Unethical behaviour in the

financial services industry has

been a very destructive force
which not only had a huge,
negative global financial impact;
it’s also been very costly in terms
of reputation and brand—which
does not bode well for the future
of financial services as a whole.

Ethical Issues
in Financial
Markets
 Abstract
In usual terms, ethics arise from the moral
obligations and responsibilities of people.
Ethical behaviour as a whole can have a
positive impact on the society whereas
unethical behaviour can culminate into a
full-fledged crisis, especially when it comes
to the financial sector.

This document highlights the ethical issues

that may arise in the financial sector. It
covers the types of ethical issues that can
be found while operating in financial
markets, why is it important to mitigate
them – why the financial sector is the most
regulated industry in the world, some
major financial scams that occurred due to
the ethical issues and finally, a few steps as to how to eradicate this problem of ethical issues and
securing the financial services sector more and more.

Introduction
The main functions of the financial sector are to borrow and lend money, liquidity, and determination
of prices, valuation of businesses, assimilation, coordination and analysis of information. A financial
market is a larger term for a marketplace where the trade and exchange of assets like bonds, equities,
derivatives and currencies are facilitated through buyers and sellers. They have a well-defined and
structured pricing system, where the trade is regulated by rules and provisions of both legal and moral
nature and the macroeconomic forces that are at play in determining the state of the financial
markets. The different types of financial markets include stock markets, money markets, capital
markets, foreign exchange markets, OTC markets, primary and secondary markets, amongst many
others.

Thus, in basic terms, the role of a financial sector is to guarantee the fluidity of transactions that are
of importance to national and global economic activity – this being done by an efficient use of available
capital. There has been a great deal of explosion in financial activity which has made the financial
services an independent sector – both in concept and as a profession. This independence has given
way to financial innovations which has further created an array of opportunities but also carries dire
consequences if not handled properly. All the parties in a financial market are very crucial and they
should display ethical and just behaviour on their parts.

Due to the dire consequences which can culminate into a global crisis like the Great Depression or
economic recession, it is easily proven that any activity in the financial sector - bears a responsibility
towards the economy as a whole – both at a micro and macro level. Thus, for their own sake as well
as the world’s sake, the players must make an effort to enforce ethical behaviour and build a strong
ethical foundation.

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The price for this ethical
foundation is constant and
consistent vigilance. The
opportunities provided by
the financial sector that may
be beneficial if exploited
correctly, also make way for
potential ethical abuse. With
people being dependent on
information for exchange
and transactions, new and
complex innovations, the
decision-making should be
quick but precise and
correct. The industry and the
players have to recognise the
ethical obligations like:

Fiduciary Obligations: Managers of pension funds have obligations towards the beneficiaries. Brokers
are obligated to handle the client’s wealth efficiently. These obligations also pose thousands of ways
in which conflict of interests and other unethical behaviour may arise.

Confidentiality: The handling and protection of confidential information is an absolute necessity to

give a fair chance to all the parties handling the transaction – avoiding information asymmetry and
thus problems of adverse selection and moral hazard.

Disclosure: In the complex transactions, the manner and extent of disclosure of vital information play
a very crucial role in laying the ethical foundation of the financial industry.

Thus, the presence of ethical behaviour in financial industries is very much required. The areas of
ethical behaviour include: professionalism, integrity of capital markets, duties to clients and
employers, investment analysis, recommendations and actions, conflicts of interest amongst many
others.

