[MUSIC] So welcome to this lesson on the role of ethical values, and in particular, honesty and trust in the financial markets. We will see in the course of this whole module and MOOC that actually people's individual decisions making is driven by three parameters. Their preferences, their emotions, and finally their ethical values. So let's first turn to the preferences. The standard economic theory tells us that the Homo Oeconomicus is actually an individual, whether it's a man or a woman, who maximizes his or her expected utility of wealth, and thus behaves as we will see, in a very selfish manner. Then you've seen that people are actually also motivated by their emotions, their driven by fear, sadness, happiness, exuberance, and that also influences their decision making. We've also seen that the media by conveying certain emotions, certain sentiment, can affect people's decision making. And what we will see now is what is the role of ethical values. Do they play a role when you make financial investments? And by ethical values, I mean certain values, certain rules that define what is right and what is wrong. For instance, a sense of respect, a sense of justice, and in our case, it's going to be honesty. So when we talk in finance you have the left side and you have the right side. On the left side that's what you teach to finance students in a one-on-one class, it's the Homo Oeconomicus it could actually be a woman. And what she cares about is maximizing the number of dollars, or the utility of dollars, of a given decision. He or she doesn't care how she gets to these dollars. On the right side I like to quote Mark Twain, who was the famous writer and humorist of the 19th century who said the following. He said, honestly is the best policy when you are having money involved in it. And these are the modern view of financial decision making. Where you consider the individual as having selfish preferences but also preferences for others and also preferences for the process. In other words, I care how I get my dollars, whether it's one million, whether it's one franc, or whether it's one renminbi. I care about the process that leads to that money. So why should we care about ethical values? And in the traditional finance perspective, as I said, this is irrelevant. In truth, and especially since the subprime crisis, it matters a lot. Over the seven last years the financial services industry has paid collectively $235 billion in fines. Where do these fines come from? All kinds of unethical, dishonest behaviors. Think about the rogue traders at JP Morgan, Societe Generale. Think about the abusive selling of mortgages during the subprime crisis. Think about the Ponzi schemes by Madoff in the portfolio management industry. Think about the manipulation of the LIBOR rate by a few banks or the manipulation more recently of the exchange rates. So does this have some implications for the public at large? Of course. Tax payers had to bail out some banks during the subprime crisis. We had a slower rate of gross induced by the financial crisis. And we had a lack of trust in the financial markets by the general public so the costs are high. So what I'm going to do here is talk about an experiment that we have conducted on honesty. And what I mean here is a topic called experimental finance. What is experimental finance? It's a topic where basically we put students in a laboratory, and these are students in psychology, in finance, or in economics, and we studied their decision making in the laboratory. And the study has been conducted with two colleagues of mine, Professor Alex Wagner and Professor Carmen Tanner from the University of Zurich. And it looks as to how people trade honesty for monetary benefits. So the question that we're asking refers to a specific set of ethical values which we call protected values. So protected values in psychology are ethical values such as justice, respect, or honesty, but which are seen as absolute or non-tradable against monetary benefits. In other words a person has high protected values for honesty will not cheat in order to gain a higher pay-off. So the question we will ask is how does this influence financial decision making? And the experiment we're conducting is on earnings management. So what is earnings management? Well, Most CEOs, most corporation engage in a certain form of earnings manipulation, earnings management meaning that you embellish the results, the reported income in order to meet analyst expectations and to lower the variability of your earnings. Of course this is not illegal. It's permitted by accounting standards. And here the CEO faces a trade off. If he manages the earnings and reports a higher earning per share, his variable compensation will increase because it depends on the stock price, which itself depends on the earning per share. So, what financial theory, basic financial theory will tell you is that in such a case all the CEO should manage the earnings. And our students or experimenters were asked to play the role of the CEO and to decide whether or not they should actually manage the earnings per share. So, let me go a little bit more in detail about how we conduct such an experiment. It was conducted at The University of Zurich. We had about 260 students, slightly more men than women. And they were in the fields mostly of economics and finance, but also 40% in psychology, and 10% in other fields. I should reassure you immediately, women are not more honest than men. Despite what I would have liked to see, gender plays no role here. So the decision was very easy, in each situation the student who plays the role of a CEO has to decide whether or not she's going to report the true earnings, $0.31 per share, or the managed earning, $0.35 per share. And we're going to try and explain her decision, or his decision by a set of independent variables essentially, the cost of telling the truth. In other words, how much bonus do I have to forego if I announce $0.31? Then the protected values for honesty of each participant which are measured by your questionnaire that looks at how much they're willing to trade off honesty for financial benefits and we also looked at the gender, the field of studies, whether they worked part time or not other factors that could influence the results. So, first let me ask you what you think the outcome or results of the study were? Remembering that in classical finance everybody should lie if there was a true benefit of lying. So to understand the situations that our students were actually confronted with you see that there were five situations. In each case they had to report either $0.31 or $0.35. In the first situation they would get the same pay as the CEO. An important feature of experimental finance is that actually these students are paid. The cash payment in the third column is the payment to the student, and you see that in the first situation there's no incentive to lie. However, in the last situation the CEO loses $240,000 if he actually tells the truth. And the student loses also 1.20 Swiss francs. So here, there's a cost of telling the truth. So now let us find the surprising results that we have discovered in this experiment in the second part of this presentation. [MUSIC]
