Ethical Orientation in Banks
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Over the past 30 years, the banking sector has been characterized by increasing attention to ethics, which intensified as a consequence of the global financial crisis. Banks have the privilege and responsibility of directly interacting with a wide and diversified clientele and are supposed to base their long-lasting relationship with this clientele on trust, transparency, and proper behavior. Special types of banks, “alternative” to traditional banks in what they consider ethical behavior, have been increasingly present in the market. While alternative banks still cover a limited market share in terms of intermediated funds, awareness on their values and operational choices has been spreading throughout the financial community. The concept of social impact finance, currently permeating the financial sector, is a product of such a process. One interesting question, therefore, emerges: are these banks truly special and clearly distinguished from traditional banking? A second concern focuses on the role that these banks may play in the financial system due to a more intense ethical orientation. To answer these questions, it is necessary to outline a suitable analytical framework. Differently from the common approach, which is purely based on banks’ investment choices, this contribution draws from some cornerstone work on ethical business and is enriched by the original view of a classical author of the Italian business economics academic community. The resulting holistic approach bases banks’ ethical orientation on the institutional nature of financial intermediaries, their ultimate strategic goals, and their role in the economy and in society. To make the analysis more concrete, the suggested theoretical framework is used to study two types of banks that are commonly considered particularly ethically oriented: cooperative and alternative banks. It emerges that a small size may be critical in facilitating the achievement of a high degree of ethical orientation. The conclusions drawn based on these cases are used to offer some critical perspectives on the role of ethics in the current overall banking system.
KeywordsEthical banks Alternative banks Cooperative banks Ethical financial products Transparency Social impact Marginal clientele
Over the past 30 years, the banking sector has been characterized by increasing attention to ethics, which intensified during and after the global financial crisis. The tremendous increase in nonperforming loans in the USA, the worldwide diffusion of the credit risk embedded in US banks’ loan portfolios through securitization, and the consequences on financial systems and real economies led the international community to attribute to the banks’ lack of professional deontology the role of trigger of the whole devastating process. In fact, other financial intermediaries as well as other nonfinancial actors (e.g., political, institutional, or private operators) played a significant role. However, banks, especially retail banks, still retain the privilege and responsibility of directly interacting with a wide and diversified clientele and base their long-lasting relationship with this clientele on trust, transparency, and proper behavior.
These aspects have indeed been examined with reference to the largest banks in the world. On a different scale, special types of banks, which are self-defined as ethical or alternative to traditional banks in response to what is considered pervasive unethical bank behavior, have been increasingly present in the market. Initially, in the 1990s, these intermediaries sparked skepticism in the traditional banking system. On the one hand, bankers felt that the incidence of alternative banks was going to be minimal, and on the other hand, some bankers objected that the presence of banks self-defined as “ethical” questioned the idea that traditional banks could also be ethical. The adjective "alternative" may induce a perception of marginality. It is difficult to estimate the actual market share of these banks given that attributing banks to the “alternative” category is not straightforward. The FEBEA – European Federation of Ethical and Alternative Banks and Financiers – includes some cooperative banks but does not include some large, alternative, banks. The FEBEA’s total assets amount to 30.5 billion Euros (http://www.febea.org – last access July 12, 2020). Triodos Bank alone reports an amount of total assets of 12.1 billion Euros as of December 31, 2019 (http://www.triodos.com). Taking the example of Italy, Banca Popolare Etica, with its 2.1 billion Euros in total assets as of December 31, 2019, represents about 0.07% of the Italian banking system (http://www.bancaetica.it; http://www.bancaditalia.it – web sites accessed on July 12, 2020). As a matter of fact, these banks are still characterized by limited size, but awareness on the values and the operational choices they promote has been spreading throughout the financial community. The adjective “alternative” is used as these banks are actually “special” in their positioning and operations when compared to traditional banks, while their “ethical” quality is more difficult to assess, as will be explained in this chapter.
The concept of social impact finance, currently permeating the financial sector, is a product of a cultural debate that originated much earlier than the global financial crisis and is now inspiring the strategies of banks and other intermediaries of various size and geographic coverage around the world. One interesting question, therefore, emerges: are alternative banks truly special and clearly distinguished from traditional banking? A second concern focuses on the role that these alternative banks may play in the financial system, both in terms of the financial transactions performed and as a benchmark for traditional banks in their aspiration to adopt a more intense ethical orientation. To answer these questions, it is necessary to outline a suitable analytical framework. Specialness may concern the ethical nature of the banks or the way they choose and approach their market and offer their products. It is easier to assess specialness based on market strategies and products offered. However, this perspective limits the assessment to the surface of the problem. A study on the ethical nature of banks, instead, is particularly challenging, as it considers the fundamentals of ethical behaviors and their effects on banks’ governance. The heterogeneous ways in which to express an ethical orientation make it difficult to set a dividing line between “good” and “bad” banks’ actions. The nature of the problem is much deeper: it requires clarification of the inherent meaning of the adjective “ethic” from the institutional point of view.
A preliminary issue to be clarified is the relationship between the attributes “ethical” and “social” as they are often considered overlapping. Even Friedman (1970), in his liberal conception of the firm, weakens his position on wealth maximization by exploring the need for entrepreneurs to conform with the basic rules of a society, which are regulated by laws and ethical values. The corporate social responsibility (CSR) approach corroborates this view when it portrays the attributes “ethic” and “social” as interchangeable (see, e.g., Pava and Krausz 1996): actions and investment choices with positive social effects are considered ethical. However, these are different concepts, and an ethical nature is not necessarily determined by social relevance. This causal effect leads to denying the existence of ethical content in actions that are not socially important (Rusconi 1997). This contribution, shows that a wider view of ethics in finance, linked to the roots of the institutional nature of firms, may allow to understand the possible links between ethics and social impact.
This chapter is organized as follows. In the next section, a brief review of the concept of business ethics, which is applicable to the subsequent analysis, is based on some cornerstone contributions and is enriched by the original view of a classical author of the Italian business economics academic community. The resulting conception of ethics in business is then applied to the banking case. To make the analysis more concrete, the suggested theoretical framework is used to study two types of banks that are commonly considered particularly ethically oriented. The conclusions drawn based on these cases are used to offer some critical perspectives on the role of ethics in the current overall banking system. The literature used draws from different fields, but this contribution is mainly based on a managerial approach to ethics in banking.
