and development:

(a) Equity and market research

(b) Investor education

(c) Training of personnel

(d) Financial information services

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 CHAPTER 5

SCOPE OF FINANCIAL SERVICES

The scope of financial services is very wide. This is because it covers a wide range of
services. The financial services can be broadly classified into two:

(a) Fund based services and

(b) Non-fund services (or fee-based services) Fund based Services

The fund based or asset based services include the following:

1. Underwriting

2. Dealing in secondary market activities

3. Participating in money market instruments like CPs, CDs etc.

4. Equipment leasing or lease financing

5. Hire purchase 6. Venture capital

7. Bill discounting.

8. Insurance services

9. Factoring

10. Forfaiting

11. Housing finance

12. Mutual fund Non-fund based Services

Today, customers are not satisfied with mere provision of finance. They expect more
from financial service companies. Hence, the financial service companies or financial
intermediaries provide services on the basis of non-fund activities also. Such services are
also known as fee based services. These include the following:

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1. Securitisation

2. Merchant banking

3. Credit rating

4. Loan syndication

5. Business opportunity related services

6. Project advisory services

7. Services to foreign companies and NRIs.

8. Portfolio management

9. Merger and acquisition

10. Capital restructuring

11. Debenture trusteeship

12. Custodian services

13. Stock broking

The most important fund based and non-fund based services (or types of services) may be
briefly discussed as below: A. Asset/Fund Based Services

1. Equipment leasing/Lease financing: A lease is an agreement under which a firm

acquires a right to make use of a capital asset like machinery etc. on payment of an
agreed fee called lease rentals. The person (or the company) which acquires the right is
known as lessee. He does not get the ownership of the asset. He acquires only the right to
use the asset. The person (or the company) who gives the right is known as lessor.

2. Hire purchase and consumer credit: Hire purchase is an alternative to leasing. Hire
purchase is a transaction where goods are purchased and sold on the condition that
payment is made in instalments. The buyer gets only possession of goods. He does not
get ownership. He gets ownership only after the payment of the last instalment. If the

9
buyer fails to pay any instalment, the seller can repossess the goods. Each instalment
includes interest also.

3. Bill discounting: Discounting of bill is an attractive fund based financial service

provided by the finance companies. In the case of time bill (payable after a specified
period), the holder need not wait till maturity or due date. If he is in need of money, he
can discount the bill with his banker. After deducting a certain amount (discount), the
banker credits the net amount in the customers account. Thus, the bank purchases the bill
and credits the customers account with the amount of the bill less discount. On the due
date, the drawee makes payment to the banker. If he fails to make payment, the banker
will recover the amount from the customer who has discounted the bill. In short,
discounting of bill means giving loans on the basis of the security of a bill of exchange.

4. Venture capital: Venture capital simply refers to capital which is available for
financing the new business ventures. It involves lending finance to the growing
companies. It is the investment in a highly risky project with the objective of earning a
high rate of return. In short, venture capital means long term risk capital in the form of
equity finance.

5. Housing finance: Housing finance simply refers to providing finance for house
building. It emerged as a fund based financial service in India with the establishment of
National Housing Bank (NHB) by the RBI in 1988. It is an apex housing finance
institution in the country. Till now, a number of specialized financial
institutions/companies have entered in the field of housing finance. Some of the
institutions are HDFC, LIC Housing Finance, Citi Home, Ind Bank Housing etc

6. Insurance services: Insurance is a contract between two parties. One party is the
insured and the other party is the insurer. Insured is the person whose life or property is
insured with the insurer. That is, the person whose risk is insured is called insured.
Insurer is the insurance company to whom risk is transferred by the insured. That is, the
person who insures the risk of insured is called insurer. Thus insurance is a contract
between insurer and insured. It is a contract in which the insurance company undertakes
to indemnify the insured on the happening of certain event for a payment of

10
consideration. It is a contract between the insurer and insured under which the insurer
undertakes to compensate the insured for the loss arising from the risk insured against.
According to Mc Gill, Insurance is a process in which uncertainties are made certain.
In the words of Jon Megi, Insurance is a plan wherein persons collectively share the
losses of risks. Thus, insurance is a device by which a loss likely to be caused by
uncertain event is spread over a large number of persons who are exposed to it and who
voluntarily join themselves against such an event. The document which contains all the
terms and conditions of insurance (i.e. the written contract) is called the insurance
policy. The amount for which the insurance policy is taken is called sum assured. The
consideration in return for which the insurer agrees to make good the loss is known as
insurance premium. This premium is to be paid regularly by the insured. It may be paid
monthly, quarterly, half yearly or yearly.

