CHAPTER 3
ETHICAL ISSUES IN FINANCIAL
PRODUCT DEVELOPMENT
PREPARED BY:
CAROLIN ANN ENCHAS
NOOR AZILLAH MOHAMMAD ALI
DR MOHD SAMSURI GHAZALI
DR ABDUL AZIZ LAI BIN MOHD FIKRI LAI
CONTENT
1) Transparency and Disclosure of Information
2) Conflict of Interest in Product Design
3) Responsible Lending and Borrowing
4) Consumer Protection and Financial Services
INTRODUCTION
In today's dynamic financial landscape, the
development of financial products plays a pivotal role
in shaping the economic well -being of individuals and
societies as a whole.
However, with great power comes great responsibility,
and this chapter delves into the ethical considerations
that surround financial product development.
We'll explore key aspects such as transparency,
conflicts of interest, responsible lending and
borrowing, and consumer protection in financial
services.
3.1 TRANSPARENCY AND DISCLOSURE
OF INFORMATION
01 Transparency is the bedrock of ethical financial product development. It
embodies the principle that all relevant information regarding a
financial product should be readily available to consumers, allowing
them to make well-informed decisions. Transparency promotes trust and
confidence in financial institutions and ensures that the financial system
functions smoothly.
Consider a scenario where a bank offers a complex investment product to its
02 customers without adequately disclosing the associated risks and fees. In this case,
investors may be lured by the promise of high returns but unaware of the potential
downsides. When the product underperforms, investors can suffer significant
financial losses, eroding their trust in the financial institution.
Enhanced transparency in financial markets has far-reaching effects. It attracts more
03 investors and encourages savings and investment. According to a study by the World
Bank, countries with higher levels of financial transparency tend to experience greater
economic growth and stability (World Bank, 2019). Transparency is not merely an ethical
consideration but a driver of economic prosperity.
3.1 TRANSPARENCY AND DISCLOSURE
OF INFORMATION
01 Transparent disclosure of fees and risks is a fundamental component of
ethical financial product development. Customers should have access to
detailed information regarding the costs associated with a financial
product and an understanding of the potential risks involved. Without
such information, consumers may make decisions that are not aligned
with their financial goals, leading to negative outcomes.
Imagine a credit card company that buries its fees in fine print and uses complex
02 jargon in its terms and conditions. Customers who don't fully comprehend the fees
may unknowingly accumulate debt, leading to financial distress. This lack of
transparency can harm consumers and tarnish the reputation of the financial
institution.
To enhance transparency, financial institutions must provide clear and concise
03 disclosures, including the total cost of ownership, potential penalties, and the
probability of risk events. Such transparency empowers consumers to make informed
choices that align with their financial objectives, ultimately contributing to a healthier
financial ecosystem.
3.2 CONFLICT OF INTEREST IN
PRODUCT DESIGN
Definition of Cross-Selling
Conflict of Interest Commissions Kickbacks Incentives
DEFINITION OF CONFLICT OF INTEREST
Conflicts of Interest arises when an individual or institution has
competing professional or personal interests that may potentially
undermine their impartiality or objectivity in decision-making. In other
words, it can be defined as situations in which financial institutions or
their employees have incentives that may compromise the interests of
their customers.
These conflicts can lead to a situation where an individual or entity
Conflict of Interest prioritizes their personal gain or the interests of a related party over the
best interests of their clients, customers, or the organization they serve.
These conflicts can arise in various forms, such as commissions, kickbacks,
or cross-selling incentives. Identifying and mitigating conflicts of interest
is essential for ethical product development.
COMMISSIONS
Commissions are a common form of compensation for financial
professionals, such as brokers or investment advisors. They earn a fee or
percentage of the amount they sell or manage for their clients.
This payment structure can create a conflict of interest when advisors are
more inclined to recommend financial products or investments that pay
higher commissions, even if they may not be the best choice for the client.
This can lead to biased advice that prioritises the advisor's earnings over
the client's best interests.
Commissions
A financial advisor recommends a high-commission mutual fund to a
client when a lower-cost option with similar performance is available. The
advisor's motivation is to earn a higher commission, potentially resulting
in increased costs for the client.
KICKBACKS
Kickbacks involve financial professionals receiving financial incentives,
gifts, or other benefits from product providers, such as mutual fund
companies or insurance firms, in exchange for promoting their products
to clients.
These incentives may compromise the advisor's objectivity, as they are
motivated to recommend products that offer them kickbacks, even if
there are better options available elsewhere. This can lead to product
Kickbacks recommendations driven by personal gain rather than client benefit.
A financial advisor receives a bonus from an insurance company for
selling a specific insurance policy, so they recommend that policy to
clients even if it may not be the most suitable option.
CROSS-SELLING INCENTIVES
Cross-selling incentives involve financial institutions offering bonuses or
incentives to employees who sell multiple products or services from the
same institution.