Ethics in Banking
The envisaged link between ethical banking and social actions is a consequence of the fact that, in practice, several initiatives of ethical finance concentrate on their social utility: financing socially worthy projects (e.g., those supporting the preservation of life, peace, or the environment); actions connected to the facilitation of access to financial services by operators traditionally considered unbankable (i.e., because they are characterized by features such as a small size or the absence of sufficient collateral); the promotion of nonprofit organizations; and the exclusion of investments in non-socially worthy sectors (for a comprehensive review of these criteria, see Renneboog et al. 2008; Viganò 2001). As a consequence, the so-called ethical products offered by banks (the adjective “ethical” is here used for simplicity, without implying the expression of a judgment on the real products’ ethical quality, which depends on the bank’s overall ethical orientation; see section “A Holistic View of Ethics in Banks”) often concern forms of savings that foresee the relinquishment of all or part of the interest earnings and the assignment of the corresponding amount to socially worthy initiatives. Funds can be offered as grants or loans or capital participations; the depositors may not only give up some interest earnings but also directly invest their own capital in such ventures. Stanwick and Stanwick (1998) agree on the limitations of this approach. The ethical orientation of a firm goes beyond its CSR, and evaluating the sectors of intervention is insufficient. With specific reference to banking, judging ethical orientation based on investment choices related to social responsibility, such as promoting actions in favor of and opposing actions against specific social or moral values, relies on the value system of the proponent. As an example, interest on loans is a practice that is not accepted in Sharia-compliant finance but is applied elsewhere and practical actions may differ according to degrees of tolerance (on Islamic ethics and ethical attitudes of Islamic bank managers, see Rice 1999 and Quttainah and Almutairi 2017). Islamic experts stress that the simple respect of Sharia law does not ensure ethical behavior and, according to INCEIF, the Global University of Islamic Finance, considering Islamic finance automatically immune from unethical practices is a misconception (https://www.inceif.org/misconceptions/ - Accessed on June 7, 2019).
Over the years, several studies have analyzed the implications of such choices on the performance of financial intermediaries (and firms in general), and there are no unanimous findings on whether ethical behaviors, measured according to this reductive approach or exclusively based on CSR or on specific moral values, positively or negatively affect performance. Rudd (1981) says that institutional investors’ choices based on exclusion criteria imply higher transaction costs, higher labor costs, and higher risks. Some authors even foresee the possibility that the spreading of news on social responsibility would be detrimental to the firm if it induces to perceive that the company is making extra profits (Boyle et al. 1997). Other studies state that socially responsible firms perform as well as or better than other companies. Stanwick and Stanwick (1998) stress that profitability may act as a stimulus for a socially responsible action. Pava and Krausz (1996) affirm that CSR may indeed increase financial performance, but they also contemplate the self-promotion effect on companies due to CSR actions, the case of measurement errors, or the possibility of reverse causation, where only highly profitable companies may afford CSR actions. An extensive analysis by Renneboog et al. (2008) of different international studies highlights the diversified results and the complexity of the approach. In the specific banking case, Simpson and Kohers (2002) report a positive relationship between corporate social and financial performance, while Soana (2011) does not find any significant statistical link. Hillman and Keim (2001) suggest that the effects of CSR on performance depend on the intended meaning of CSR. If CSR means better relationships with stakeholders, there should be an improvement in the firm’s value. In contrast, a reductive view that only selects some sectors to be avoided may decrease the value of the firm. The contrasting results may come from the difficulty of defining and measuring social and ethical values, the lack of a theoretical framework, the lack of data and information, the risk that ethical choices are simply ostensible (Rusconi 1997; Paulet et al. 2015 explicitly refer to window-dressing attitudes), or different perceptions of ethics given individuals’ backgrounds or changes in life phases (Loe et al. 2000; Lewis and Unerman 1999). Therefore, an approach to ethical finance and ethical banking based on only specific investment choices appears limited. Nevertheless, with the aim of obtaining objective indicators of ethical orientation or of elaborating performance indices of socially responsible companies, this approach was extensively followed. One of the pioneering indices in this respect was the Domini 400 Social Index. This index was created in 1990 and subsequently became the MSCI KLD 400 Social Index. The index highlights companies with high Environmental, Social and Governance (ESG) ratings and excludes companies selling products with negative social or environmental impacts (https://www.msci.com/msci-kld-400-social-index Accessed on June 7, 2019).
A Holistic View of Ethics in Banks
Objectivity in ethical judgment may be complex, but denying the possibility of setting an evaluation frame would mean acknowledging ethical relativism. While, in banking, an analysis of single actions without verifying coherence with the more general ethical principles often prevails and is typical of the reductive view, a holistic approach to a firm’s ethics offers a wider perspective. The holistic approach remains focused on general plans, without entering into concrete situations in which ethical dilemmas would need to be faced (Rusconi 1997).
The holistic approach to banks’ ethics presented in this chapter bases the analysis of banks’ ethical orientation on the institutional nature of financial intermediaries, their ultimate strategic goals, their role in the economy and in society, and their effects on governance. The distinction between ethical and unethical actions is less neat than it is under the reductive view, as this approach does not propose directly measurable criteria. Rather, this approach questions these apparently objective criteria and proposes a frame through which to evaluate the ethics and social value of a firm (bank) as a whole.
A widespread conceptual framework aligned with this approach is stakeholder theory (see, among others, the illustrative work of Freeman and Reed 1983), in which groups other than shareholders (i.e., workers, customers) express their expectations regarding the firm’s actions. Firms must aim at balancing the satisfaction of the economic interests of all entities, even when they conflict with each other. Some original work on the importance of reconciling the expectations of different actors surrounding the company originates from the earlier Italian classical school of business economics. For the purpose of this analysis, reference is made to the Italian business economist Carlo Masini (1974), whose view of the nature of the firm can be adapted to the banking case.