7. Factoring: Factoring is an arrangement under which the factor purchases the account
receivables (arising out of credit sale of goods/services) and makes immediate cash
payment to the supplier or creditor. Thus, it is an arrangement in which the account
receivables of a firm (client) are purchased by a financial institution or banker. Thus, the
factor provides finance to the client (supplier) in respect of account receivables. The
factor undertakes the responsibility of collecting the account receivables. The financial
institution (factor) undertakes the risk. For this type of service as well as for the interest,
the factor charges a fee for the intervening period. This fee or charge is called factorage.

8. Forfaiting: Forfaiting is a form of financing of receivables relating to international

trade. It is a non-recourse purchase by a banker or any other financial institution of
receivables arising from export of goods and services. The exporter surrenders his right to
the forfaiter to receive future payment from the buyer to whom goods have been
supplied. Forfeiting is a technique that helps the exporter sells his goods on credit and yet
receives the cash well before the due date. In short, forfeiting is a technique by which a
forfeiter (financing agency) discounts an export bill and pay ready cash to the exporter.
The exporter need not bother about collection of export bill. He can just concentrate on
export trade.

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9. Mutual fund: Mutual funds are financial intermediaries which mobilize savings from
the people and invest them in a mix of corporate and government securities. The mutual
fund operators actively manage this portfolio of securities and earn income through
dividend, interest and capital gains. The incomes are eventually passed on to mutual fund
shareholders.

Non-Fund Based/Fee Based Financial Services

1. Merchant banking: Merchant banking is basically a service banking, concerned with

providing non-fund based services of arranging funds rather than providing them. The
merchant banker merely acts as an intermediary. Its main job is to transfer capital from
those who own it to those who need it. Today, merchant banker acts as an institution
which understands the requirements of the promoters on the one hand and financial
institutions, banks, stock exchange and money markets on the other. SEBI (Merchant
Bankers) Rule, 1992 has defined a merchant banker as, any person who is engaged in
the business of issue management either by making arrangements regarding selling,
buying or subscribing to securities or acting as manager, consultant, advisor, or rendering
corporate advisory services in relation to such issue management.

2. Credit rating: Credit rating means giving an expert opinion by a rating agency on the
relative willingness and ability of the issuer of a debt instrument to meet the financial
obligations in time and in full. It measures the relative risk of an issuers ability and
willingness to repay both interest and principal over the period of the rated instrument. It
is a judgement about a firms financial and business prospects. In short, credit rating
means assessing the creditworthiness of a company by an independent organisation.

3. Stock broking: Now stock broking has emerged as a professional advisory service.
Stock broker is a member of a recognized stock exchange. He buys, sells, or deals in
shares/securities. It is compulsory for each stock broker to get himself/herself registered
with SEBI in order to act as a broker. As a member of a stock exchange, he will have to
abide by its rules, regulations and bylaws

. 4. Custodial services: In simple words, the services provided by a custodian are known
as custodial services (custodian services). Custodian is an institution or a person who is

12
handed over securities by the security owners for safe custody. Custodian is a caretaker of
a public property or securities. Custodians are intermediaries between companies and
clients (i.e. security holders) and institutions (financial institutions and mutual funds).
There is an arrangement and agreement between custodian and real owners of securities
or properties to act as custodians of those who hand over it. The duty of a custodian is to
keep the securities or documents under safe custody. The work of custodian is very risky
and costly in nature. For rendering these services, he gets a remuneration called custodial
charges. Thus custodial service is the service of keeping the securities safe for and on
behalf of somebody else for a remuneration called custodial charges.

5. Loan syndication: Loan syndication is an arrangement where a group of banks

participate to provide funds for a single loan. In a loan syndication, a group of banks
comprising 10 to 30 banks participate to provide funds wherein one of the banks is the
lead manager. This lead bank is decided by the corporate enterprises, depending on
confidence in the lead manager.

