BUS604: Innovation and Sustainability

What went wrong in the world of finance? Why did so many CEOs take such huge risks? Why did so many directors engage in fraud? A detailed analyzis of the financial crisis and the accounting scandals goes beyond the objective of this chapter. But in order to judge whether social enterprises and impact investing embody a fundamental rethinking we have to understand some of the main characteristics of the financial crisis and the different accounting scandals. Many books have been written on these, but I will base my analyzis on three authoritative sources: the documentary Inside Job about the financial crisis, the book Too Big to Fail about the fall of Lehman Brothers and its consequences, and the book The Smartest Guys in the Room about Enron.

In The Smartest Guys in the Room: The Amazing Rise and the Scandalous Fall of Enron, Bethany McLean and Peter Elkind provide an inside view. It starts in 1984 when Ken Lay becomes the CEO of Houston Natural Gas and ends with the collapse of Enron in 2001. Along the way it describes the development of new financial products; the method of mark-to-market accounting that led to overrating; the fraudulent financial constructions of hiding debt in subsidiary companies; the corporate culture of vicious competition; and the hubris of its main characters. Finally, it tells the story of an enterprise that abandoned its roots, which lay in providing society with good services.  Enron is not an isolated scandal but a "symptom of a system that fails on all points".

The international bestseller Too Big to Fail by Andrew Ross Sorkin gives an inside view of Wall Street and the bankruptcy of the Lehman Brothers investment bank. It reveals what happened behind closed doors and describes the actions of the leading figures in this financial drama. It tells the story of the "fallibility of people who thought they themselves were too big to fail". Sorkin provides an in-depth insight into their personalities, their hunger for power and their greed.

The 2010 documentary Inside Job by Charles Ferguson provides a staggering report on financial malpractices. It tells the story of new financial products with large risks that drove companies, shareholders and customers to the abyss. Deregulation of financial service industries led to high-risk investments with customers' savings and to large-scale lending, where in some cases the leverage ratio of lending exceeded thirty times the assets of a bank; or in the case of Iceland, loans taken out in excess of ten times the size of the country's GDP. These were margin levels comparable to the prelude of the crash of 1929. It shows that deregulation enabled the creation of a chain where all risk was passed on and exposure was maximized, but no one was responsible: the homeowner's mortgage and debts to the local lender were bought up by large investment banks, who bundled debts to create derivative investment products.

These products in turn were sold to investors, but also insured, swapped and passed on as new insurance investments. The same investment bank would simultaneously sell a product to clients while betting on its failure. Very few understood the complexity of this increasingly unstable system, in which CEOs and traders rewarded themselves with short-term premiums and bonuses while passing losses on to others. They lost sight of long-term risks and isolated themselves from the wider economy, society and even their own companies. They eventually gambled not only with their clients' and investors' funds, but also with their own firms and the entire financial system. The cover of the DVD ironically notes that the film cost over $20,000,000,000,000 to make!

"The core of the problem of the financial crisis is the single-minded pursuit of shareholder value. As a result, banks have abandoned their core objective: to fund enterprise". – Pieter de Rijcke

We can draw on the so-called 'practices model' to understand the financial crisis and accounting frauds. This model was developed by the philosophers Jochemsen, Glas and Hoogland.  A big advantage is that it encourages us to understand professional practices and institutions from three different perspectives: the intrinsic nature and purpose of the enterprise (structure), its roots in society (context), and the basic beliefs that motivate its actors and their culture (direction).

Structure

The structure of a practice refers to the intrinsic nature of a practice and the formal aspects of an organization. It has to do with the nature of the primary process, its organizational structure, procedures and code of conduct. The discussions induced by the crisis and the accounting scandals focused on the 'rules of the game': statutory regulations, internal procedures, and supervision. Better rules and more supervision are required to prevent new crises and scandals. Consequently, in the whole of the Western world accounting principles for business and the regulation of banks are being extended and sharpened, and supervision has been intensified.

In general, I agree with the call for more rules and supervision. However, this call can easily lead the conversation away from the core issue-namely, that practices and their structures primarily concern their 'internal goods', 'essence' or 'excellence', as defined by the philosopher Alasdair MacIntyre, who in turn draws upon Aristotle.  The idea of 'internal goods' refers to the values that are realized specifically by those practices.