As extensively explained in Viganò (2001), on which the following description is mainly based (unless differently indicated), Masini’s approach differentiates from stakeholder theory as he overcomes the conflicts between the objective of the firm and those of the actors within and surrounding the company. Masini defines the company as a socioeconomic institute, a complex of elements and factors, of energies and personal and material resources. The company is a long-lasting, dynamic institution that appears as a unity, where elements and factors complement each other to achieve the common good. The enterprise is autonomous but must take into account connections with other components of human society. Therefore, the goals of the enterprise must coincide with the goals of the people for whom it is created and managed: these persons inject energy and personality into the company. This aspiration to achieve the well-being of people accounts for the ethical character of a company. Masini goes further by distinguishing between “economic interests” and “interests of other kinds,” which represent the conditions necessary for the company to be respected and enhance the value of economic interests. Institutional economic interests must merge; through the firm, different interests pertaining to different persons pursue the goals of the firm’s socioeconomic community, allowing the achievement of a level of common good that, otherwise, could not be reached. The complementarity of expectations is essential.
Puts the person at the center of its interests and institutional goals for the common good.
Is oriented by a constituency that expresses the institutional objectives and, at the same time, considers the expectations of other actors who are external to the company but are directly or indirectly affected by the bank’s actions, integrating the firm’s strategy.
As a consequence, sets its targets by considering profit a binding condition for the survival of the company rather than a goal. The firm’s ethical goal is the satisfaction of human needs to achieve the common good.
This approach is necessarily generic regarding the definition of common good and does not offer an action evaluation grid based on the firm’s daily choices. Rather, this approach offers background criteria for concrete choices based on the social nature of a firm and its continuous aspiration to improve society. In this way, the dichotomy between ethics and social action is overcome.
Applying these concepts to banking implies abandoning the widespread reductive approach of a strict relationship between investment choices and ethical orientation: an investment strategy focused on minorities, on the needy, and on the environment entrenches the risk that unethical behavior is masked by apparent ethical investment strategies, with little impact on an authentic social responsibility toward the stakeholders and the world. For example, investing in a green fund can represent a way to feel or appear good rather than an expression of a deep involvement in the environmental problem. Based on the preceding discussion, instead, the socio-ethical nature of the bank is justified by the efforts to make the intermediation process excellent to satisfy the goals not only of shareholders and workers but also of investors and borrowers and, eventually, of the community. This ethical mission coincides with the bank’s final institutional and entrepreneurial goal.
In the case of banking, while profit and wealth maximization are normally considered institutional goals, banks may have a different governance (Becht et al. 2011) and different goals. Sometimes, goals depend on the conflicting interests of workers, clients, and shareholders. However, if the definition of constituency given by Masini (1974) is considered, conflicts between the goals of the constituency and those of the institution reveal that the constituents are not correctly identified. The constituency must include all the possible entities interacting with the bank; the agency problem deriving from the separation between ownership and control is overcome through corporate governance rules that align the expectations of all constituents. The balance of the contrasting forces relies on tools such as contractual and incentive strategies favoring the intended behaviors. This contractual view attributes an important role to explicit and implicit prices in giving the suitable signals to satisfy the expectations of the constituency (Mottura 1998). When price conditions are not suitable, the bank loses its signalling role. An example can be found in lending: if the bank follows an adequate evaluation process, loan pricing is a signal to entrepreneurs regarding the quality of their projects, which may also induce a potential borrower to give up the intended project if the price shows that the project is likely to fail.
Effectively satisfy borrowers, with the aim of making the evaluation process excellent and guaranteeing the satisfaction of these customers
Effectively satisfy investors by offering risk/returns options suitable to their desire to develop their savings/consumption choices over time according to their preferences
Preserve profitability, which allows the bank to operate over the long run and to continue offering effective services, to contribute to the stability of the financial system, and to respect the interests of all actors linked to the bank
As is indicated, there is no conflict between the goals of the constituency and those of the institution since the persons who express these goals are all strictly linked to the institution itself. Noninstitutional goals, instead, are external and represent the conditions for the bank to successfully operate in society (Masini 1974). In the figure, while acknowledging the importance of internal signals of success (analyzed later in this chapter), the focus of the examples is on market signals to emphasize the importance of always aiming at being aligned with the market. Specific indicators of success may differ in different types of banks. However, all banks must ensure that the market is expressing appreciation by positively responding to the conditions proposed for products and services.
Some studies claim that ethical banks should achieve social and economic profitability at the same time (see the discussion proposed by San-Jose et al. 2011). In our view, long-term financial sustainability is a consequence of the capacity of these banks to conform with the stakeholders’ utility functions, which eventually determines the terms negotiated and the bank’s operational conditions. In this respect, while Bollen (2007) supports the view of investors sensitive to investment attributes different from risk return, Renneboog et al. (2008), in a study on socially responsible investment with an extensive literature review, find hints of this sensitivity but not an unequivocal demonstration of it. The following analysis explains that investors’ and other stakeholders’ sensitivity to banks’ efforts to pursue social objectives becomes a key factor in banks’ financial and overall success.
Quadrant A includes banks that innovate by fostering their ethical standards due to an increased awareness of ethical orientation. The pursuit of ethical behavior is, for these banks, strategic and an integral part of their objectives. Quadrant B refers to banks that declare they are aware of and constantly monitoring the ethical content of their own behavior and of the products they offer. Consistent with this approach, such banks do not believe they need specific actions to increase their ethical intensity (in this way, they may approach the ideal model). Quadrant C includes banks that, despite offering products commonly classified as ethical, do not declare that they perceive a culture of ethical behaviors. The positioning of these banks, therefore, corresponds to a marketing strategy aimed at satisfying the segments sensitive to the ethical-social content of the products offered. Quadrant D includes banks that are neither sensitive to a particular ethical tension nor interested in ethical products.
To refine the analysis, it is necessary to clarify the meaning of so-called ethical products. Savings collection products that relinquish remuneration for allocation as charity can be correlated with the banks of quadrant C. These products are easy to pack and offer: investors’ only limitation is that they give up part of their remuneration. Thus, these products may be promotional instruments that target segments that are aware of their link with the world of social responsibility and do not involve high risk on the part of the intermediary. A different case is the savings product aimed at direct investments in ethical sectors of high social value. These products are typical of banks in quadrant A, which are willing to eventually take on greater risk to implement their ethical aspirations. The banks of quadrant B, on the other hand, do not develop ad hoc products. Instead, within the ambit of their activity, these banks identify market segments worthy of attention. The difference between the banks of quadrant B and those of quadrant A is in the need, for the latter, to change their governance and organizational models in order to innovate their approach and offer products that, according to their view, show a higher ethical intensity.