A single bank cannot give a huge loan. Hence a number of banks join together and form a
syndicate. This is known as loan syndication. Thus, loan syndication is very similar to
consortium financing.

6. Securitisation (of debt): Loans given to customers are assets for the bank. They are
called loan assets. Unlike investment assets, loan assets are not tradable and transferable.
Thus loan assets are not liquid. The problem is how to make the loan of a bank liquid.
This problem can be solved by transforming the loans into marketable securities. Now
loans become liquid. They get the characteristic of marketability. This is done through the
process of securitization. Securitisation is a financial innovation. It is conversion of
existing or future cash flows into marketable securities that can be sold to investors. It is
the process by which financial assets such as loan receivables, credit card balances, hire
purchase debtors, lease receivables, trade debtors etc. are transformed into securities.
Thus, any asset with predictable cash flows can be securitised. Securitisation is defined as
a process of transformation of illiquid asset into security which may be traded later in the
opening market. In short, securitization is the transformation of illiquid, non- marketable
assets into securities which are liquid and marketable assets. It is a process of

13
transformation of assets of a lending institution into negotiable instruments.
Securitisation is different from factoring. Factoring involves transfer of debts without
transforming debts into marketable securities. But securitization always involves
transformation of illiquid assets into liquid assets that can be sold to investors.

14
 CHAPTER 6

CHALLENGE FACED BY FINANCIAL SERVICES

SECTOR

Financial service sector has to face lot of challenges in its way to fulfil the ever growing
financial demand of the economy. Some of the important challenges are listed below:

(i) Lack of qualified personnel : The financial services sector is fully geared to
the task of financial creativity. However, this sector has to face many
challenges. In fact, the dearth of qualified and trained personnel is an
important impediment in its growth. Hence, it is very vital that a proper and
comprehensive training must be given to the various financial intermediaries.
(ii) Lack of investor awareness : The introduction of new financial products and
instruments will be of no use unless the investor is aware of the advantages
and uses of the new and innovative products and instruments. Hence, the
financial intermediaries should educate the prospective investors/users of the
advantages of the innovative instruments through literature, seminars,
workshops, advertisements and even through audio-visual aids.
(iii) Lack of transparency : The whole financial system is undergoing a
phenomenal change in accordance with the requirements of the national and
global : : environments. It is high time that this sector gave up their orthodox
attitude of keeping accounts in a highly secret manner. Hence, this sector
should opt for better levels of transparency. In other words, the disclosure
requirements and the accounting practices have to be in line with the
international standards.
(iv) Lack of specialization : In the Indian scene, each financial intermediary
seems to deal in different financial service lines without specializing in one or
two areas. In other words, each intermediary is acting as a financial super
market delivering so many financial products and dealing in different varieties
of instruments. In other countries, financial intermediaries like Newtons,
Solomon Brothers etc. specialize in one or two areas only. This helps them to

15
 achieve high levels of efficiency and excellence. Hence, in India also,
financial intermediaries can go for specialization.
(v) Lack of recent data : Most of the intermediaries do not spend more on
research. It is very vital that one should build up a proper data base on the
basis of which one could embark upon financial creativity. Moreover, a
proper data base would keep oneself abreast of the recent developments in
other parts of the whole world and above all, it would enable the fund
managers to take sound financial decisions.
(vi) Lack of efficient risk management system : With the opening of the economy
to multinationals and the exposure of Indian companies to international
competition, much importance is given to foreign portfolio flows. It involves
the utilization of multi currency transactions which exposes the client to
exchange rate risk, interest rate risk and economic and political risk. Unless a
proper risk management system is developed by the financial intermediaries
as in the West, they would not be in a position to fulfil the growing
requirements of their customers. Hence, it is absolutely essential that they
should introduce Futures, Options, Swaps and other derivative products which
are necessary for an efficient risk management system. The above challenges
are likely to increase in number with the growing requirements of the
customers. The financial services sector should rise up to the occasion to meet
these challenges by adopting new instruments and innovative means of
financing so that it could play a very dynamic role in the economy.

