ACCA's latest paper, Risk and Reward – tempering the pursuit of profit, published today , answers the question.
The financial crisis highlighted serious ethical failings in the financial services, not helped by the difficulty in enforcing ethical behaviour. There was a failure of "people risk".
Enforcing business ethics – ethics being defined as "principles or norms of behaviour regarded as desirable by the majority of society", according to Paul Makosz, a former consultant on ethics to the World Bank – can be done either through rules or principles.
In a rules-based system, everyone – the regulated, the regulator, and the public – knows exactly what is permitted. However, while popular, rules-based approaches have flaws that have been exposed by the crisis. Chief among these is that rules define what they don't define. This sounds odd, but by explicitly outlining what isn't allowed, rules imply that everything else is – creating loopholes to be exploited.
Take the "Repo 105" accounting by Lehman Brothers. According to the official investigation into the bank's collapse, Lehman was able to move debt on and off their balance sheets at will by picking and choosing which legal jurisdictions and accounting standards they wanted to comply with. But this did not break any rules; the absence of any benchmark of conduct which would have prevented this sort of regulatory arbitrage arguably actually legitimised what they did.
Rules, it seems, began to replace responsibility. The alternative is a system based on principles and values. The Financial Reporting Council (FRC) reinforces such a system in their new UK Corporate Governance Code. The new code says that governance is about what the board does and how it sets the values of the company, and is based on the principles of accountability, transparency, probity and focus on the sustainable success of an entity over the longer term.
The move by the FRC to focus more on principles is very welcome. A principles-based approach is preferable to the rules-based approach. However, in a principles-based system, often only hindsight can clarify whether an action or decision was ethically sound or not. There are no loopholes in principles, but there is ambiguity.
This means individuals in any organisation must want to make the right ethical decisions. Ultimately, it is they who make the decisions, so the effectiveness of any set of rules or code of practice will be dependent on the competence and integrity of the individuals in authority.
It is up to professional bodies – such as ACCA – to ensure that those we train value integrity and ethical behaviour, but employerstoo must place a high premium on ethics.
Our paper makes three key recommendations: First, businesses must prioritise the recruitment of senior executives and financial staff who have a strong ethical compass.
Businesses must ensure they have a strong ethical culture; this should include setting the right tone at the top and then ensuring, and monitoring, that this is reflected throughout the organisation.
Finally, businesses should maintain the higher profile – with sufficient resources – given to the risk function since the onset of the financial crisis and not be tempted to cut this back when recovery sets in.
Paul Moxey is head of corporate governance and risk management at ACCA