The financial scandals of the past decade have left many Americans wondering whether or not Wall Street is an inherently immoral place. Does finance attract people who are comfortable with doing morally dubious things? Or, perhaps worse, does it simply turn good people bad?
Maureen O’Hara, a professor of finance at Cornell University’s business school and the author of the recent book Something for Nothing: Arbitrage and Ethics on Wall Street, would say no to both questions. In her book, O’Hara provides a detailed accounting of common financial strategies, and then analyzes recent scandals, weighing in on whether or not the strategies at play in them were unethical.
One of her main arguments is that the moral boundaries that can be so apparent in everyday life can be difficult to see, let alone adhere to, when financial firms and their workers are so often involved with purposely opaque financial products and strategies. This opaqueness represents a departure from the past. “What might have been obviously exploitative when contracts were simpler is now concealed by layers of cash flows transformed in ways that require complex calculations even to construct, let alone to value,” O’Hara writes.
Before getting into case studies of individual scandals, O’Hara walks readers through the concept of arbitrage, one of traders’ most basic tools. Arbitrage—the simultaneous buying and selling of a product from different markets to take advantage of price differences between them—is generally regarded as a morally neutral market strategy that’s at the heart of how anyone stands to make money in the markets. For instance, a trader who at the same time buys shares of stock for $10 from one party and at the same time sells those same shares of stock to another for $11 is practicing arbitrage. But in today’s markets, arbitrage often isn’t that simple. It can involve buying and selling products that have been artificially created, broken apart, and repackaged. It can involve buying and selling on several markets, in several currencies, adhering to and circumventing the financial and accounting rules of various countries. And these more complex maneuvers leave more room for bad behavior.
Take one of the first examples O’Hara gives: Lehman Brothers. In order to appear healthier in its quarterly reports and meet industry requirements for assets, the company would enter into repurchase agreements—essentially taking out short-term loans—that made some of the company’s illiquid assets (holdings that can’t easily be sold or traded for cash) look like cash. Repurchasing isn’t inherently bad; it’s a financing tool that plenty of banks use to get quick cash in exchange for securities plus interest. But in order to hide its debt—and the fact that it had used of financing to do so—Lehman Brothers executed the deal in London in order to skirt U.S. rules about how the deal would be reported. This strategy allowed Lehman Brothers to erase as much as $50 billion of debt from its books, according to O’Hara, thus hiding how dangerously leveraged the bank actually was. Ultimately, she deems this strategy ethically dubious, not because it helped precipitate a financial calamity, but because the strategy was set up to avoid the law.
Her book offers numerous such case studies of financial scandals. She uses LIBOR rigging, the London Whale, and Goldman Sachs’s Greek currency swaps to show the intricate mechanics of how complicated arbitrage and its related strategies can become. These examples also show how finding a new spin on an ethically acceptable principle—arbitrage—can easily veer into morally questionable territory. O’Hara offers a verdict on whether or not a certain tactic was ethical or not. Some, such as lying about the quality of loans that were packaged and sold to government entities like Fannie Mae and Freddie Mac, are wrong anyway they’re viewed, she argues. But then there are more nuanced questions, such as whether or not it’s immoral for a bank to sell mortgages that it wouldn’t want to hold on its own books. This, O’Hara finds, isn’t unethical, since the market and other buyers have the ability reject bad products that are being sold, as long as they aren’t misrepresented.
So, even though not all behavior on Wall Street is morally suspect, some is. What makes the industry conducive to the violation of ethical norms? O’Hara cites two universal cognitive biases that may plague the financial world: “motivated blindness” and “indirect harm.” Motivated blindness essentially suggests that people will see what they want to see, overlooking information that suggests that what they’re doing may be bad as long as their actions are beneficial to them. This can be especially problematic when incentive structures are flawed, such was when workers are rewarded for dubious things like opening fake accounts for real customers. Meanwhile, the indirect-harm theory says that when the victims of bad behavior are far removed from bad actors, they don’t seem real, and thus don’t provoke enough sympathy to curb unethical behavior. O’Hara suggests that the financial industry is set up in such a way that distances actor from potential victim.
What can be done, then, about the industry’s hazy ethical lines? Regulation and additional laws, O’Hara says, are often a flawed and retroactive response to the problems that allow for bad behavior. That’s because regulation will always lag behind mutable financial products and the creativity of financial experts, whose first task is to derive a profit, often by exploiting loopholes and finding new ways to get an edge over competitors. “You can count on them to arbitrage their way around explicit rules, relying on the specificity of these rules to obviate their usefulness,” she writes. “In this context, the rules themselves incentivize the very untrustworthy behavior you seek to constrain.”
She suggests moving away from more rule-making and toward creating better ethical standards for all banks and bankers. A start might be implementing cultural changes that force bankers to reckon with the responsibilities that come with their job. O’Hara notes that the Netherlands is piloting a program that would force its bankers to take an oath similar to the one taken by American doctors. In addition to agreeing to abide by existing laws, the oath contains promises that bankers will be open, transparent, and remain aware of their obligation to society. No matter the solution, change won’t happen immediately—but O’Hara is optimistic that it’s possible.
The judgements of the book might be hard for many outside of the realm of finance to accept or agree with. O’Hara gives banks and bankers what, at times, feels like a lot of leeway on practices that seem at best unfair, and at worst deceptive. Her point isn’t to condemn the industry or push for radical change. Instead, O’Hara is careful to always keep the main goals of finance—solving problems and making money—front of mind. And her verdicts on ethics and suggestions for change reflect that. For those who want to work within the existing framework of finance to create change, her recommendations are nuanced and seemingly achievable. But those who are wholly disillusioned with the industry and demand radical change will be left unsatisfied.