16
 CHAPTER 7

ETHICAL ISSUES OF FINANCIAL SERVICES

As we all have read, there is an opinion that greed and unethical behavior by market
participants is a culprit for financial crises and therefore it would be unwise to ignore the
area of ethics and the requirements ethics put on market participants. Financial
intermediaries must keep to rules of law, industry standards and act ethically. Dealing
with ethics is not a sideline of the financial service industry but should be a part of its
core. The question that arises is what is ethical and what is unethical? Are there any
minimum requirements? Can certain intermediaries take ethics to a higher level? Law and
industry standards are far from straight forward, ethics is an area for more interpretation.

1. Misrepresentation and Misconduct, Independence and Objectivity A starting

point is to examining the ethical aspects of the financial service industry towards
stakeholders, uncovering standards of conduct in the industry and explore
stakeholders view on current ethical conduct as well as trends. The part will cover
a study of current behavior and standards and research the literature available the
field. The outcome will cover the aspects of ethical behavior in financial services.
What we have today and what is desired from stakeholders and not met by todays
standards as well as ideas for improvement. The implications may lead to
suggestions for the industry of how to deal with issues of loyalty and importance
of firewalls between departments as well as a more elaborated code of conduct.
Participants in financial services must be true professionals and as a minimum
requirement have knowledge about the law. The firms employing the
professionals are responsible for compliance with legal requirement and industry
specific regulations and best practices for the industry.
1.1 Objectivity and independence In investment analysis and recommendations its
important that the analyst is not on the side of the analyzed company but is being
objective. Even worse would be to recommend customers to buy a security the
analysts company wants to get rid of. Federal, state and market regulators singled
out three of the firms Citigroup's Salomon Smith Barney, Merrill Lynch and Credit

17
Suisse First Boston -- and accused them of outright fraud in issuing bogus research.
(11) For example before the dotcom bubble burst in year 2000 Merill Lynch
recommended investors to buy tech stock while they themselves was selling. In the
end they were fined USD 100 million. (University of Wollongong) If the analysts
employer do banking or advisory services to the company being analyzed it must be
declared. Moreover analysis and investment banking decisions must have complete
separation. If this is not functioning there is a real risk of mispresentation. (University
of Wollongong) Independence and objectivity means not being biased by personal
relationships, personal benefits such as gifts or other forms of compensation. If an
analyst has conflicts of interest it must be declared and should possibly disqualify the
analyst to avoid any doubts of objectivity. (4) Misconduct, is easier to describe and is
attributed to fraud, deceit and dishonesty in all its forms. Reasons for misconduct can
be greed, personal gain or desperation trying save ones job or jobs in the financial
service providers organization or to save the company. Every financial service
company needs an independent compliance department as well as internal and
external audit. (2012 Financial Services Industry Compliance Benchmark Study)
Obey the law. If more than one law applies and are in conflict or states the case
differently. Comply with the strictest law, regulation or rule. If unethical or worse
illegal activity is suspected, by a financial service provider or its employees, the
company must discourage any such activity considered unethical and if it is violation
of law, notify a competent authority or regulatory body. (2012 Financial Services
Industry Compliance Benchmark Study) To mislead, make a false statement or leave
out an important fact is misrepresentation. An example is when a financial service
provider guarantees (not in writing, but by saying sure theoretically there is a
risk but in reality..) a high risk free return when in fact there are risks involved with
the investment. There been several such cases in the subprime crises. CDO or CMO
was sold as virtually a no risk investment. Investors took loans to leverage their
investment since it was 100% safe according to brokerage houses. Now these
investors sit on the loan and worthless securities. A so-called safe investment did not
just lead to the loss of invested capital, but further losses. (SVD 2010) Cheating,
stealing, lying deceiving are examples of non-accepted conduct (outside politics, that

