LexisNexis

Christine Lagarde - Washington keynote

In her keynote address at this year’s opening ceremony, the Managing Director of the International Monetary Fund (IMF) focused on how to tackle corruption and unethical behaviour, which is undermining sustainable growth and fuelling public mistrust of institutions.

As members of the IBA, you are not only lawyers, you are also ‘internationalists’ – a group that understands the importance of coming together across countries and expertise to share knowledge and forge solutions to common challenges. You have a lot in common with the IMF.

An often overlooked fact is that the IMF is a creature of public international law. Its Articles of Agreement are a formal treaty concluded at Bretton Woods, New Hampshire in 1944. They entered into force in December 1945 with the support of 44 members.

Today, we are a truly global institution with 189 members. And we have a unique mandate: promoting economic prosperity and financial stability through international cooperation and an open system for the free flow of goods and investments.

Shifting inequalities

Over the past few decades, this open and integrated architecture has worked well – for the most part. Globalisation brought large welfare gains to developing and emerging economies. But it has been a double-edged sword – the shift in global production has also meant job losses and environmental damage for millions of people.

In fact, while inequality across countries has fallen, it has generally increased within countries. We have recently seen some good news in the United States – a rise in median household incomes in 2015. Longer-term trends, however, have been less favourable, especially for middle-income families, who have seen their income shares in total income shrink, from 47 per cent in 1970 to 35 per cent in 2014. The loss in income share was almost fully offset by the increase in the share of high-income families.

Public corruption – the abuse of public office for private gain – afflicts economies at all stages of development

In these circumstances, it is not surprising to see a growing backlash against globalisation, especially in industrialised economies. Coming on the heels of the financial crisis, this backlash has evolved into a deeper problem – a growing gap in trust in institutions.

According to the 2016 Edelman Trust Barometer, trust among the broader public in institutions is well below 50 per cent – hardly shifting from its 2008 low. It is also at its lowest for government institutions and the financial services sector. Trust among the elitesin all institutions, on the other hand, is at an all-time high, at 60 per cent.

A key factor fuelling this distrust is corrupt and unethical behaviour, actual or perceived, in both the public and private sector. Think not only of Bernie Madoff or the Libor rigging, but also the FIFA scandal that shook the sports world, or the travails of Petrobras that almost engulfed a whole political system.

Both the actual behaviour and the perception that there is corruption can be highly corrosive to society. This has contributed to the growing support for populist policies.

Addressing corruption and unethical behaviour involves not only improving the quality of the legal framework but also the quality of the individuals who implement this framework.

Indeed, more than 2,000 years ago, Aristotle believed that the central preoccupation of political science should be about ‘forming its citizens to be of good character and capable of noble acts’.

So today I would like to focus my remarks on the macroeconomic consequences of corruption in its many forms – why it matters, and what the IMF is doing about it.

One might ask: why should the IMF care about corruption? For a simple reason. Public corruption – defined as the abuse of public office for private gain – afflicts economies at all stages of development.

It is hard to measure, yet its economic and social costs are substantial. The annual cost of bribery alone is estimated at a massive
$1.5-2tn – roughly two per cent of global GDP. And the impact goes well beyond these direct costs. Corruption undercuts countries’ efforts to deliver sustainable and inclusive growth through the following three channels.

Firstly, by weakening fiscal capacity. When citizens feel that wealthy individuals are able to avoid paying taxes through bribes, it delegitimises the whole system. And, not surprisingly, other people decide not to comply, which undermines the ability of the state to raise revenue. At the same time, government spending becomes skewed toward areas with greater opportunity for graft – such as public procurement for construction projects. In extreme situations, the combination of depressed tax revenues and inefficient public spending can result in large fiscal deficits and critical debt situations.

The annual cost of bribery alone is estimated at a massive $1.5-2tn – roughly two per cent of global GDP

Second, corruption discourages investment and perpetuates inefficiency. Uncertainty and the cost of doing business increase with corruption, which acts as a tax on investment. Government borrowing costs can also be affected. For example, evidence of corruption in Petrobras contributed to a series of credit downgrades for Brazil and a widening in market spread.

Third, corruption entrenches poverty and inequality. By lowering spending on sectors like education and health, corruption disproportionately affects the poor who rely more on social services. 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

For the past two decades, we have been actively engaged with our member countries in addressing corruption. Our experience has shown that mitigating corruption requires a holistic and multifaceted approach, tailored to the specifics of each country.

A first strategy is to strengthen the rule of law. A case in point is our recent engagement in Ukraine. It is a particularly instructive case because of the openness with which the authorities have approached the corruption issue. Following the [Euro]maidan Revolution in 2014, the new government invited the IMF to assist them in conducting a comprehensive diagnostic study of corruption.

The process has not always been easy and the implementation record is mixed. But the key point here is that the authorities’ willingness to expose the extent of the problem allowed the IMF to work with them to make fighting corruption a key component of the reform programme.