Relating specific banks to each quadrant is problematic. First, banks may change their attitude over time; second, the intentions behind the positioning cannot be assessed by simply looking at the public information. It is even difficult to identify a correspondence between the quadrants and bank categories with regard to their size, location, or legal status. While it may seem easy to link banks in quadrants A or B with smaller, local banks, it would be superficial to say that large, international, bank corporations cannot show a genuine interest in higher ethical intensity, although this goal might be harder to achieve in practice, as will be explained later in this chapter.
However, there are banks that, due to their institutional setting, to their choices in terms of the type of clientele served, or to their special link with the community, are more likely to be assigned to quadrants A or B. For example, with regard to the market perspective, investments in the non-profit sector or in support of so-called marginal clientele (Viganò 2001) are considered ethically oriented. Marginal groups rarely obtain bank financing because the determination of the viability of their projects necessitates a study based on complementary criteria rather than pure profitability, often due to the (perceived) risks and the high costs of serving them. Consistent with the critiques expressed with regard to the reductive view, a focus on these sectors may mirror a restricted vision of ethical finance. However, such a focus can indeed be included in an ethical banking strategy according to the holistic view. The ethical content of these initiatives does not lie in the product itself but is contained in the effort to identify and understand potentially bankable situations, which cannot be demonstrated under traditional evaluation parameters. What matters in the holistic view is that banks spontaneously (not as a result of public incentives) choose to widen their market to include areas in which other banks are not able to operate. In doing so, these banks satisfy the expectations of entities (stakeholders) that otherwise would be excluded, which would cause an overall decrease in the common good.
From a historical perspective, in periods of poverty, an ethical orientation focused on serving marginal sectors is more naturally pursued by banks. Cooperative banks, operating in several countries since the nineteenth century and now widespread in poor countries, are considered good examples of ethically oriented banks as they have a natural pool of marginal clientele. Serving marginal clientele becomes a strategy – although not the only or most relevant strategy, to increase the ethical orientation of such banks. Indeed, the cooperative banks’ ethical orientation aligning with the holistic view is the outcome of their governance model. Another case is represented by some alternative banks. The next section elaborates (mainly drawing from Viganò, 2001) on the cooperative bank model, while the subsequent section examines alternative banks, their innovative governance and product offerings, and their possible specialness in the banking system.
Ethics and Cooperative Banks
One of the main institutional objectives of cooperative banks has been to promote the financial inclusion of marginal sectors, usually the poorest sectors, not only access to loans but also education, which fosters monetary savings. Mario Masini, in a background paper for the World Bank World Development Report of 1989 entitled “The Italian ‘Casse Rurali e Artigiane’ (1880–1920s),” considered organization and governance key elements allowing cooperative banks to operate in marginal segments. Indeed, these features make the cooperative banks model more ethically oriented than other bank models. In fact, members of cooperative banks form a complex body, acting at times also as depositors, borrowers or even workers in the bank. Therefore, the alignment of the interests of the different stakeholders portrayed by Masini (1974) is achieved almost automatically. Moreover, membership in such a bank is normally instigated by the shared principles of mutuality and democracy; the member base is, then, homogeneous in its interests and goals (Di Salvo and Schena 1998).
The centrality of members is the dominating element that reflects the quality of the contractual relationships of the bank. In particular, the common denominator of being members alters the utility of the relationship among the member-managers/workers, the member-depositors, and the member-borrowers. For member-depositors, the expectation of remuneration from savings may be mitigated by the sense of belonging and the possibility, as a member, of influencing the strategy of the bank (Guinnane 1997). Member-borrowers are probably less sensitive to loan costs given their expectations regarding bank profit sharing. These members care about the solvency of the bank while they ask the bank to share the risk of their project. As in the case of member-depositors, the sense of belonging to the cooperative and the quality of a long-lasting relationship reduce agency problems and contribute to smooth potential recovery processes. High-quality bank-customer relationships are actually costly, but peer monitoring among members may contribute to keeping these costs under control. A potential conflict between depositors and borrowers (highlighted by Smith et al. 1981) may arise due to the higher risk aversion of depositors, but in addition to other benefits of being members, the possibility for both parties to be, at times, depositors or borrowers (depending on their life cycle phase) makes this conflict unlikely. Indeed, the peculiar corporate governance of cooperative banks, centered on the members, makes it easier to implement the model of ethical orientation inspired by Masini (1974). The practical implementation represented by the attraction toward marginalized sectors is made possible by the specific relationships among the different stakeholders that are underpinned by the characteristics of being members of the bank.
Another feature supporting the ethical orientation of cooperative banks is the dividend distribution strategy. Commonly, part of the annual profit is not distributed and is either capitalized or given to the community in the form of social investments or charity. Funds granted to the community may be considered social dividends. Members draw some utility from this activity, even if it is not financially profitable. However, the ethical orientation and the propensity for charity do not soften the profitability constraint. These banks may show higher interest margins (as described, e.g., by Kaushik and Lopez 1996) and higher operating costs than other types of banks. This dynamic is consistent with a member-clientele sensitive to the quality of the relationship and of the service received and ready to discount this qualitative advantage from the financial component of the contract they sign with the bank. When the financial sustainability constraint is respected, profit allows the social function to be exercised as a service to members and to the community in the long run and to satisfy the constituency of the bank, which comprises different stakeholders, due to the members’ common bond. Over time, in several countries, cooperative banks evolved through reorganization and the restructuring of ownership rules modifying the dynamics just presented: access to nonmembers or growth may have loosened the common bonds and increased agency problems. In recent periods, the specificity of cooperative banks has been discussed: Kotz and Schmidt (2017) stress the softer effects of the global crisis on German cooperative banks due to their business model, while the critical evolution of such banks during the global financial crisis in Cyprus is described in Kleanthous et al. (2019). Butzbach and von Mettenheim (2015) focus on the competitive advantage of several managerial aspects of “alternative” banks (among which they include the cooperative ones). D’Amato and Gallo (2017), in contrast, show governance deficiencies of Italian cooperative banks during the global crisis. In making the difference, size may be a strategic element. The case of alternative banks further confirms this point.
