Compliance and Ethics in Investment Banking

by Jörgen Eriksson on May 17, 2012

Andrew CarnegieAndrew Carnegie (1835-1919) was an American industrialist, being the  founder of the iron and steel industry in the United States. He was also a philanthropist.

At the age of 33, when he had an annual income of $50,000, Carnegie wrote himself a note, “Beyond this never earn, make no effort to increase fortune, but spend the surplus each year for benevolent purposes.” He did not keep this resolution, but as his fortune grew so did his concern for using his fortune to provide greater opportunity for all.

In the brief paper “The Gospel of Wealth,” first published in the North American Review in 1899, Carnegie stated his doctrine concerning the responsibility of the wealthy individual to society. Wealthy people, he believed, should use the fortune they have earned to provide greater opportunity for all and to increase knowledge of humankind and of the universe.

Carnegie began to practice his own doctrine in the 1880s with the building of libraries, the particular philanthropy with which Carnegie’s name is especially associated. During his lifetime Carnegie gave more than $350 million to various educational, cultural, and peace institutions, many of which bear his name.

The consciousness and giving nature of Andrew Carnegie stands in sharp contrast to the Masters of the Universe of modern investment banks.

Since 2007, as the financial crises has played out, there has been much criticism of investment banking and calls for more ethical behavior by investment banks and investment bankers. In my opinion, the criticism has been just and valid.

A friend of mine who had been running a mid sized investment bank but was forced to leave told me that his organization had become impossible to steer, as the high paid bankers behaved as if they played a game where each new years individual bonus to the top performers, based on risky deal making, was higher than what they possibly could earn for the rest of their lifetime in any other profession. Thus behavior was decided by greed.

The question then is, why should they have showed restraint as just one more year of profits and bonuses made them each more money than a lifetime of earnings in any other career?

On a macro level, the financial crises has shown that ethical failures can have profound consequences on the value of an investment bank and its reputation, and given the importance of banks in the macro economy, consequences on the national and multi-national economic balance as a whole.

The crises destroyed century old multinational institutions such as Lehman Brothers and Bear Stearns. The failure of individuals can become the failure of the entire institution where they are employed.

The collapse of Barings Bank due to Nick Lessons gambling with futures trading on the Tokyo index was an early example in modern times. The loss of more than $2 billion on complex derivative positions in a small trading unit at JP Morgan in London last week was the most recent example, and is the direct inspiration to the writing of this blog post.

The JP Morgan trading loss was revealed in regulatory filing and will dent the company’s profits, although it still expects to make about $4 billion this quarter. The loss numbers are staggering, but it is only in times of system failure that these events pulls a large bank to the brink of collapse. It is almost as if the industry has come to expect these enormous mistakes and accepts the high stake risk taking.

By understanding that high paid bankers behaved as if they played a game where each new years individual bonus to the top performers, based on risky deal making, was higher than what they possibly could earn for the rest of their lifetime in any other profession, we have the explanation of the risk taking. However how can such barriers of ethics be breached?

Investment bankers typically have compulsory training in legal and regulatory compliance, but not in ethics. Compliance, by definition is concerned with complying with existing laws and regulations, and every investment bank has a Compliance Department and sophisticated processes to ensure this happens.

Ethics on the other hand is a broader subject, and is fundamentally about discerning what is right in a given situation, and acting on it.

Raphaels school of AthensRaphael’s School of Athens and the Wisdom of the Ancients.

The Greek philosophers were the first to define Western Philosophy, the rational and critical inquiry into basic principles. Philosophy is often divided into four main branches: metaphysics, the investigation of ultimate reality; epistemology, the study of the origins, validity, and limits of knowledge; ethics, the study of the nature of morality and judgment; and aesthetics, the study of the nature of beauty in the fine arts.


There is naturally some blurring between compliance and ethics . Both are concerned with standards in doing business. However, whereas compliance is primarily concerned with a finite body of regulation and legislation, ethics deals with the underlying nature, intent and result of a situation or action.

Every situation in investment banking has ethical connotations, but many are outside the areas governed by compliance. As a result, much business takes place without moral scrutiny.

In practice, it is perfectly possible for an investment banker to structure a non-compliant deal to avoid a specific compliance problem, and in the process ignore any significant ethical question that the deal raises. The financial crises of recent years has exposed the dangers of this approach.

Ethics, therefore, involves going beyond the legal requirements and rules imposed by regulatory bodies to determine what is right and what is wrong when making a business decision.

I believe it is about time for business schools and the financial industry to provide training on how to make a judgment about likely outcomes to asses whether a decision is right or wrong.

A greater awareness of ethics in the investment banks has the potential to change corporate culture and have considerable impact on specific abusive practices and on individual investment bankers whose ethical standards are poor.