Employees may feel pressured to push products or services that clients
may not need, solely to meet sales targets and earn incentives. This can
lead to clients purchasing products or services that are not aligned with
their financial goals or needs.
A bank offers bonuses to its employees for selling a combination of Cross-Selling
services, such as checking accounts, credit cards, and loans. This may Incentives
encourage employees to convince customers to open multiple accounts,
even if they don't require all of these services.
REGULATORY FOR CONFLICT OF INTEREST
Commissions Consider a financial advisor who receives hefty commissions for
promoting specific investment products. In this scenario, the advisor may
be inclined to recommend products that generate higher commissions,
even if they are not the best fit for the client's financial goals. This conflict
of interest can result in financial harm to the client.
Kickbacks To address conflicts of interest effectively, financial institutions need
robust policies and procedures. These measures may include disclosing
potential conflicts to clients, providing clear guidelines for employees,
and establishing independent oversight mechanisms.
Cross-Selling
Incentives
REGULATORY FOR CONFLICT OF INTEREST
Governments and regulatory bodies worldwide have recognized the importance of
managing conflicts of interest in the financial industry. For instance, in the United
States, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
Commissions introduced measures to manage conflicts of interest in financial institutions,
particularly in the sale of financial products (Congressional Research Service, 2018).
In Malaysia, the Securities Commission and the Central Bank have implemented
guidelines and regulations aimed at managing conflicts of interest among financial
Kickbacks intermediaries. These measures contribute to a more transparent and ethical
financial ecosystem, bolstering investor confidence without compromising
profitability.
Cross-Selling Financial institutions must adhere to these regulations and, more importantly,
Incentives cultivate a culture of ethics and integrity within their organizations. This cultural
shift helps prevent conflicts of interest from arising in the first place, ensuring that
customers' interests remain paramount.
3.3 RESPONSIBLE LENDING AND BORROWING
Irresponsible lending practices can have dire consequences for individuals and the broader economy. During the
global financial crisis of 2008, irresponsible lending played a pivotal role in the collapse of financial institutions and
the subsequent economic downturn (Blundell-Wignall, Atkinson, & Lee, 2008). These consequences of irresponsible
lending can be divided into three sectors which includes financial institutions, borrowers and broader economy.
Financial Institutions Borrowers Broader Economy
• Credit Risk Exposure • Debt Burden • Economic Instability
• Asset Quality Deterioration • Financial Stress and Distress • Asset Bubbles
• Regulatory Scrutiny and Legal • Reduced Consumer Spending
Consequences • Regulatory Changes
• Reputation Damage
CONSEQUENCES OF IRRESPONSIBLE LENDING
FINANCIAL INSTITUTIONS:
a. Credit Risk Exposure: Irresponsible lending practices increase a financial institution's exposure to credit risk. When loans
are extended to borrowers who may not have the means to repay, the institution faces a higher likelihood of loan defaults.
This can result in significant losses, especially in the case of unsecured loans or loans with inadequate collateral.
b. Asset Quality Deterioration: Irresponsible lending can lead to a deterioration in the quality of a financial institution's assets.
Non-performing loans (NPLs) increase, and the institution may be forced to write down or write off these loans, negatively
impacting its balance sheet and profitability.
c. Regulatory Scrutiny and Legal Consequences: Financial institutions engaged in irresponsible lending practices may face
regulatory fines and legal actions. Regulatory authorities and consumer protection agencies closely monitor lending
activities to ensure compliance with laws and regulations. Violations can result in costly legal battles and regulatory
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d. Reputation Damage: Irresponsible lending practices can tarnish the reputation of a financial institution.
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CONSEQUENCES OF IRRESPONSIBLE LENDING
BORROWERS:
a. Debt Burden: Irresponsible lending can burden borrowers with unmanageable levels of debt. High-interest rates,
hidden fees, and inappropriate loan terms can lead to a debt trap, making it challenging for borrowers to meet their
financial obligations and negatively impacting their credit scores.
b. Financial Stress and Distress: Borrowers who have taken on loans they cannot afford may experience financial stress
and distress. This can result in reduced spending capacity, increased anxiety, and potential personal financial crises,
impacting not only individual borrowers but their families as well.
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CONSEQUENCES OF IRRESPONSIBLE LENDING
BROADER ECONOMY:
a. Economic Instability: Irresponsible lending practices can contribute to economic instability. When a significant
number of borrowers default on loans, it can lead to financial sector crises, as seen in the global financial crisis of
2008. This instability can affect economic growth, job security, and overall economic well-being.
b. Asset Bubbles: Irresponsible lending can contribute to the formation of asset bubbles, such as housing bubbles.
When lending standards are lax, it can lead to inflated asset prices. When the bubble bursts, it can result in
widespread economic disruption, as seen in the housing market crash of 2007-2008.
c. Reduced Consumer Spending: As borrowers struggle with high levels of debt and financial stress, they are likely to
reduce their spending, which can, in turn, impact consumer-driven industries and overall economic demand.