The internal goods concern the legitimacy of an enterprise's 'license to operate' or 'right to exist'. The internal goods of healthcare are cure and care for patients, and the internal goods of banking are financial services for citizens and enterprises. For Plato in The Republic, the essence of a physician is the extent to which he is a healer. As a corollary to his work, the doctor makes money; but being a money-maker is not an essential part of the definition of a physician.

The idea of 'internal goods' is contrasted with the idea of 'external goods', which are those goods that are external to the aims realized by the practice, e.g. prestige, status and money. Being a rich or famous doctor is not a part of the essence of the practice of medicine, which serves to benefit the patient. The private benefit to the physician is the external good.

The idea of 'excellence' emphasizes that practices are not about average performance but about excellent performance according to the aim of the pursuit and the standards in the sector. MacIntyre emphasizes that the realization of excellence in internal goods requires virtues that are characteristic of that practice. That means, in his modern reinterpretation of Plato's and Aristotle's philosophy, 'excellence' and 'virtues' are directly related.

Additionally, in the ethics of Aristotle the idea of 'happiness' (eudaimonia) is not a short-lived emotion, but a term that implies a lifelong 'living well' and 'faring well' according to fulfillment of the potential and highest abilities of human nature. The ideas of 'internal goods', 'excellence', and 'virtues' clearly show where business institutions failed. The focus was shifted from 'internal' goods to 'external' goods. The primary purpose of a business is to provide excellent goods and services, to which profits are a corollary. Losing sight of the primary purpose means replacing excellence with profits, and reducing virtues to targets. In addition, long-term sustainability was replaced by short-term focus on profits and bonuses. Robert Solomon describes this financial focus as 'abstract greed' because in his view it has nothing to do with 'real wants, real needs, or real expectations'.

Context

The context of a practice refers to the influence of the environment on professional practices and the organizations in which they are embedded. It refers to the network of stakeholders that exert influence on the organization.

In business ethics there are two approaches with respect to stakeholders. Milton Friedman argues that business corporations have only one social responsibility: to increase their profits. Consequently, a corporate executive should focus on only one stakeholder: the owners or shareholders. Friedman believes in the free market, denies social responsibilities other than increasing profits, understands society as a 'collection of individuals' and of the various groups they 'voluntarily form', and states that business has to stay 'within the rules of the game' (legislation). On the other hand, R. Edward Freeman argues for a broader stakeholder approach. In his view, stakeholders whose interests are affected by an enterprise have a right to make a claim. That means that a corporate executive has to balance the multiple claims of (conflicting) stakeholders.

He acknowledges that business has a normative core that reflects 'liberal notions of autonomy, solidarity, and fairness as articulated by John Rawls, Richard Rorty and others'. The financial crisis and accountancy scandals show that the Friedmanian approach dominates in many organizations. From a philosophical point of view, a 'double reduction' takes place. First, the broader societal context of stakeholders is reduced to shareholders. Second, the interests of shareholders are reduced to short-term financial interests.

Direction

The direction refers to the basic beliefs that underlie the professional practices and institutions in which they are embedded. Inside Job, Too Big Fail and The Smartest Guys in the Room clearly show that many financial institutions and industrial corporations believe in the idea of the free market, deregulation by governments, maximization of profits, and fierce competition. John Gray goes one step further. He describes the present business climate as a utopia that spurs its followers to a blessed future and legitimates any action to realize that future.  John Cassidy describes the rising influence of what he calls 'utopian economics' that is blind to how real people act and denies the many ways an unregulated free market can produce disastrous unintended consequences. From a philosophical point of view, I would like to emphasize the direction component of a practice in general and the values and beliefs that underlie organizations in particular. Worldviews, values and basic beliefs not only determine the way we observe the world but also guide our understanding of reality and even steer the way we shape the world. The idea of the financial world as a 'professional practice' was very helpful in analyzing the financial crisis and its features. I draw three preliminary conclusions.

First, regarding structure, the financial industry has lost sight of its primary calling. This industry focuses its attention on maximizing turnover and profits instead of delivering excellent financial products that serve customers and contribute to society's long-term prosperity.

Second, regarding context, the financial industry has lost its roots in society. It concentrates its efforts on serving the financial interests of shareholders instead of the financial and non-financial interests of all stakeholders.

Third, regarding direction, the financial industry is in the firm grip of the ideology of the free market. A worldview or ideology functions not only as a guide for action but also as a pair of glasses with which to observe society and to legitimate its ideas. The analyzis of the financial crisis and accounting scandals showed that key players in the business and financial world were profit-driven, focused on the interests of the shareholders, believed in the free market, and rejected control by the government.