Causes of Ethical Issues in Financial Sector

Ethical issues range from budding conflicts of interest (soft money, front running), confidentiality
(leaking fire walls, cheat sheets, insider trading) to disclosure (trailing commissions, yield burning),
etc. Following are the most common types of causes of ethical issues found in the financial sector:

1) Self-interest culminating into greed and selfishness: The accumulation fever which starts
with the amassing on funds or monetary gains for short-term goals – eventually turning into
an obsession for long-term wealth-maximization. The obsession for accumulation is not bad,
it is the unchecked obsession that lets one operate at the expense of someone else that is
unethical and immoral.
Swaps can be considered an example in this regard – the income generated by a company in
each quarter being recognised during accounting and expensed being deferred by

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 capitalisation as an asset – results in an inflated net profit or bottom line. This profit is not
being made out of the company’s operations or mission activities, but by playing around with
the company’s asset mix.
2) Equating moral behaviour with legal behaviour: An action may not be restricted by a court
of law, but it can be immoral. Laws are kept in place to prevent the moral agreements from
breaking down, yet it is comprehended that to be moral is to obey the law.
For example, swaps again to avoid taxation. Investing of assets and playing around with them
is not illegal. Similarly, the January effect – selling stocks in December to rebuy them in January
is not illegal, but companies do it in order to avoid tax liabilities.
3) Adverse Selection: This occurs when sellers have information that buyers don’t enabling
buyers to go for average pricing since they can’t judge or valuate the asset or security of the
trade.
4) Individual responsibility collapses under the nature and extent of client demands: A lot of
times, it’s the client that pushes the employee or the seller to act unethically. A temptation to
gain consumer trust and gain more profitable clients creates a sort of conflict of interest for
the dealer. For example, falsifying claims and applications on behalf of the client in the
insurance sector is one of the known unethical frauds committed.
5) Unrecognised Responsibility: A lot has come in the way of the financial players seeing the
consequences of their actions like :
 The complex technology that has created a virtual world where consequences of
financial activities are invisible
 Distance of the financial sector from other economic sectors, both institutionally and
culturally – making it difficult to assess the impact of financial activities on other
sectors
 People taking undue advantage of market imperfections under the theoretical pretext
of there being a perfect financial market
 Lack of consideration of all macroeconomic factors due to the complexity and
magnitude of them
6) Issues of Responsibility and moral hazard:
 The need for truthfulness: Consumers should know what kind of financial market they
are dealing with. Financial players and dealers need to make sure that clients aren’t
misled by the company’s statements and activities
 Durability: The requirement and attractiveness of liquid assets and the frenzy for
immediate gains has had an effect on the smooth functioning of the real economy.
The problem of durability highlights that means other than liquidity are required to
create trust between players and ensure the stability of the financial system
 Ethical Remuneration: When one form of transaction is more profitable for the seller/
employee than the other, they start pushing the clients to take that up – this being
done at the expense of the clients. The operator in order to seek profits, shuns his
duties and responsibilities towards the client
7) Conflicts of interest between firm and clients: A lot of times, especially in the stock brokerage
companies, situations arise, when employees are expected to help the company achieve its
goal, here, profit maximization. These might lead to conflict of interest with the investing
client – counter to the firm’s goal.
The most obvious conflict is that it is not necessarily in the best interest of the investor client
to buy or sell a particular security at a particular price. It is important to recognize that it is
not necessarily a common problem. Except in very rare cases, sell-side security analysts cannot

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 force an investor to buy or sell a security. Whether to trade a security is left entirely to the
discretion of the investor or investment manager, where analysts often run afoul of their
responsibilities in recommending securities is in the temptation to provide inaccurate
information that makes a recommendation look better than it should or to tout a stock by
using exaggerating wording or hyperbolic language.