Ethics and Alternative Banks
Alternative banks claim to be inspired by explicit ethical principles, with the main goals of contributing to the benefit of society as a whole and caring about social welfare, the environment, and, more generally, the progress of the world. On these principles, see, among others, FEBEA (http://www.febea.org). A significant case is Triodos Bank (http://www.triodos.com), founded in the Netherlands in 1980 and expanded in other European countries. Alternative Bank Schweiz (http://www.bas.ch) in Switzerland and Banca Popolare Etica in Italy (http://www.bancaetica.it) are other examples. The names of these banks reflect nuanced self-perceptions, ethical vs. alternative, as discussed above (Web sites accessed on June 7, 2019). A mainstream interpretation of these banks’ behavior relates to their ability to satisfy the expectations of a market niche sensitive to the social impact of financial transactions (social investors) by offering specialized products: their specialness indeed pertains to the values they claim to follow in defining their objectives, strategies, operations, and products. While it may appear obvious, defining the criteria on which to assess the ethics of the behavior of these banks is a subtle exercise, as explained earlier in this contribution. Alternative banks can be analyzed according to the reductive perspective focused on specific investment choices or according to a deep and robust holistic analysis of the ethical nature of banks. In following the holistic approach, the way this banking model meets stakeholders’ expectations on the banks’ ethical orientation has an impact on profitability; size may eventually limit specialness given the profitability constraint. The underlying hypothesis is that the larger these banks become, the harder it is to meet stakeholders’ expectations, which are mostly based on a direct relationship with the bank and on their control over transactions. Size emerges as a key element for preserving specialness and ethical orientation.
Behavioral models for alternative banks are limited in number. San-Jose et al. (2011) investigate the differences between ethical and traditional banks and develop an index (RAI, Radical Affinity Index) for measuring specialness based on the most common characteristics of ethical banks: transparency and quality of information, placement of assets, alternative guarantees, and participation in governance. In what follows, transparency, information quality, and participation in governance are not only characteristics of ethical behavior but also necessary elements that allow alternative banks to achieve their social goals and be sustainable. Paulet et al. (2015) compare conventional and ethical banks with regard to strategic choices made as a consequence of the global financial crisis. By analyzing several cases, the authors highlight some of the operational aspects that differentiate alternative banks in practice and substantial differences in the business model, particularly the nonprofit maximization of alternative banks. The authors stress the local outreach of these banks. While agreeing on these well-known characteristics, this analysis shows that the main difference is caused by the governance model and the consequent size limit. Relano (2008), in a comparison with traditional banks, analyzes the effects of being an alternative bank on the structure of the balance sheet and shows that financial aggregates which originate form transactions with customers have a high weight with more emphasis on the original bank core business as compared to other banks. The focus, instead, is here on the structure of the income statement to explain how the optimal size choice is strategic if the aim is to ensure the quality of the relationship.
Drawing from agency theory and delegated monitoring in banking, hereunder, size emerges as a key driver of success. Size is considered in Diamond (1996), who states that the demand for monitoring by bank investors depends on the monitoring costs. When the number of investors is sufficiently high enough to reap the benefits of diversification, delegated monitoring costs can be reduced by issuing deposits, that is, a form of unmonitored debt. Haubrich (1989) points out that in banks, a key role is played by long-term relationships that exist in the lending activity but less in bank-depositor relations. In the case of alternative banks, though, relationship lending is far more relevant than in small-business lending, and a relationship-based approach is strategic on the deposits side as well. Jensen (2001) states that agency costs may increase under this approach, especially when the bank grows. This analysis will show that an optimal (limited) number of customers may allow the achievement of high-quality bank-stakeholder relationships and the achievement of breakeven and of the bank’s social goals. What follows elaborates on Viganò (2001) and Viganò and Castellani (2015); the formal approach followed in modeling the behavior of alternative banks is made here more descriptive (a formal representation of the findings is included in Box 1 in the Appendix).
The active role of shareholders/members in defining the bank’s strategies and the bank’s preference for social investments.
The capacity of depositors to select the investment conditions, i.e., the destination of the fund, and the possible charitable uses of their interest revenues.
The sharing of the bank’s mission by personnel, which can influence wage setting policies.
The presence of borrowers with risk-return profiles that may not meet the requirements of traditional banks: relatively low income, small size, (perceived) high risk, and loans intended for social impact projects. Some of these borrowers, defined as marginal clientele, may be the typical customers of microfinance institutions or cooperative banks, at least in their earlier stages (Viganò 2001, 2004).
Alternative banks enjoy economies of specialization with regard to evaluation and often set lending interest rates that are below-market rates. The target profit is not maximized but set at a level that allows the bank to be sustainable. However, if the bank can sufficiently control the key variables (cost of funding, overheads, and risks), then the profitability level could ideally align with that of traditional banks. The degree of control over these key variables depends on several factors: the preferences of clientele and expected remuneration of the (human and financial) resources that shareholders, depositors, and personnel make available to the bank. The analysis shows how the satisfaction of stakeholders’ preferences contributes to achieving both target profitability and a high level of specialness and ethical orientation. The leverages that alternative banks may operationalize to this end are discussed hereafter with respect to the different stakeholders: depositors, shareholders, borrowers, and the personnel.
i: market interest rate on deposits
Sad: degree of satisfaction of the social aspirations of depositors
Dc. degree of control by depositors over the destination of deposited funds
Xd: percentage points of interest rate that are forgone by depositors
σpd: degree of perceived bank risk by depositors
The depositor’s utility is a direct function of the net return (i–Xd) on the deposit, the depositor’s degree of control over the bank’s uses of funds (Dcd), and how far the bank meets the depositor’s expectations in terms of social returns (Sad). The depositor’s utility is negatively related to perceived risk (σpd). It follows that the bank has a special interest in showing its social impacts to keep the cost of deposited funds low. Depositors are given a remarkable amount of risk-free decision power regarding their funds’ destination, as they take neither the typical risks of direct lending to the target sectors nor the equity risk of shareholders. A greater Dcd increases depositors’ utility and decreases their perceived risk, which increases Xd. However, a stronger Dcd increases the bank’s costs: direct information and communication costs and an indirect loss of freedom in investment decision making with a suboptimal allocation of funds. Xd is also affected by perceived risk, σpd, but not real risk because the former is included in the depositor’s utility function. The greater the depositor’s access to information is, the more the perceived and real risks converge. If the bank is fully transparent and effective in its communication, depositors may accept less direct control (Dcd). Transparency and depositors’ control can be considered improper substitutes. If only a marginal portion of the depositor’s wealth is invested, as suggested by MacKenzie and Lewis (1999), the elasticity of the interest forgone by depositors to the perceived risk may be lower. This result may induce the bank to avoid large deposits, as the owners can be more risk averse. In summary, the bank’s degree of control over Xd (i.e., the ability of the bank to decrease funding costs) mainly depends on the bank’s social returns, depositors’ ability to meddle with the bank’s allocation policies, and depositors’ perceived risk.
