There are now many stories about why the Global Financial Crisis caused the largest downturn in economic activity since the Great Depression. These include high leverage, the combination of securitisation and subsidisation of mortgages for poor people, and asset price bubbles exacerbated by international imbalances. The world financial and economic system came close to collapse, and may do so again unless underlying problems with the way we run our financial services industry are fixed.

What to do now is the focus of a Study Group which we are running at the Balliol College Interdisciplinary Institute, Oxford, which involves philosophers, lawyers, historians, economists, civil servants, and bankers. David discussed some of our work at the CLMR conference on Public and Private Enforcement in Sydney at the end of last year, highlighting how financial firms were often not acting in the interests of clients, and how managers took on inappropriate ‘tail risk’ to maximise their remuneration. A particular example is the removal of capital (by private equity firms) that then leaves the remaining corporation too weak to cope with a downturn. This happened in the case of Southern Cross Healthcare in the UK, and it nearly happened to Qantas. David argued then that managers and employees in financial services need to become professionalised, in the way that lawyers and doctors are. It is a crucial task for corporate governance to ensure that this happens.

In our work in Oxford we have been seeking to understand the micro-foundations of what went wrong. It seems to us that financial services is an industry in which trust is important, but that trust has been eroded. We have been endeavouring, most of all, to determine how the erosion of trust can be traced back to the way in which employees in the financial sector failed to take care of the interests of their clients and customers. We have also been investigating the way in which financial institutions, as institutions, influenced the behaviour of their employees towards their clients and customers.

Second we have been seeking to understand what changes are necessary. In particular we have been investigating what framework of moral obligations could and should be imposed on employees within financial institutions. What should the resulting ‘integrity system’ of professional obligation look like? And how should this integrity system interface with the financial institutions themselves, with the legal system, and with the regulatory framework?

The more we explore particular cases the worse the problem looks. The Global Financial Crisis has revealed repeated examples of failures to sustain professional and ethical behaviour throughout the financial system, especially in the US. These include grossly inadequate risk management systems, under-resourced capital and liquidity backing for activities, blatant disregard of customers interests and deliberate miss-selling, moral hazard, regulatory arbitrage and the deliberate disguise of balance sheets and risks.

It is a daunting task to know how to fix these problems, and we fear that the regulatory changes now being implemented will not by themselves be enough. We fear that the financial system has reached a ‘tipping point’ where the erosion of trust and integrity is so significant that it endangers the economies it is supposed to serve. The sheer scale of the losses created by financial services behaviour is of a different order-of-magnitude (principally because of leverage and securitisation) than in previous crises. Governments may not be able to protect the system if we have another serious crash.

Financial service firms around the world regularly ‘contract around’ the regulations, and see compliance with regulations not as a guide to how they might change their behaviour, but as an inconvenient sideline to their other activities. Competition does not seem to be enough in the financial industry to prevent abuse (perhaps because many industry players have ceased to believe that reputation matters much to their bottom line). There are concerns over regulatory capture and the ‘revolving door’ of personnel between regulators and the regulated. The GFC and previous crises have highlighted how much of the regulatory system was ‘asleep at the wheel’, failing to listen to those who warned of impending dangers and failing to take action fast enough when problems emerged. Gatekeepers – accountants, lawyers, securities analysts and credit rating agencies – have been shown to be woefully inadequate. Where regulators and legislators do try to take decisive action, the lobbying power and resources of the industry water these down or make them ineffective.

We believe that a new integrity system needs to be designed, negotiated and implemented, in order to reintroduce professional and ethical standards. In designing this system we need to consider both past history and behavioural norms in different types of society. Obviously the US, with its free market tradition, is different from China, with its central planning background, or Germany, with its culture of mutual support for failing companies coupled with empowerment of stakeholders. The UK has a long history in the Financial Services Industry, dating back to the eighteenth century. The industry was based on trust, mutual respect and leadership, features which have been eroded in the last three or four decades.

Our research has repeatedly reminded us of the importance of individuals and firms taking responsibility for their actions, and we find analogues in successful integrity systems elsewhere. Doctors and other medical staff operate to very high professional standards, defined and enforced by their professional associations. Solicitors apply rigorous standards to their behaviour towards clients and face exclusion from the profession if they transgress. Industries as diverse as diamonds, clothing, architecture and advertising have developed, and follow, voluntary codes of conduct which mostly prevent abuse. A key feature of these systems is the importance of reputation; another is a genuine fear of exclusion. We are exploring how such principles can be made effective for financial services.

This article was co-authored by Nicholas Morris, a Senior Visting Research Associate at Balliol College, the University of Oxford and a doctoral candidate at the Faculty of Law, The University of New South Wales. Details of the Balliol project can be found here