Most Common Types of Unethical Practises in the Financial Sector

1) Creative Accounting: Practises that may not follow the rules to the – mainly systematic
misrepresentation of true income and assets by corporations to raise the bottom lines and
avoid tax liabilities.
One of the main genres is slush fund accounting where earnings from current quarter are
hidden away just in case the profit from next quarter is not up to the mark. This happened at
Freddie Mac in 2004 where an investigation was setup to see if insurance policies from
insurers like General Re of Berkshire Hathaway were used for slush fund accounting.
2) Earnings
Management: This
occurs when
managers use their
own judgement in
financial reporting and
alter the reports to
mislead some
stakeholders about
the economic health
and performance of
the company or to
influence some
contractual outcomes.
It uses aggressive
accounting tactics to decrease or increase revenues, profits, assets or EPS. It takes place in the
form of: unsuitable revenue recognition, inappropriate accruals or estimate of liabilities,
excessive provisions and generous reserve accounting, and intentional breach of financial
reporting standards.
3) Financial Analysis: When the analysis is used to misrepresent the organisation, its situation
and prospects – this is usually to obtain money by misleading people to invest in a stock
market bubble – profiting from the raised price – removing funds before bubble collapses, for
example in a stock market crash.
4) Insider Trading: This occurs when a person having access to material information deals in
securities. This is illegal when the information used is private and is not available to all public
and investors. For example, in 2017, former Amazon analyst, Brett Kennedy was charged with
the breach of information of Amazon’s first quarter earnings to Maziar Rezakhani for $10000.
Rezakhani had made $115,997 by trading Amazon shares based on the access to information
from Kennedy.
5) Securities Fraud: Investors are deceived and manipulated, resulting in theft. This is becoming
more complex in nature as the financial innovations and vehicles are increasing in order to

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 achieve higher returns. The globalisation of the financial sector has led the fraudsters to find
new markets, new investors, and new bank havens to hide the unjust riches.
6) Bucket Shop: It usually refers to an operation in which the customer is sold a hypothetical
interest derivative or security, but in actual the transaction is not executed on the exchange –
the transaction basically goes into the bucket.
7) Forex Scam: Here individual traders are convinced of gaining very high profits by trading in
forex markets - these scams include – churning of customer accounts, selling software that is
“supposed to” lead customer to higher profits, improperly “managed” accounts, false
advertising and Ponzi schemes.
8) Market Rigging: To change/alter prices of security to gain unfair advantage in the market.
Financial markets rely upon benchmarks for value of products. Market rigging undermines the
free-market economy by manipulating supply and demand as well as inducing asymmetric
information.
9) Latency Arbitrage and front running: This involves that the fastest players observe a price
change, transact on another exchange for the
same before the price changes there. Also, brokers
might transact through their own accounts initially
to raise the price of the stock before fulfilling the
customer’s stock order – which in turn increases
the price of the stock and hence the profits made
by the broker. All this is basically facilitated
through sale of fast access to material data.
10) Churning: A broker conducting excessive
transactions from the clients account to increase
commissions at the expense of the clients’ loss.
Churning also is found in the excessive or
unnecessary trading of mutual
funds and annuities.
11) Credit and Debit Card Frauds: These occur
due to compromise of confidential data related to
the accounts.
12) Bank Cheques: Creation and duplication
along with alteration of financial papers to benefit
the criminal.
13) Mortgage: To materially misrepresent the
information on application to obtain a loan or
obtain a sub-prime loan.
14) Declaration of bankruptcy: Since bankruptcy
discharges an entity of its liability to pay, such frauds are committed via concealment of assets,
petition mills and multiple filings.
15) Pump and Dump: This uses the information asymmetry in the market to carve out profits for
few at the expense of others. The influential individuals pump up the value of a stock well
beyond its real worth using inaccurate information – creating a bubble of expectations around
it – luring other investors to invest in them – which pushes up the price of the asset – the
holdings are then sold off by ‘dumping’ the stocks – leading to price crashes thus ruining other
investors who got the short stick of the information asymmetry.