In the case of pure shareholders, the utility function and the interpretation of its components are the same as those of pure depositors. By replacing the interest on deposits (i) with the dividend rate (d), Xs (the subscript s stands for shareholder) is the percentage of dividends the shareholder is willing to give up. The shareholder’s utility is a direct function of the net return (d –Xs) on the investment, the shareholder’s degree of control over the bank’s use of funds (Dcs), and how far the bank is able to meet shareholder expectations in terms of social impact (Sas); the shareholder’s utility is negatively related to the perceived risk (σps). However, while a depositor sets the net remuneration in advance, the shareholder accepts a reduced dividend, which is determined ex post. Shareholders’ control over the bank’s investments (Dcs) is not a special feature of alternative banks; furthermore, σps is also different from that of depositors since meddling with the bank’s investment strategies should be the natural role of equity holders. Therefore, the bank has less discretion in setting Xs and Sas is its main leverage, which confirms the importance of effective transparency and the pursuit of social impact. The case of the shareholder-depositor is similar to that of the pure shareholder, even though there may be a trade-off between claiming higher remuneration on deposits and equity. The case of a shareholder-borrower is unusual but occurs when membership is a condition for loan eligibility. Compared to pure shareholders, shareholder-borrowers may forgo part of their investment return (increasing Xs) to reduce the interest on the loans they receive. In fact, as shareholders, these borrowers have control of the investment, and they may be more tolerant of the risk regarding their loans. Opposite behaviors may also apply with possible offsetting effects on profitability.
The interest rate on loans (rc), which mostly depends on the borrower’s probability of default (pd) and may be aligned with the market rate (rm) or may be different (assuming zero bank fees).
The expected profitability of the borrower’s investment (ri).
The borrower’s satisfaction of social objectives (Sab) through their motivation to implement “ethical” projects. Borrowers often show unattractive combinations of risk returns, though they are coupled with high social value.
The expected economic and social returns (ri and Sab) increase the demand of loans, while the loan cost (rc) decreases it. The borrower is interested in Xb, i.e., the discount on rm, to obtain the subsidized interest rate rc = (rm–Xb). Xb should be inversely proportional to the borrower’s economic (ri) and social (Sab) return on the project. Xb also decreases if pd is high because of the borrower’s risk. An increase in rc may occur if business development services (BDS) are offered for free or at favorable rates (Lämmerman and Ribbink 2011). Financial advice and monitoring are useful to strengthen the bank-customer relationship. If BDS increase both economic and social returns, then the borrower is more willing and able to pay a higher interest rate. The offer of BDS allows alternative banks to apply interest rates close to market rates, even though, at the same time, there are associated operational costs. However, lending risk should decrease. Since the shareholder-borrower combination is unusual in alternative banks, these banks do not enjoy the advantage of shareholder peer monitoring, which is common in cooperative banks. This gap can lead to greater BDS costs. A final remark related to lending concerns the control that depositors have over the loan allocation. This control puts a costly and risky constraint on the bank, which should increase rc. The common concern of both depositors and borrowers for social values, a unique feature of alternative banks, may eventually become an obstacle rather than an advantage in the pursuit of bank profitability.
The personnel in alternative banks are often sensitive to the banks’ social impact and may accept below-market salaries. (i–Xw) (the variables used for depositors and shareholders are applied to workers with the subscript w) is positively related to workers’ degree of control over the bank’s investments (Dcw) and the bank’s ability to meet workers’ expectations in terms of social impact (Saw), while it is negatively related to perceived risk (σpw). Personnel have high control due to their easy access to information through a kind of “social insider trading.” This factor affects the perceived risk: personnel would ask for higher salaries (decreasing Xw) if the bank’s risk were higher than the market risk. Hybrid situations, where personnel are also depositors, shareholders, or borrowers, have effects on Xw, Xd, Xs, and Xb. Combinations of these variables may make personnel indifferent and achieve the same utility level. The effects on salaries (through Xw) seem the most important, but the directions of these effects are not completely straightforward. Lower wages can be compensated by higher returns on deposits for worker-depositors. However, personnel may prefer a combination of lower salaries and lower remuneration of deposits for greater social impact by the bank. Similar considerations can be made by shareholder-workers who consider the dividend one determinant of their income. As the bank is able to promote a positive image of itself, it can increase personnel commitment (Valentine and Godkin 2017), and motivated personnel will encourage the implementation of more socially oriented activities.
These leverages, as previously described, do not help control costs under all conditions. A study originally developed by Viganò (2001) and refined by Viganò and Castellani (2015) suggests that the specificity of the relationship with stakeholders supports the hypothesis of a direct link between the volume of transactions and the unitary costs of loans and deposits. In fact, an increase in the number of interactions (deposits, loans, or shareholders) may reduce the degree of control Dc of each category of stakeholder and increase their perceived risk (σp). Consequently, the share of returns that stakeholders are willing to forego, Xd, Xs, Xw, decreases if the bank does not implement adequate measures to re-establish stakeholders’ original degree of control, which increases operational costs.
