Mending the Trust Divide

IMF News, September 18, 2016

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Authors: Christine Lagarde
Published: September 18, 2016

Context and framing

Speech by Christine Lagarde, IMF Managing Director, International Bar Association Conference, Washington, DC, September 18, 2016.
IMF described as a "creature of public international law" with Articles of Agreement concluded at Bretton Woods in 1944 and entered into force in December 1945 with the support of 44 members; today it has 189 members and a mandate of promoting economic prosperity and financial stability through international cooperation and an open system for the free flow of goods and investments.
Globalization delivered large welfare gains to developing and emerging economies but also produced job losses and environmental damage for millions; inequality across countries has fallen while inequality within countries has generally increased.
United States median household incomes showed an uptick in 2015, but longer-term trends saw the income share of middle-income families fall from 47 percent in 1970 to 35 percent in 2014, with the loss almost fully offset by the increase in the share of high-income families.
Trust gap: 2016 Edelman Trust Barometer reports broader public trust in institutions at 48 percent versus elite trust at 60 percent; the split of 12 points is the largest recorded. Trust is lowest for government institutions and the financial services industry.

1. Corruption in the public sector — costs and channels

Key findings and statistics

Public corruption defined as the abuse of public office for private gain.
Annual costs of bribery alone estimated at US$1.5–2.0 trillion — roughly 2 percent of global GDP. [6]
Channels through which corruption undermines sustainable and inclusive growth:
- Weakening fiscal capacity
- Tax morale and compliance decline when citizens perceive wealthy individuals avoiding taxes via bribes.
- Government spending skews toward areas with greater opportunity for graft (e.g., public procurement). One study found public projects in eight European countries were on average 13 percent higher because of corruption. [7]
- In extreme cases, depressed tax revenues and inefficient spending can cause large fiscal deficits and critical debt situations.
- Discouraging investment and perpetuating inefficiency
- Corruption increases uncertainty and the cost of doing business, acting as a tax on investment; can affect government borrowing costs.
- Example: evidence of corruption in Petrobras contributed to a series of credit downgrades for Brazil and a widening in market spreads.
- Entrenching poverty and inequality
- Corruption lowers spending on education and health, disproportionately harming the poor.
- By some estimates, child mortality rates are one third higher in countries with high corruption, and infant mortality rates are almost twice as high.

Mitigating strategies implemented by the IMF and partners

Holistic, multifaceted approaches tailored to country specifics; key strategies include:
- Strengthening the rule of law
- Case study: Ukraine (post-Maidan Revolution 2014). IMF conducted a comprehensive diagnostic showing pervasive corruption, an overbearing opaque regulatory framework, ineffective judiciary, and "state capture."
- IMF engagement in Ukraine focused on four areas:
- (i) legislative reforms: procurement, anti-corruption, asset disclosure by public officials, anti-money laundering;
- (ii) establishing a new anti-corruption agency with active support of civil society;
- (iii) strengthening the business climate by streamlining and simplifying the regulatory framework;
- (iv) judicial reform to enhance independence and integrity.
- Authorities published the IMF report; implementation has been mixed but the openness enabled IMF collaboration.
- Increasing fiscal transparency
- IMF revised Fiscal Transparency Code used to evaluate member practices upon request.
- Example: Albania assessment found over 250 public corporations with liabilities equivalent to 30 percent of GDP not included in published fiscal reports.
- Anti-money laundering (AML) frameworks and compliance assessments
- IMF has advised members for almost 15 years on AML frameworks and helped assess compliance with Financial Action Task Force (FATF) standards.
- "Panama Papers" leaks highlighted global financial secrecy and the need for transparency on beneficial ownership; IMF recommends greater transparency in countries including Belize, Cyprus, and the United States.

2. Unethical behavior in the private sector — financial sector focus

Findings

Private sector often facilitates public corruption (for each bribe taken, a bribe is given).
Unethical behavior in the private sector, especially the financial industry, can precipitate systemic crises (excessive risk-taking and unethical behavior were major contributors to the global financial crisis).
Ethical failures include not only fraud but also excessive risk-taking that harms society even when not fraudulent.
Perception of impunity undermines trust; example cited: whistleblower who refused US$16.5 million award from the U.S. Securities and Exchange Commission in protest at perceived lack of action against senior bank executives. [8]

Policy and institutional responses

Better regulation and intrusive supervision
- IMF has called for more intrusive supervision following the crisis and supports international improvements in supervision and regulation. [9]
Compensation and incentive reforms
- IMF work shows changing compensation incentives can realign rewards with long-term firm performance. [10]
- Example: United Kingdom regulations allowing remuneration clawbacks for misconduct by senior executives.
Rule of law and credible prosecution
- A credible threat of prosecution is critical to creating incentives against unethical behavior.
Culture and values beyond compliance
- Regulation alone can foster a mere "compliance" mentality; need to promote a culture of values where professionals act ethically even when unobserved.
- Education and leadership as levers:
- Business schools shifting curricula to emphasize professionalism and societal value over high bonuses; examples include mandatory business ethics at INSEAD (France and Singapore), managing ethics and social responsibility at ESADE (Spain), "Giving Voice to Values" curricula in many U.S. top-tier business schools, and a Georgetown course on enhancing individual integrity through meditation.
- Industry initiatives: Dutch financial industry made an Ethics Oath mandatory for executives and bankers (as of the speech year), with penalties for breaking the pledge.
- Leadership role
- Executive teams that model and enforce ethical behavior are critical; the G-30 report found banks with embedded ethical culture had executive teams that sanctioned improper practices transparently and consistently. [11]

Policy recommendations and priorities

Strengthen the rule of law to prevent state capture and ensure judicial independence and integrity.
Increase fiscal transparency via adherence to the IMF's revised Fiscal Transparency Code and improved reporting of public-sector liabilities.
Enhance AML frameworks and beneficial ownership transparency, and follow through on international initiatives exposed as necessary by leaks such as the "Panama Papers."
Improve regulation and intrusive supervision of the financial sector to reduce excessive risk-taking.
Reform remuneration and incentive structures in financial firms to align pay with long-term performance and make clawback mechanisms available.
Foster a culture of values through:
- Education changes in business schools to emphasize ethics, professionalism, and societal responsibility.
- Institutional codes of conduct that reflect genuine values, not merely compliance checklists.
- Leadership that acts as role models and enforces zero tolerance for unethical behavior.
Support civil society engagement and transparency measures to enable diagnosis and public accountability (illustrated by the Ukraine engagement).

Conclusion

Enhancing integrity in public and private sector governance is essential to mending the trust divide and restoring confidence in institutions necessary for sustained and inclusive growth.
The speech invokes Aristotle and Adam Smith to underscore that good citizenry, trust, and moral sentiments underpin functioning markets and societies.

Source: Mending the Trust Divide — Speech by Christine Lagarde, IMF Managing Director, International Bar Association Conference, Washington, DC, September 18, 2016.