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Some major financial scams around the globe due to unethical behaviour

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  Toshiba Accounting Scandal: Investigators found evidence of false and inappropriate
accounting practises and inflated profits being reported in multiple Toshiba units – with
practises of booking prospective profits early, pushing back losses. The pressure of profit
targets from the management on the presidents with no acceptance of failure encouraged
employees into false accounting practises. The final admission by Toshiba CEO stated that the
company had overstated its earnings by $2 billion over 7 years.
 Chanda Kocchar Case: A currently ongoing case, Chanda Kocchar and her family has been
accused of conflicts of interest with regards to a loan extended to Videocon group. The case
included the ICICI bank extending a Rs. 3250 crore loan to Videocon group and involvement
of her husband in the sanctioning and restructuring of the loan. The allegations also include
that NuPower – a company floated by Deepak Kocchar and Videocon group also got
investments from the loan – making Chanda Kocchar a direct beneficiary of such loans and
thus being accused of quid pro quo and conflicts of interest with regards to the loan.
 LIBOR: It was a series of fraudulent schemes and actions related to London Interbank Offered
Rate which is an average of international interest rate calculated after all major banks of the
world submit the interest rate at which they are willing to lend capital to each other. Some of
the biggest banks during the crisis of 2008 understated their interest rates misleading others
about the actual financial status of these banks.
 Wells Fargo fake accounts: Employees were encouraged to order and issue credit cards for
pre-approved customers by filling in their own contact details. Fraudulent checking and saving
accounts were also created to complete their quotas. Unwarranted insurance policies had also
been issued.
 Punjab National Bank Nirav Modi case: Nirav Modi acquired fraudulent LoUs from a junior
official of PNB for overseas credit from other lenders. PNB suspended over 10 officers over
the Rs. 11400 crore scam and referred the matter to CBI for investigation.

Principles to inculcate ethical behaviour

o To create a corporate culture that is responsible enough to understand that profits are
necessary but profit maximization at all costs should not be the ulterior motive. The toxic
culture of Toshiba which encouraged managers to falsely report earnings or Barclay which
understated the LIBOR tax rate should be discouraged in order to create a well-functioning
market
o To keep the clients’ interests first - Clients in any form be it government or individuals should
be kept first. Any financial services company is not wrong to look for profits but doing so at
the expense of the client is wrong. Improving the financial health of the clients should be the
prime target and profit achievement of the organisations
o Administering funds with prudence and transparency and accuracy – to avoid scams, frauds
and defaults, there should be a proper background and credit check in place before
administering funds to anyone. Also, subprime loans should be avoided at all times,especially
during bubbles and crashes
o Prioritization of ethics over client instructions – it’s true that clients come first but a sense of
moral responsibility towards the economy as a whole should encourage employees to decline
such immoral activities requested by client – and not be privy to clients’ questionable

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 behaviour – even at the risk of losing that clients’ business. This will help uphold the image
and integrity of the institution in turn bringing more business to the table.
o Legal is not ethical and moral – a knowledge of the difference between legal and moral
obligations is the key to an efficient functioning financial markets and economy as a whole –
choosing not to exploit loopholes and technicalities should be the approach

References

 “A Question of Ethics: Navigating ethical failure in the banking and financial services
industry” – CA ANZ (Chartered Accountants Australia New Zealand)
 https://economictimes.indiatimes.com/industry/banking/finance/banking/chanda-kochhar-
a-huge-beneficiary-of-videocon-loan/articleshow/63547816.cms
 http://www.accounting-degree.org/scandals/
 https://www.scribd.com/document/35586209/Unethical-Practices
 “The psychology of unethical behaviour in the finance industry”- Marko Pitesa
 https://www.morganintl.com/blog/finance-treasury/5-key-ethical-guidelines-for-best-
practice-in-financial-services/
 https://blog.iese.edu/ethics/2014/06/25/ten-recommendations-for-the-necessary-ethical-
rearmament-of-banking/
 “Ethical Issues in Financial Activities” – Jean Michel Bonvin, Paul H. Dembinski
 “Insider Trading 2.0 -The ethics of information sales” – James J. Angel, Douglas M. McCabe
 “Ethical Issues in Financial Services” – Thomas W. Dunfee, Robert Gunther
 “Ethical Issues facing stock analysts” – J. Paul Newsome

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