The costs related to a higher Dc are likely to suffer diseconomies of scale. In fact, when depositors substantially increase in number, they perceive a loss of control that depends, for example, on the limited ability of existing personnel to follow the investment directions of a large number of customers. Only an incremental increase in scale would allow the bank to keep up with an increased number of depositors. A substantial increase in borrowers reduces the ability of personnel to directly monitor lending risk unless specific measures are taken. Paulet et al. (2015) assert that alternative banks are decentralized. Decentralization is likely to remain effective when control systems are in place. This approach would require a process redesign, the adoption of different lending technologies, which increases costs. Information and control costs are therefore related to the number of actors (depositors and/or borrowers or shareholders): the gathering and monitoring of information and the pursuit of a high level of transparency may become less effective. Unexpected and large increases in scale (expansion is expected to occur with an increase in the number of small transactions rather than with an increase in their average size given the characteristics of alternative banks) would not allow the bank to adequately fulfil the expectations of its customers and meet the high transparency standards and, through this, operate according to the stated ethical orientation. Transparency does not mean only public disclosure but high-quality information flows and proximity to stakeholders, as depicted in the holistic approach to ethical banking. The bank’s social value is important per se and as a positive marketing message. If the bank fails to promote its potential social value, it may also fail to reach out to its target market segments willing to offer resources under preferential conditions. It is therefore in the specific interest of the bank to be loyal to its mission and to disclose its success in the pursuit of social impacts to the market with adequate signals.
Dimension-related transparency, in addition to being a key factor of ethical orientation, is, therefore, connected with profitability. Jensen (2001) states that the reason why agency costs may be increased by socially oriented behavior is the loss of focus on performance measures. This contribution, on the contrary, shows the importance of performance measures as drivers of strategy because good performance allows banks to pursue the social objectives that, conversely, are a determinant of good performance. It also states that there is an optimal size that allows a bank to ensure the best quality and the lowest costs of control. On size, Schminke (2001) found that members of larger organizations display stronger ethical predispositions. The specific relationships among stakeholders explain the contrasting result depicted here for alternative banks. In support of the conclusion in this chapter, Mitchell et al. (1992) focus on small banks’ personnel emphasizing internal ethical issues. Climent (2018) compares an alternative and a commercial bank after the global financial crisis and finds lower financial performance but higher growth in volumes of loans and deposits in the former. However, Viganò and Castellani (2015) found confirmation of the size limit based on the trends over 18 years of the main financial aggregates of the alternative bank they analyzed. They also found lower personnel costs (aligned with the current analysis) and lower cost efficiency than a group of comparable cooperative banks. Regardless of how large the potential market is, size is both a limit and the key determinant of alternative banks’ specialness. Upper and lower bounds of bank size can be identified. Below the lower bound, the breakeven may not be achieved, and above the upper bound, a change in scale and organizational setting is necessary to serve a greater number of customers, likely entailing a loss of quality in the relationship with customers. An analytical representation of how to define these bounds is offered in the appendix, Box 1. With an increase in size, a more structured organization and a delegated monitoring system may increase complexity and reduce transparency. This result changes stakeholders’ perception of playing an active role in the bank’s activities and decision-making process and reduces the differences between alternative and traditional banks.
Critical Perspectives on the Role of Ethics in Banks
From the previous analysis, it emerges that all banks have an embedded potential ethical orientation that is externalized when they are led by the desire to satisfy of the expectations of stakeholders to achieve the common good. The ideal, holistic model presented in section “A Holistic View of Ethics in Banks” depicts the different driving forces of this attitude. Alternative banks are an application, and not the only one, of this principle, which is eased by the specific nature of their stakeholders. It is not a conceptual revolution but a significant innovative attitude that allows the widening and completing of the market.
In fact, alternative banks’ focus on the social sensitivity of a particular market niche and their consequent strategy of product differentiation allow them to be competitive in their target market against traditional banks. Alternative banks offer a whole range of sophisticated financial and nonfinancial services to depositors and borrowers, and they disclose the social impact of their activities. The question of how to measure social impact is a highly debated subject (see, for the case of microfinance, Hulme 2000); however, these non-price competitive strategies meet the expectations of their “alternative” customers and make the bank ethically oriented. The stronger efforts and higher innovation capacity that are required to address the target market mirror an ethical orientation. Another signal is represented by the pursuit of transparency, whose importance is increasingly stressed as a worldwide, cross-cultural value (Vaccaro and Sison 2011; Neves and Vaccaro 2013). San-Jose and Cuesta 2018 foresee transparency as first element in their RAI index; they also applied the index and focused on transparency with reference to Islamic banking; for an ethical identity disclosure index for Islamic banks, see also Rahman et al. 2016).
The particular ethical orientation of alternative banks emerges from the previous analysis, but the relationship between traditional and alternative banks is a rather controversial issue. The radical position of some ethical finance supporters (especially in the past) is that there be a clear separation between the two to avoid contamination. Isolating alternative finance from the traditional sector, besides being impractical, is not desirable, as the ultimate objective of the promoters of ethical banking is to induce traditional banks to rethinking their choices in favor of new approaches to socially worthy actions.
Reality shows that there is not a clear-cut distinction between alternative and traditional banks. As depicted in section “A Holistic View of Ethics in Banks”, while some banks are barely sensitive to ethical values, others offer only so-called ethical investment products and adopt social impact measures as a marketing strategy, but some traditional banks are effectively concerned with sharing ethical values and information with their stakeholders and aim to meet stakeholders’ expectations and have an impact on society by increasing social value. Even when these attitudes are stimulated by the search for a reputation to foster financial performance in the long run, the fact that development and marketing objectives act as stimuli for an ethical orientation cannot be criticized: it may be a first step toward a thorough response by banks to ethical issues. From this perspective, the boundary between traditional and alternative banks becomes blurred, and the phenomenon of alternative intermediaries can be seen as a moment of market completion, which may eventually lead to a process of progressive integration.
Indeed, some traditional banks have an inherent ethical orientation and are the closest banks to the ideal model presented in this chapter. A certain degree of physiological discrepancy from the ideal model is intrinsic in the imperfect human nature and in the institutions created by human beings. Physiology may turn into pathology when the levers of good governance are out of the bank’s control. This result may happen for several reasons but is probably more likely to happen under specific conditions, particularly under certain size conditions. Ideal growth should take advantage of economies of scale and scope without losing control. With growth, effective delegation mechanisms must be established. Size is critical for alternative banks but is also a strategic element of success or failure in traditional banks in relation to developing an ethical orientation. In large banks, a more structured organization increases complexity and may reduce transparency and weaken the bank-customer relationship, which is considered a key factor in the success of banks (e.g., Linsley and Slack 2013, highlight the role of relationships in an ethic of care approach, which was lacking in the critical case of Northern Rock bank). In fact, formal procedures, the delegation of power and incentive systems, structured monitoring, and automatic data treatment require that the organization is perfectly aware of any single process in order to achieve a satisfactory bank’s performance and the aim of responding to stakeholders and to society about behaviors.
