Ethics and Entry Barriers

I often meet young people aspiring of a career in finance, who are keen on knowing the mix of skills which will help them excel in the next thirty years. My suggestions to them work at three levels. At the simplest, I tell them to tool up on financial economics, mathematics, and computer programming, for they will matter far more in the future than they have ever mattered in the past. I broaden that to the theme of change itself, where speed of learning and adaptability are the core competences of greatest value in a world dominated by ever-accelerating change. Finally, I talk about ethics. I tell them that it in their selfish interest to cultivate the highest standards of ethics and fairplay. In a world where corruption and ethics-lapses are commonplace, there is great value for the individual to set himself apart by being clean.

It seems paradoxical, in a world where a steady supply of scandals hits the headlines with depressing regularity, to say that there is an opportunity for individuals to improve their lot by avoiding the sleaze. An equally paradoxical aspect, which is discussed ahead, is the way poor ethics generates entry barriers diminishing the competitiveness of markets.

The question at stake is the importance of ethics, smoothly functioning "rules of the game", protection of private property, and legal enforcement. Why do these things matter in a modern capitalist economy? Can we not simply fall back upon the "buyer beware" principle, and settle in for a life in the jungle? We often see people making arguments like "investors in CRB were foolish enough to have been taken in - they failed to see through CRB, so they must now pay for it."

In India today, we have an economic environment where institutional arrangements are in a state of flux, and the legal system works fairly poorly. Fraud, i.e. promises which are not upheld, is fairly endemic. Violations of property rights continue to take place, though at a lower pace than in the preceding decades. Reneging on contracts takes place on a greater scale in India than in most other countries. In India, a government agency can be a counterparty but counterparty risk can still exist.

Mistrust of contracts is pervasive across the economy, given the failure of the legal system. Litigation is often used as a cheap multi-decade delaying tactic. The threat of slow litigation helps generate many patently unfair out-of-court settlements, where the aggrieved party prefers to settle for 50 paisa today instead of waiting a decade to get a rupee.

These problems are particularly acute in the financial sector. In the corporate sector and in the securities industry, effective functioning critically relies upon trust and fairplay between individuals and firms. Without effective punishments for ethics lapses, financial contracting can become quite infeasible.

The basic point being made here is hardly new: contract enforcement is vital to a healthy, well-functioning capitalism. We can ask, further: "How does capitalism develop in a world with poor enforcement of contracts"? How do rational, intelligent people cope with a pervasive risk of having others renege on contracts? Their adaptation is in two parts: (a) undertaking fewer contracts and (b) being choosy about the people to contract with.

The first part is the cost of poor contract enforcement for India's economy : the economy would use suboptimal levels of specialisation of production processes. If a supplier of parts cannot be trusted to keep his promises about quality and time schedules, then vertical integration might be a better option. This brings to mind the old adage "if you want to get something done, do it yourself". This is, of course, exactly wrong compared with the way skills and productivity grow in a modern economy, where specialisation and hence contractual obligations are the bedrock of efficient production processes.

The second part of the adaptation is based on choosing a few entities who can be trusted. Suppose there are two potential suppliers of parts, and a legal contract can be drafted imposing strong penalties for failure on either quality or time schedules. In a world with a strong legal system, the two suppliers are equal. Without it, the more trustworthy of the two will command a higher price.

"Reputation" matters far more in an economy like India than it does in well-developed markets. Without legal enforcement, the trust that a person can command becomes of paramount importance in determining the comfort that others have in contracting with him.

This hinders entry into markets, because old and established entities obtain an edge. Being old and established helps elicit trust, and there is a sense of a "club" of old and established entities which will be exceptionally careful about not reneging on contracts with each other.

The functioning of a stock exchange, and the brokerage industry, offer a direct application of these ideas. In a world where stock exchanges do poor regulation of members, and ethics lapses are pervasive, a personal feeling of trust becomes important in the mind of the customer. Customers would pay higher brokerage fees in order to have the peace of mind of dealing with a trusted broker. Last year, when a payments crisis surfaced on the BSE with a broker who shorted Sesa Goa and went bankrupt, I heard the fund manager who was on the buy side say (with much relief) that his broker was W. I. Carr, which promised to meet all obligations regardless of what BSE did.

This was a situation with steep entry barriers - if a new brokerage firm were started, it would take years to become as trusted as W. I. Carr. Trust often flows along with old family and school connections, which further slows down the entry of new players. In such an industry, we would expect to see large differences between the brokerage rates supported by a few "trusted" brokers and those commanded by run of the mill outfits.

Once an exchange comes about with stringent rules about contract enforcement and fairplay, the competitive advantage conferred by being trusted is diminished. Fairplay here is defined as no opportunity for gala, a clearing corporation as counterparty to all trades, and dispute resolution that works in a swift and efficient manner without favouring the broker. Once these institutions are in place, the entry barriers into the brokerage industry are sharply diminished, because a streetcorner brokerage would be as trustworthy as venerable names in the business. The brokerage rates supported by "highly trusted" brokers would not be as much higher as compared with those of a one-year old startup. Such a world is more fair as compared with one where the old, established entities form a closed club which is hard to break into.

This gain in competitiveness is the ultimate payoff of good contract enforcement. A frictionless capitalism without entry barriers vitally depends upon safe contracting between strangers. An efficient legal system, and institutions like futures market clearinghouses, are important for the economy because they enable this. In the meantime, while we are in the throes of a scandal a month, there is a "trustworthiness premium", i.e. excess returns to trust, which both individuals and firms can harness.

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