18
 is). Financial service providers caught with miss-conduct may create a bad reputation
for the whole industry. Any conduct even if legal, if it can reflect badly upon
reputation, then it must be avoided.
1.2 Integrity of Financial Markets Participants Insiders trading is illegal, however rules
vary between markets and jurisdictions. An insider is anyone with access to material
non-public information. Professional participants must make sure rules are kept to
keep trust and reputation intact. A lost reputation can destroy a financial market
participant. Moreover the participants may not conduct market manipulation that is to
buy and sell in a way to create an illusion that there is more interest in a security than
the real interest. Its not just immoral but also illegal. The above illegal and unethical
practices can help to make bubble larger and create a crisis in securities markets;
therefore it is a major concern. (Bank for International Settlements)
1.3 Duties to Clients It is needed for brokerages and investment banks to put their client
first. First before their own self-interest or their companies interest. The client is
paying for a service and has the right to loyalty. If the institution is investing clients
money they must act with prudence and be as careful as if the money was their own.
Research however shows that people tend to be more reckless with other peoples
money. This is also true with politicians spending taxpayers money. The more
detached from the source of funds the less prudent behavior.
When giving advice, its necessary to be fair with the clients as well as while making
investment analysis. An expert must understand the clients needs, knowledge and
objectives in regards to risk and return. Investments must match the clients age and
financial situation and fit with the clients other asset. An overall portfolio view is
needed. There is even a EU directive (MIFID Markets in Financial Instruments
Directive) covering the above. (9) If a financial service provider is performing
portfolio management or propitiatory trading in a clients portfolio, limits must be set
up and the client must be informed about all risks and be made aware of the
probability to lose money. The clients objectives and wants must be met. Any
deviations from limits must be discussed with the client beforehand. Accurate and
complete information of the portfolios performance and composition must be
available at request at anytime. All client data are between the financial service
provider and the client and must be kept confidential. A financial service provider

19
 should only break the confidentiality if the client so wishes, if it is ordered by a
competent court of law or if it suspects illegal activities, such as insider trading,
money laundry etc.

1.4 Employees Loyalty to Employer and Clients To start with loyalty go two ways, it's a
two way street and if co-workers do not trust or are not treated equitable, the employer
can demand loyalty as much as it like to no avail. Employees must be diligent, carful,
thorough and without conflicts of interest. If giving advice its important that the advisory
separates facts and opinion. Exercise diligence, independence and thoroughness.
Documentation of investment analysis and advices given should be kept. It is also
required that the communication is made simple making sure the client understands all
implications and risks. Analysts cannot accept gifts, including entertainment from the
corporations they are analyzing. Integrity and objectivity may be compromised.
Accepting gifts from investment clients is okay, but the employer must be notified.

1.5 Conflicts of Interest If issues can lead to conflicts of interest, the issues must be
disclosed. A client transaction always has priority of investments in own book. Never
front a client. To front a client is to buy first in the market in own book and then sell to
client from inventory. If the advisor earns commission, compensation or other benefits
from recommending a product, service or asset this fact is material and must be disclosed.
Conflicts of interest will occur if the same financial service provider, provide brokerage,
analysis and investment banking services. Awareness is a must and analysis must be
shielded from pressure from the investment banking division. Of course the investment
banking division should have no say or input or be allowed disapprove or approve as well
as make changes the analysis. A corporation issuing stock or bond may pay for a report or
analysis. When the report is published it must be stated who financed it since it do create
a conflict of interest and no investor is to believe that its an independent report created
by someone without a vested interest in the corporation analyzed. One opportunity to
make the conflict of interest less severe is to have the corporation pre-pay and after that
have no say in recommendations, outcome and conclusions. Still analysts known to write
friendly reports may attract more clients.

2. Integrity of Capital Markets

20
2.1 Material Non-Public Information Information is non-public until it has been disclosed
to the general public, through press releases etc. Informing a selected group of people,
like current investors or analysts is not considered making information public. Anyone
that is anyone having access to non-public information that can influence the value of a
financial asset when made public or as time passes may not exploit or make others to
profit on such private material information. It is difficult to determine what constitutes of
materiality. Aspects considered; the reliability of the information, the type of information,
the source of information. If the source is considered less trustworthy it is more unlikely
that the information can be considered material compared to a sure source such as an
insider. The more difficult it is to see how the information affects the price on an asset,
the less likely it can be considered material. It is normal for stock market analysts to draw
substantial deductions from public and non-material inside information received from the
corporations top management while studying a company. An example; insiders in a
company knowing that the annual report will be better or worse than analysts expect have
material non-public information and may not act on that information to make money or
avoid losses. A rumor on the internet claiming that a certain company will earn more or
less than expected cannot normally be considered material. Reliability is general low. The
specificity of the information, the extent of its difference from public information, its
nature and its reliability are key factors in determining whether a particular piece of
information fits the definition of material.