The global financial crisis proved that in some banks internal organization and control systems were not sufficiently fine-tuned to avoid distortive behaviors that ultimately led to banks’ financial distresses and failures. The crisis has surely been the outcome of several contributing factors, including those that were external to the banks. An interesting work by Schoen (2017) offers a revision of the main phases of the crisis and suggests some perspectives through which to reflect on the ethical behaviors of various actors (among them, mortgage brokers and lenders or rating agencies and regulators). Overall, the sudden public discovery of an unbearable level of risk revealed that internal governance was weak. If banks had put in place effective governance systems that not only constantly monitored the overall risks taken but also detected eventual deontologically unacceptable behaviors, the distortive process that spread worldwide could have been limited. In a healthy organization, uncontrolled growth in credit granting with limited or no effective credit risk evaluation would not be tolerable. In contrast, the euphoric attitude toward innovative risk negotiations coupled with distortive incentives to managers was not monitored.
Observers point out that this phenomenon was exacerbated by a period of weak regulation (Schoen 2017). Regulation may, in fact, contain critical behaviors and drive banks’ choices. However, when regulation substitutes for internal effective governance, the outcome may not be the intended one. In this respect, Kane (2018), in an original interpretation of the role of public interventions in large bank rescues, explains the limitations of regulation and suggests new moral standards interlocking the main players (in his case, the government and bank managers). Bank regulation is increasingly sensitive worldwide and sets standards in terms of governance with compulsory formal internal control processes for the various strategic functions. Many banks are also adopting internal ethics manuals or comply with regulations that encourage a higher ethical standard. Ethical codes may have some impact due to their communication effects (Valentine and Godkin 2017). However, if these standards are not actually embedded in the governance system, they remain just guidelines with limited effectiveness (see also Hurley et al. 2014). Kane (2018) refers to the Dunning-Kruger effect (related to failing to recognize personal limitations) and depicts the self-overestimation of banks’ (and regulators’) skills, making them unaware of the injustice perpetrated during the global financial crisis. Kane evokes as an effective measure the increased individual liability of bank managers (specifically, in too-big-to-fail banks), which would lead them to comply with Kantian ethical imperatives, particularly with regard to treating individuals as ends and not as means. Other works stress malpractice and distortive behaviors. An extensive book by Boatright (2010) analyzes the relationship between finance and ethics and offers different practical perspectives with respect to financial markets and financial services, highlighting critical aspects such as insider trading, the risks originating in the different operations or in governance. Some observers claim the need to regain basic values, such as integrity, trust, responsibility, professionalism, and the quality of services (Cowton 2010; Congleton 2014). While in the reductive approach based on investment choices, transparency is necessary at least for communication purposes, it is actually a prerequisite of a holistic ethical business attitude, where honesty drives the achievement of the common good. In turn, this self-regulation (i.e., governance oriented toward long-term financial and social sustainability) makes, in the holistic view, external regulation more effective and complementary.
Implementing the ideal model in large entities requires that the governance, internal organization, processes, and control systems be perfectly aligned with the highest objectives of the bank. Organizations are made by humans, and innermost human behaviors are hard to monitor. However, banks must put in place incentives and controls that, on one side, keep the ethical awareness and the motivation of personnel aligned with the bank’s overall objectives and, on the other side, are effective in detecting distortions. The extreme diversification of intermediaries and contracts in recent decades (Rajan 2005) has inhibited a full understanding of the underlying management and decision processes. Banks are currently operating in economies with highly diversified and often highly volatile stages of development, and technology can make bank operations leaner but less personalized. In these complex organizations, establishing high-quality standards and alignment can increase costs that are likely to be compensated for by the long-term perspective, as portrayed in the ideal model. The alternative is that the banks face the highest risk of losing control over their operations, leading to unsustainability. The possible short-term profits created by such a practice would be largely offset by the very plausible negative consequences, which would occur in the medium-long run. The global financial crisis offers clear evidence: the maximization of short-term profit with limited investment in quality standards led to financial distress. This has also been a lesson learned by bank stakeholders who lost trust in their banks (especially in the large ones, as analyzed by Hurley et al. (2014)) and became aware of the need for increased ethical, long-term orientations in banking.
The future will reveal whether this seemingly trivial but in fact very powerful intuition will be internalized by banks and their governance systems. Especially in this post-crisis period, when the hard consequences still need to be overcome by banks and when competition exists not only among banks but also between banks and nonfinancial operators that are increasingly entering the financial service market, differentiation strategies may matter. Showing an apparent ethical orientation as a diversification signal would be a temptation, but it is not resolutive. Such a solution may help in the short run to attract some customers, but what truly matters is an ethical orientation embedded in daily operations and the ability to show this strong commitment to the clientele.
To redirect banks’ incidental or deliberate diversions from the ideal model, from physiological to pathological cases, no rules or contingent remedies can suffice; the long-term perspective is required. Changing an organization and its culture means working with subjective and complex relationships (Connel 2017). Laouisset (2009) suggests, in the case of UAE banks, a “balanced multi-dimensional virtuous scorecard (i.e., material, intellectual, emotional, volitional and spiritual).” Eventually, turnarounds are demanding and require generational change to be successful. Awareness is essential to this end. Experiences of alternative banking are case studies for traditional banks and act as one driver. Alternative banks’ small size may represent an advantage, as explained above, but their overall attitude can be a benchmark that can be adapted to larger banks. Another driver to increase awareness and innovative bank behavior is represented by a demand for financial services that are increasingly responsive to ethical issues. The pressure of a sensitive public opinion (and market) will probably be a very powerful element in the process of embedding an ethical orientation in banks. Recent positions taken by several cross-generational movements in support of the environment are a good example of driving forces for a better world. Specific actions aimed at raising concern about banks’ ethics have been at the center of the alternative bank movement. What will make these actions more effective today is, on the one hand, a constructive dialogue rather than an unfavorable attitude with respect to traditional banking and, on the other hand, a larger audience that is already sensitive to the promotion of attitudes in favor of the future of mankind and the planet. A third driver that can also influence public opinion is the contribution of research and the dissemination of ideas. This chapter, with no pretension to being exhaustive, is meant to add to this process.
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