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this is necessary to prevent future crises, it can also lead to added compliance costs and reduced profitability for
financial institutions.
RESPONSIBLE LENDING
Responsible lending encompasses a comprehensive
assessment of a borrower's capacity to repay a loan and
providing appropriate financial education. It's not merely
about making loans accessible; it's about ensuring borrowers
can manage their debt responsibly.
Consider a scenario where a bank extends large mortgages to borrowers
without verifying their income or ability to repay. This can lead to a
housing bubble, as witnessed in the United States in the mid -2000s,
followed by a severe economic crisis. Responsible lending practices
could have averted such a catastrophe.
In Malaysia, responsible lending practices have been instrumental in maintaining
the stability of the banking sector. Statistics from the Central Bank of Malaysia
(Bank Negara Malaysia) indicate that non -performing loan ratios have remained
low, averaging around 1.5% in recent years. This reflects the effectiveness of
responsible lending practices in ensuring that most borrowers can meet their
repayment obligations.
FINANCIAL EDUCATION AND EMPOWERMENT
To promote responsible lending and borrowing, financial institutions should invest in financial
education initiatives . These programs equip consumers with the knowledge and skills required to
make sound financial decisions .
Financial education programs can teach individuals about budgeting, saving, and managing debt
effectively . When consumers have access to financial education, they are better equipped to
understand the implications of taking on debt, thereby reducing the risk of financial distress.
Moreover, responsible lending practices contribute to more stable financial markets, ultimately
reducing the likelihood of financial crises. They are crucial for the long-term sustainability of the
financial sector and the overall well-being of the economy .
3.4 CONSUMER PROTECTION AND FINANCIAL SERVICES
Consumer protection is the Consider a scenario where a bank The SC's Corporate Governance
cornerstone of ethical financial misrepresents the terms and Blueprint 2011 outlines specific
product development. It ensures conditions of a loan to a practices to enhance corporate
that consumers are treated fairly, borrower, leading to unexpected governance in Malaysia. This
their rights are respected, and charges and financial strain. includes recommendations for
they have recourse in cases of Without consumer protection boards of directors, enhancing
misconduct. This is particularly measures, the borrower may have transparency, and ensuring
vital in financial services, where no means of seeking redress. accountability.
individuals may lack the expertise
to navigate complex financial
products and services.
BENEFITS OF SAFEGUARDING
CONSUMER PROTECTION
Benefits Explanation
Vulnerability of Financial products and services are often complex and can be difficult for
Consumers the average consumer to fully understand. Consumers may not possess the
necessary knowledge to make informed decisions, which makes them
vulnerable to potential exploitation or harm.
Trust and The financial industry relies on trust and confidence. When consumers have
Confidence faith that they will be treated fairly and ethically, they are more likely to
engage in financial transactions, invest, and save. Consumer protection helps
maintain this trust, fostering a healthy and stable financial system.
Fair Treatment Consumer protection ensures that financial institutions treat customers
fairly and provide them with accurate, clear, and transparent information. It
prevents deceptive practices and ensures that consumers are not taken
advantage of due to their lack of expertise.
Financial Stability Inadequate consumer protection measures can lead to financial crises.
Irresponsible lending and misrepresentation of financial products can result
in consumer defaults, which can have systemic consequences and
undermine the stability of the financial industry.
Economic Growth A well-protected and confident consumer base is more likely to participate
in the economy. Consumer spending, saving, and investing contribute to
economic growth. When consumers are protected, they are more likely to
engage in these activities.
REGULATORY AGENCIES
Many countries have established regulatory agencies to oversee and enforce consumer protection laws in
the financial sector. For example, the Consumer Financial Protection Bureau (CFPB) in the United States is
responsible for safeguarding consumers from unfair and deceptive practices (Consumer Financial Protection
Bureau, 2021).
Financial institutions must comply with these regulations, which encompass rules on fair lending,
transparent pricing, and handling customer complaints. By doing so, they demonstrate their commitment
to ethical product development and consumer protection.
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CONCLUSION
In conclusion, ethical considerations in financial product
development are not just a moral obligation but also a
strategic imperative for the financial industry.
Transparency, conflict of interest management,
responsible lending and borrowing, and consumer
protection are all vital aspects that contribute to the
long-term sustainability and trustworthiness of the
financial sector.
By adhering to ethical principles, financial institutions
can foster a healthier and more prosperous financial
ecosystem for everyone.
THANK YOU
CAROLIN ANN ENCHAS
UiTM Cawangan Sarawak
NOOR AZILLAH MOHAMMAD ALI
UiTM Cawangan Negeri Sembilan
DR MOHD SAMSURI GHAZALI
UiTM Cawangan Pahang
DR ABDUL AZIZ LAI BIN
MOHD FIKRI LAI
UiTM Cawangan Sabah