2.2 Firewalls The idea is to in some extent separate departments with access to insider
information such as the corporate finance and investment-banking department with
analytics, trading, sales and brokerage. Physical separation, different buildings or even
location is a safety solution worth considering. People who do not meet do not
communicate as much and the risk of leakage of sensitive information is if not eliminated
at least minimized. Avoid career paths going from analytics, brokerage and trading to and
from corporate finance. Also storage of sensitive information must be considered, such as
access to databases etc. When communicating in between departments is needed, it must
be supervised and overseen. The question is by whom. That by the way summarizes the
main problem of self-regulation. It is important that employees are restricted from
trading, either by law or by employment contract. Also the financial intermediary must

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monitor and follow up on employees trading as well as trading in own book, proprietary
trading. One solution is that employees make their (and their families) trading records
available to the employer.

2.3 Proprietary trading If a firm has access to any form of material non-public
information it can choose to cease trading involved instruments. However that might not
be the appropriate action if the firm acts as a market maker or have other good reasons,
like maintaining liquidity, to continue its operations as normal not to disclose material
non-public information. Crucial is that the intermediary acts passively and only to market
orders from clients and traders avoiding taking position benefitting from the material
non-public information.

2.4 Arbitrage trading Arbitrage trading must be avoided since it is active, not reactive like
on customers demand nor is it passive. This in itself increases the risk of illegal activity.
For this reason all arbitrage trading must be stopped involving instruments on the
companys watch-list.

2.5 Market Manipulation Market manipulation is an illegal activity with the aim of
misleading market participant. It means participating in undertakings that distort prices
and/or trading volumes. Market manipulation includes buying and selling the same
security to increase the traded volume. An other example is the practice of spreading false
information misleading other market participants to undertake transactions they would
otherwise not undertake. Transactions that artificially distort prices or volume to give the
impression of activity or price movement in a financial instrument are not allowed.
Moreover cornering the market is not allowed when it leads to influencing prices on
derivatives derived from the underlying asset.

3. Duties to Clients When transactions are carried out for a clients purpose the
intermediary for example a broker must do what they can to protect the clients interest
above its own interests. i.e. carry out the transaction in the best possible way given the
current knowledge, market situation as well as other circumstances. Caution and
discretion is also something a client has the right to expect. In advisory pre-transaction or
discretionary trading risk and return must reflect the clients needs and wishes. Any limits

22
or guidelines set by the clients must be strictly observed and an overall portfolio view is
required. An intermediary cannot look at each trade as an isolated event.

All clients must be treated fair. The intermediary cannot give advantages to certain clients
at the expense of other clients. Fair treatment does however not imply equal treatment. A
large important client may receive better service, lower commission and other benefits
that do not directly impact other clients negatively. Different clients can therefore receive
a different level of service but its not allowed to give a negative influence on other
clients. If the intermediary provides different service levels these levels must be clearly
stated. However fair treatment do include same advice in investment proposals i.e. if the
intermediary recommend a particular stock it should be recommend to all investor that
fits the investment profile. Information must be disclosed to all clients at the approximate
same time, giving all clients a chance to act on the disclosed information. Disclosing
information to only a few clients (selective disclosure) or to some clients earlier and to
other clients later is discriminatory; its unfair and not allowed. (10) Primary and
secondary offerings should be offered to all clients suitable for the investment. Minimum
block size however is okay. The intermediary is not allowed to use their knowledge and
industry membership position to take advantage of the clients. If an investment advice
changes from a for example buy to sell the intermediary must pay great attention
disclosing the information to all holders at the same time. (9) A system to assure
compliance to the rules above in regards to fair treatment must be in place. Also a system
of grievance must be available fair and easy to use for clients thinking that their rights
been violated.