Successful investment bankers must be focused and determined. They do not routinely break existing laws or corporate policy when it is made clear. If there is a requirement for higher ethical standards then successful investment bankers should be able to respond accordingly.

Who knows, maybe a higher focus on ethics may even make some of them follow Andrew Carnegies example. Strong individual examples in civil society can provide the drive and glue to greater purpose development, as we have written about in another recent blog.

About Jörgen Eriksson :

Jörgen Eriksson is the founder of Bearing and is the Chairman of the firm since it was created. He has successfully expanded Bearing into covering projects on four continents. He is also Adjunct Professor of Innovation Management at the International University of Monaco and at Universitat Politècnica de Catalunya in Barcelona and he is an active member of the Founders Alliance organisation.

Working with consulting engagements across Bearings practices, he has over the past fifteen years participated in and supervised a large number of client projects, from innovation system development and place development and branding, to merger and acquisition assignments and leading edge research and business development activities for key clients.

His new book, Branding for Hooligans, will be published in 2015. It is about how innovation and branding are key survival factors in our modern times of hyper competitive markets.

Prior to Bearing, he was Director of Europe, Middle East, and Africa for Trema Treasury Management, a technology and consulting services provider, supplying financial software solutions for the global financial industry, Clients included The European Central Bank, Citibank, SEB, South African reserve Bank, Deutsche Bank, Abu Dhabi Investment Authority (ADIA), as well as many other large financial institutions and Fortune 500 companies.

Early in his career Eriksson was educated at the Stockholm School of Economics, where he studied economics, financial economics and philosophy. He then worked in Scandinavian investment banks and also for the Swedish Institute of National Defense Research.

You can contact Jörgen on e-mail, connect on LinkedIn onörgen-eriksson/0/38/8a0/ and follow him on twitter on joreri508.

{ 3 comments… read them below or add one }

Stefan Olsson May 19, 2012 at 08:57

Jörgen, good article. 

You said “On a macro level, the financial crises has shown that ethical failures can have profound consequences on the value of an investment bank and its reputation, and given the importance of banks in the macro economy, consequences on the national and multi-national economic balance as a whole.”

But the underlying problem is that while these sharp swings are expected at a big hedge fund, they should not be present at a bank whose deposits are government-protected and which has access to low cost capital from governance. 

JPMorgan has a big hedge fund inside a commercial bank. They should be taking in deposits and making loans, not taking large speculative bets. This is what the new coming regulations are trying to prevent.

Just to get a proportion of the size of the JPMorgan position. A credit dealer estimated that the initial loss of just over $2 billion was caused by a move of 25 basis points, on a portfolio with a notional value of $200 billion. In its simplest form the complex position created by the bank included a bullish bet on an index of investment-grade corporate debt, later paired with a bearish bet on high-yield securities, achieved by selling credit-default swaps.

Jörgen Eriksson Jörgen Eriksson May 19, 2012 at 14:39

Dear Stefan, I agree on your comment. Iit is an important contribution to the blog post.

Unlike commercial retail banks and savings banks, investment banks do not seek cash deposits from customers, and they do not make traditional interest-bearing loans to individual customers. Instead they make their money by corporate advise, by underwriting securities, by facilitating mergers and acquisitions, and by brokering securities to investors.

However it can be very tempting for individuals at investment banks to take extra-ordinary risky positions when they can make extra-ordinary returns. Sometimes to take extra-ordinary risks can be corporate policy but after the recent crises it seems to become more uncommon. The possible outcome of the risk factor in “extra-ordinary risk and return” have finally been understood by the corporate leadership.

The problem you point out is when a traditional commercial retail or savings bank includes an investment bank department, such activities play with the entire balance sheet of the organisation. In the often prudent asset and liability management units of the banks, who manages the banks risks, this must be a nightmare to work with. The recent movie Margin Call shows us in fiction how this can turn out.

So, by logic we can conclude that it is not a good idea to mix a risk-averse commercial bank with a risk-taking investment bank.

What is interesting in recent years is that the playing field on Wall Street shifted in 2008, when the financial crisis forced all of the largest surviving Wall Street firms to convert themselves into bank holding companies in order to gain eligibility for federal aid. The move transferred the firms from the investment-oriented regulatory oversight of the Securities and Exchange Commission to the commercial banking-oriented regulation of the Federal Reserve, with consequences that are still unclear.

By the next financial crises we will know what outcome we will get from this risky mix.

Michael Deutsch Michael Deutsch May 23, 2012 at 12:46

Not as well established as Andrew Carnegie, but still known in Management literature is Gary Hamel (Competing for the future). He just published a new book, “What matters now”, which I am currently reading. He devotes the whole first chapter to what he calls one of the make-or-break challenges of organisational success: Values. He advocates (or rather sees it as a pre-requisite) a “moral renaissance” in Business and also uses the current banking examples. The other drivers which matter most in his opinion are innovation, adaptability, passion and ideology.

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