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February 2006
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A violation of trust

This article was written about thirty years ago. I don't know whether this particular scam on the part of the banks still goes on, but the financial institutions are little cleaner today than they were then.


I just happened to be glancing at Dacey on Mutual Funds, and a passage on the mutual fund float caught my eye. Mutual funds, you see, do not ordinarily handle the collecting and disbursing of monies and shares themselves; a bank will do this for them as a trust agent. Besides their fee they also get a bit of gravy known as the float. There is a period of a few days between the time that money arrives from a customer and when it actually gets in the account of the mutual fund, a period when the bank has the use of the money. The bank puts the money to work during the time it has its hands on it, thus making money on someone else's money - in short, getting the risks and profits of investment without having to put up any money.

Dacey was discussing the delays that sometimes occur in redeeming mutual fund shares and the conflict of interest that the float engenders. It is the duty of the bank as a trust agent to act swiftly; it is to the advantage of the bank to be dilatory. I quote:

"There is nothing wrong with the bank's using these sums, but it is certainly wrong for the bank to increase the float, and thus increase its profits, by deliberately delaying payment of redemptions."
Dacey is a rather hardnosed and blunt critic of the financial industry. He has had some rather caustic things to say about the probate courts, the mutual fund industry, stock exchange specialists, the banks, etc. However he misses a point here, and I think it is an important point, for it is symptomatic of what is wrong with the ethics of the entire financial industry.

The point is simply that there is something wrong with the banks using these sums of money. The bank is an agent of trust. I have, say, given the bank a sum of money with which to purchase shares of a mutual fund, and to hold these shares in trust. This money does not belong to the bank and for it to use these funds and profit from them is a violation of that trust. It is, in simple terms, both dishonest and unethical - whether it is legal or not.

It can be argued that there is no harm in this sort of thing. The argument is simple; neither the fund nor its purchaser have the use of the money during the period of the float; they cannot profit from it and the bank can, so it might as well. Further, there is no violation of trust because the money is in no danger. The argument can be dressed up, but that is the nub of it. It is a wholly meretricious argument.

These are the arguments of an embezzler, of any violator of trust. The embezzler contends to himself that his employer will not miss the sums that he borrows; that he means to put them to good use (for he has need of them and can use them and his employer obviously has no need of them at the moment) and that they can be safely replaced. He usually errs on the safety and replaceability, of course. Still, most embezzlements do succeed. Most of the time the money is borrowed, used, and returned - no one is ever hurt, and no one ever knows. (How do I know this? It can be statistically inferred - most embezzlers are trapped by untoward and unusual events. Most of the time the accidents that expose the average embezzler do not occur.)

Now it can be argued that the cases are not at all analogous, for the embezzler operates in secret (with an eye out for the auditors) and the banks are quite blatant and open about their little swindle (not their language, to be sure.) That much is true. However it is more a matter of the actions of the embezzler being illegal and those of the bank being quite within the law. (Banks have more pull with the legislatures than embezzlers have.) The essence of the matter remains the same; a person (be it bank or embezzler) takes money that belongs to someone else and that is entrusted to them to be used for a purpose specified by that other party, and they use that money for their own purposes to their own profit. It remains dishonest.

It can be argued that the employers of the banks in these matters (the mutual funds and their patrons) have given their implied consent to these practices. In truth, they have. If I hire a man and he tells me before I hire him that he will steal from me, I have no cause for complaint when he does so. But one must remember that if one can find no honest agents then one must dishonest ones if one is to hire any agent at all. It can be hard to find an honest agent when dishonesty is "accepted business practice." It must be remembered that most are all too ready to acquiesce, both because they feel powerless in the matter and because they perceive no direct harm to themselves.

It can be argued that the interest that the bank collects is only an indirect fee, and that the same amount of money would have to be paid anyway. The argument may be made that it is perfectly normal for banks to borrow money that they use to make a profit on. What, after all, is the difference between borrowing money at 5% and lending it out at 10%, and borrowing money and using the interest to, in effect, reduce the handling costs of transmitting it? So it can be argued. It is a false analogy and a false set of arguments. First of all, the bank does not pay interest for the period of time that it has control. Secondly, they are not being given this money as a loan; they have been hired as trust agents to transmit it. Their use of it creates an unavoidable conflict of interest, a situation that is in fundamental violation of the conditions of being a trust agent.

It is an essential element of being a trust agent that one does not profit in any way from the trust and the control of the trust except for the stated and agreed upon fees. As soon as the trustee can profit from the control of the trust a conflict of interest is created. (It must be conceded that there are many trustee situations where there is an unavoidable conflict of interest, but that is not the case here, and is not relevant here.)

Dacey criticizes the banks for yielding to the conflict of interest. It happens and they must be faulted for it. However the real fault lies use of their people's money as their own. It could be done differently; the redemptions and purchases could be strictly segregated and any money the bank enjoys the use of temporarily (this is unavoidable) could be treated as a loan to the bank on which interest is paid. This would remove the inherent conflict of interest. It would remove the inherent incentive for the bank to be dilatory about handling purchases and redemptions.

The fiscal ethics of the financial industry are inherently defective. "Ethics" in the financial industry all too often means not exploiting the conventional conflicts of interest more than the amount dictated by standard business practice. For example, it was (and may still be) customary for brokerage houses to use their customer's money and stocks and bonds in the conduct of their own business. They did not maintain segregated accounts. It is still standard practice for stock brokers to act both as advisors and as salesmen. In fact there are numerous conflicts of interest built into the brokerage business, conflicts too numerous and complicated to go into.

It is not just a question of the ancient sin of greed and of the inherent fallibility and greed of Man. The standard practices of the financial industry are streaked with dishonesty. The law accepts many of these practices as being quite all right. (Every once in a while some particularly vicious and blatant abuse gets legislated against in a burst of reform, and everyone involved pats themselves on the back.) And the prevailing ethos is and always has been that sharp practice and working the angles is something to be achieved, not something to be rooted out.


This page was last updated February 1, 2006.
Reprinted from Personal Notes #6
Copyright © 2006 by Richard Harter

Richard Harter's World
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February 2006
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Hyde County, South Dakota is the Pin Tail Duck Capital of the world. Visit scenic Highmore, SD in 2006!