3.1 Precautions The number of people within an organization that know non-public
material information as well as any other proprietary information including results from
analysis before made public, should be kept to a minimum. Timeliness; must be kept
meaning that the time from decision to make an investment recommendation until the
recommendation takes place must be kept to a minimum. Often a report will be lengthy
and take time to prepare and publish. In that case make a short brief summarized version
to publish in advance. The danger is sitting on good information too long making it
possible for insiders to act. Anyone having any aforementioned knowledge about an

23
investment recommendation about to be published, may not act, discuss or disclose this
information to anyone prematurely. Best practices include reviews or auditing, to assure
that no client received unfair dealings compared to other clients. In the case of advisory
relationships it is important to wait and start advising first when the clients wants and
needs are thoroughly understood in regards to risk, return investment horizon, objectives
as well as financial constraints. In private discretionary portfolio management, which is
common in private wealth management. The financial service provider must manage the
portfolio according to the mandate, which is according the objectives and constraints
(limits) of the portfolio. The mandate should be written and made very clear. Any
deviations must pre pre-approved by the investor. The approval must be recorded. When
disclosing periodical performance reports the reporting must be unbiased, easy to
understand, accurate, complete, timely and using fair principles of valuation. Fair
valuation in most cases means mark to market. If using time series data to compare to
historical values, the historical data must also be fair, complete and accurate. Using past
data in market communication as a guarantee or even indication for future development
is highly unethical. Lastly if the intermediary changes valuation methods, data sources,
methodology in reporting, it must have a good reason for it and disclose it fully and
accurately. Clients and former clients must be able to trust full confidentiality with the
exception of court orders obviously. Law requires other exceptions, if the client conducts
illegal activities, and disclosure. Also the tax-law and tax authorities may have the right
to receive information. In short law covers confidentiality. If not covered by law; assume
that it is in the clients interest to disclose as little information about the client as possible.
For sure never share customer data with any other organization without the customers
explicit permission.

4. Obligations towards Employers One thing to remember is that loyalty goes two ways.
Recently there been several scandals involving employees overstepping their mandate. To
mention a few; Nick Leeson, Bearings Bank, 1995, the bank bankrupted. Jrme Kerviel
of Socit Gnrale, made in 2006-2008 a loss of 4.9 billion. Kweku Adoboli from USB
made a loss of 2.3 billion. They all have one thing in common; they broke the rules

24
Employees must be loyal to their employer and obey the rules and their mandate and use
the skills, knowledge and capabilities for the benefit of the employer. An employer must
keep confidential information safe not to case damage to their employer. The examples of
the rogue traders above show the importance sticking to ones mandate following rules
and procedures. Only if rules and procedures violate local regulations or law of the
jurisdiction, only then non-compliance and disclosure is expected. Employees must not
copy or steal the customer database prior to seeking a new engagement. Moreover the
employee must not discuss changing jobs to a competitor with clients. However after
starting working for a new employer these former clients can be contacted unless the
contact information comes from the former employer. A non-compete clause in an
employment contracts is often null and void under European law. Whistle blowing is a
difficult area, but generally accepted under law if the employer conducts illegal or
unethical endeavor. If an employee receives any kind of benefit from a third party it must
ne discussed and approved by the employer. This is important and crucial to avoid any
conflict if interest or suspicion of conflict of interest. Disclosing any benefit-received
form a third party is a minimum requirement.

4.1 Compliance Back office, middle office or internal audit need to assure that they are
determined to uncover and thwart violations of valid regulations, rules, code of ethical
conduct and of course violations of the law. Relentless control and audit is needed.
Systems and procedures need to be established and formalized. Managers should refuse
responsibility unless a framework is agreed and integrated. The supervisor must decline
supervision responsibilities if such procedures have not been laid down. The rules must
be written and easy to understand. Use a simple expressive language. The importance is
understandability and usefulness not linguistically snobbery. The rules can refer to details
and should indicate where to find the details if needed. Disclosing the code of ethics to
clients is a marketing tool to create awareness of the ethical high ground claimed by the
company, keeping in mind that it is also in the best interest of the clients. (10)

4.2 Investment Analysis Analysis must be independent from corporate finance. Analysis
must be able to write an unfavorable recommendation about a company without regret or
threats of lost business. Analysis must be thorough and backed by facts and investigation.