As well as the rule of law, a second strategy to combat corruption is increased fiscal transparency. In this area, we have established international standards through a revised Fiscal Transparency Code. We use the code as the basis for evaluating practices of member countries against these standards upon request.

Another area of transparency is in the area of anti-money laundering. For almost 15 years, the IMF has provided advice to our members on the design of frameworks and institutions to combat money laundering. It has also helped to push countries’ compliance with anti-money laundering standards issued by the Financial Action Task Force.

These standards have taken on added significance given recent incidents such as the Panama Papers. These leaks gave us a window into the scale of global financial secrecy and the opportunities for illicit behaviour. They also reinforce the need to follow through on international initiatives to ensure adequate transparency on the beneficial ownership of accounts held in offshore jurisdictions. We have been recommending greater transparency in this area in a wide range of countries – including Belize, Cyprus, Greece and the United States.

The private sector plays an important role in public sector corruption. After all, for every bribe taken by a public official, there is a bribe given by the private sector.

However, even when the public sector is not involved, unethical behaviour in the private sector can have devastating consequences. This is particularly the case for the financial industry. Few would disagree that unethical behaviour and excessive risk-taking in the financial sector played a major role in precipitating the global financial crisis. It is not just a matter of fraud; excessive risk-taking is unethical, even if it does not involve fraudulent behaviour.

The goal of the financial industry must be not only to maximise the wealth of its shareholders, but also to serve society by supporting sustainable – and stable – economic activity. When the financial sector subordinates this core responsibility to its own self-interest, there is clearly high risk of ethical violation.

A further problem is the perception of impunity. Think of the whistleblower who refused to accept his share of the $16.5m award from the US Securities and Exchange Commission, in protest for the lack of government action against illicit behaviour of senior bank executives.

As with corruption in the public sector, addressing unethical behaviour in the financial industry requires mutually reinforcing strategies.

A good place to start is better regulation and supervision. The IMF has been actively calling for more intrusive supervision following the crisis – and we support the excellent work done to improve both supervision and regulation internationally. Our own work has also shown that changing incentives related to compensation practices can help re-align financial rewards with long-term performance of the firm. For example, financial authorities in the United Kingdom have issued regulations allowing remuneration to be clawed back in cases of misconduct by senior executives.

So, in both areas – public corruption and unethical behaviour – the rule of law plays a key role in creating incentives. A credible threat of prosecution is critical.

Values, not just compliance

Regulation, however, is not enough. Indeed, excessive reliance on regulation allows people to feel that as long as they are ‘complying’, they are acting ethically. What we need is a culture of values, not just compliance.

In the public sector, this involves creating strong institutions – establishing a cadre of civil servants who take pride in their independence from private influence or public interference. In the private sector, it involves professionals who take pride in doing the right thing, even when no-one is watching.

Now, as lawyers and experts in the Aristotelian tradition, we know that virtues are moulded from habit. Good behaviour is developed and nurtured over time. So how do we go about promoting individual integrity? Through focused education and strong leadership.

Good education means first looking at the training ground for finance professionals. Business schools should adopt a shift in paradigm about the meaning of individual success – placing more emphasis on professionalism and value to society, as opposed to high bonuses.

Many business schools around the world are updating their curricula to better prepare students for the variety of ethical situations they may face in their careers. There has been significant progress in this area since the financial crisis.

Separately, from an industry perspective, the Dutch financial industry, as of this year, has made mandatory an Ethics Oath for its executives and bankers, much like the Hippocratic Oath for physicians. Breaking this pledge of integrity exposes individuals to fines, suspensions and blacklists.

But, despite such efforts, a survey found that over 50 per cent of executives within the financial services industry continue to feel that, in order to succeed, they will need to be ‘flexible’ on ethical standards. This is troubling.

In public corruption and unethical behaviour, the rule of law is key in creating incentives. A credible threat of prosecution is critical

Clearly, codes of conduct must become a reflection of the values and culture of the institution rather than just another set of rules. Otherwise, they will simply perpetuate the ‘compliance’ mentality.

How can institutions make this shift in culture? While there are many intangibles, the key ingredient is leadership. And this applies in both the public and private spheres. All good principles and intentions on ethics and integrity will only be taken seriously if leaders act as role models and send a clear message of zero tolerance.

The G-30 report, Banking Conduct and Culture revealed that banks which had successfully embedded an ethical culture were those where the executive team set a strong example – by sanctioning improper practices in a transparent and consistent manner.

I would like to commend the IBA for its interest in the issue of corruption. The standing Anti-Corruption Committee and the Judicial Integrity Initiative are critical in upholding integrity within the legal profession. I also applaud the IBA for issuing in 2011 its International Principles on Conduct for the Legal Profession. It is these kinds of codes that can help instil individual accountability, and the culture of virtue and integrity that I have discussed.

The task before us is clear. Enhancing integrity in public and private sector governance is critical in mending the trust divide we see in societies today. Only then can we have enough confidence in the very institutions that are essential for sustained and inclusive growth.