25
The analyses must disclose the method of analysis and how they choose portfolio
constituents. A clear distinction must be made between hard fact and opinion. Looking
into the future estimating net income, dividend pay-out ratio etc. is opinion since its not
fact yet. Methodology of analysis must be kept for future scrutinization. All records must
be archived within the firm for the future. The records do not belong to the analyst. (9)

4.3 Conflict of Interest Conflict of interest should if possible be avoided. If that is not
possible conflict of interest that may impact objectivity must be disclosed fully as well as
clearly communicated. Then the client can make an informed choice if to use the
financial intermediary or not. Knowing if the financial service provider has reasons to be
biased is crucial information. Common conflicts of interest is about underwriting
securities with the left hand and recommending them with the right hand. The investment
banking, corporates finance department is the culprit for many conflict of interest issues.
An analyst benefits from disclosing their own portfolio, making sure that clients do not
think they just recommend what they just bought. Somewhat harder to deal with is
compensation. Full disclosure of compensation is sensitive. Still clients do benefit
knowing how the representative is paid. Pay for referrals, incentives, commissions, and
performance criteria short as well as longterm. Clients transactions must have priority
over other transactions like transactions in own portfolio. Accounts belonging to family
members are not allowed any preferential treatment and should be treated just as any
other account. Private placements create similar conflicts as IPOs. Employees should not
take part of any transactions that can be perceived as gifts or may impair judgment in
future deals. It happens that IPOs give a good shortterm return and for that reason alone
employees of financial intermediaries being responsible for the IPO should not be
allowed to take part. Firstly it means taking opportunities away from clients. Secondly it
may lead to overpromoting the stock after the IPO

5 Global Investment Performance Standards (GIPS) GIPS covers the following areas;
calculation methodology, composite construction, disclosures, input data, private equity,
real estate, presentation and reporting. (5) The aim of GIPS is to point out and bam
common misleading practises including choosing no representative accounts for
performance measurements. i.e. selecting the best performing accounts disclosing

26
information such as up to 55% return in investment. Best practise includes avoiding
giving the impression that the best accounts are average accounts. Survivorship bias
includes displaying historical performance, only showing the survivors that is
excluding underperforming accounts closed down over time. An other way to manipulate
is to set the time period in a way benefitting our performance. Time periods should be
standardized making comparison easy and comprehensive. (5) The goals of GIPS are to
create a standardized approach suitable for most financial intermediaries. GIPS aim at
establishing a standardised industry wide approach for investment firms to follow in
calculating and reporting their historical investment results to prospective clients. Keep in
mind that GIPS is not law and it is not binding. Moreover only asset managers can be
GIPS compliant. It is not available for online discount brokerages etc. If a firm want to
comply the whole form must comply it is not open for a product or a single composite.
(5) Composites should be representative and consists of aggregated discretionary
portfolios of similar strategy or possibly objective. To make unbiased composites the
composites must be created prior to known results assuring that the form is not picking
out only the best performing portfolios.

CHAPTER 7

CONCLUSION
27
To conclude non-compliance to best practices and the highest level of ethics is dangerous
and may lead to large losses including bankruptcy. The GIPS standard provides a good
comprehensive framework which de-facto has become industry standard. The main issue
is not to make the rules stricter but assure adherence and compliance to the standards
developed. Internal and external audit and a compliance department/compliance officer
are needed to avoid fraud and other unwanted unethical behavior.

CHAPTER 8

Bibliography

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1. BANK FOR INTERNATIONALS SETTLEMENTS 2012. Principles for financial
market infrastructures. ISBN 92-9131-108-1

2. BORG M. 2013. Det finns tre stt att spendera pengar. [online]. Retrieved from:
http://sloseriombudsmannen.se [cit. 2012-03-10].

3. CREUTZER A. 2010. Ett svek mot Acta-spararna, [online]. Retrieved from:

http://www.svd.se/naringsliv/nyheter/sverige/ett-svek-mot-acta-spararna_7031529.svd
[cit. 2012-03-10].

4. DAVIS M., JOHNSTON J. 2009. Conflict of Interest in Four Professions: A

Comparative Analysis, 2011, 302-357s. ISBN 3642198414 5. EDITION OF THE GIPS
STANDARDS. 2010. [online]. Retrieved from:
http://www.gipsstandards.org/Pages/index.aspx [cit. 2012-03-10]. 6. CHANDANA M,
2012 in CFA Level 1, Course Preparation, Financial Management

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