Mr. Desario looks at the financial system and the non-profit sector with
respect to ethics and solidarity in finance Address by the Director General of the Bank of
Italy, Dott. Vincenzo Desario, before the conference on "Italian society at the turn of the
millennium: opportunities and prospects of the non-profit and voluntary sector" held in Milan on
17/3/97.
The importance of the non-profit and voluntary sector is now appreciable not only
ethically and culturally, as a tendency whose expansion bears witness to the human and civic
development of Italian society, but also on the economic plane.
Everywhere, substantial budget deficits are forcing a retrenchment of public
spending and more generally an attenuation of direct government involvement in the economy.
It follows that non-profit and voluntary organizations may play an ever-larger role in reducing
social disparities, devising modes of intervention appropriate to the continually changing forms
in which inequality arises.
In Italy the need for a larger and stronger non-profit and voluntary sector is
especially great, owing to the necessity of fiscal adjustment and the inefficiency afflicting public
services.
My remarks today begin with some preliminary considerations on the
relationships between ethics, solidarity and finance. I shall follow this with a description of the
non-profit sector and some observations on banking foundations. Finally I shall examine the
funding of the non-profit sector and its relations with the banking system.
1. Ethics, solidarity and finance
The changes in Italy's credit and financial system in recent years reflect the
concern of law-makers and supervisors to foster market values and competition. The principles
of transparency and fairness in relations between banks and customers not only are embedded in
rules of conduct but have now been given the status of purposes of supervisory activity by
Legislative Decree 415 of 23 July 1996 transposing the EU Investment Services Directive into
Italian law.
Reference to these principles is not merely ritual. It bids us to recognize that the
operating environment has been radically transformed and now, even more than in the past,
demands the firm commitment of intermediaries to comply with the letter and the spirit of the
rules of good faith and fairness.
These values are inextricably bound up with the relationship between bank and
customer, which is based on trust. They make it easier to face the challenges of competition.
They promote customer loyalty and enhance the bank's reputation in the market.
Trust is essential to the operation and growth of the economy. As the Nobel
Laureate Kenneth Arrow has observed "Virtually every commercial transaction has within itself
an element of trust, certainly any transaction conducted over a period of time. It can be plausibly
argued that much of the economic backwardness in the world can be explained by the lack of
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mutual confidence."
The risk of a self-serving breach of trust by economic agents is one of the main
sources of transaction costs, in that it necessitates performance bonds and monitoring the
counterparty's behaviour.
The most effective way of reducing transaction costs is for market participants to
adhere to the precept that it is one's moral duty to respect others and not to betray their trust.
Widely shared ethical precepts and moral conduct strengthen agents' credibility and reliability,
make it easier to reach new business agreements and ultimately increase the likelihood of
success.
In a market economy the credit system has the important function of selecting
creditworthy projects, economic initiatives that can produce new benefits and increase overall
social welfare. It is essential for every bank to screen borrowers by strictly professional
standards based on technical assessment of projects' risks and returns.
Inefficient assessment of creditworthiness results in significant losses. In markets
where there is little competition, poor asset quality is reflected in higher interest rates, with
adverse repercussions on the economy as a whole. In more competitive markets, with their
narrower spreads, loan losses can lead to bank failures. And this affects other outstanding loans,
causes jobs to be lost and wipes out uninsured depositors' savings, with the risk that the failure
may spread.
Customer confidence is the banking enterprise's most valuable intangible asset. It
is the prerequisite for building stronger and more durable customer relations that can be
broadened from simple loan disbursement to the entire range of firms' financial needs.
With trust, there is a better likelihood that the relationship between bank and
customer will be consolidated as a "repeated game" in which, as game theory teaches, the
problems of opportunistic behaviour are overcome.2
This approach can be successful if the bank does not act in conflict of interest; if,
that is, it safeguards the interests of the customer together with its own, recommending financing
plans and instruments that are compatible with the customer's projects, the state of the firm and
the prospects of its market.
In finance, solidarity can be expressed by paying more attention to the customer's
needs, viewed comprehensively, and assisting the customer in making financial choices that best
serve the realization of corporate goals. Any short-term earnings loss will be offset by the future
income the bank will obtain as a result of the continuity of the relationship and from additional
corporate financial services.
The principle of overcoming conflict of interest also informs proper and
transparent relations with savers who entrust the bank with making an investment or managing
their financial assets. The intermediary that reconciles its own interest with the customer's, that
makes customer assistance a conscious value of its corporate culture, perceiving it as a tool of
competition, has a better chance of success in the financial markets.
The rule that one who acts on behalf of another must protect the latter's interest
and not make undisclosed profits from this management activity is clearly ethical in origin. It
was first stated, as regards the law of trusts, in the Middle Ages in sentences handed down by the
Chancellor of the King of England; that is, by a judge, ordinarily also a bishop, who decided
lawsuits mainly on the basis of ethical and religious canons.
Effective, correct customer assistance is premised upon thorough knowledge of
the customer. The "know your customer" rule has been reaffirmed recently by Italian financial
legislation. Law 1/1991, as well as the more recent legislative decree transposing the EU
Investment Services Directive, lays down that in carrying on securities activities the investment
firm must "acquire prior information about the financial situation of customers that is relevant to
the conduct of the activity."
This principle was made applicable to the entire banking and financial industry
with the publication of the Bank of Italy's anti-money-laundering "Decalogue", which stresses
that familiarity with the customer is essential not only for detecting suspect transactions but also
for maintaining stable customer relations.
Intermediaries have increasingly recognized the importance and the positive
implications of this rule. Appreciable steps towards self-regulation have been taken, such as the
code of conduct for banks, adopted in 1996, which sets standards of fairness in dealings with
customers. When they enjoy real consensus, such initiatives are an especially effective tool for
reinforcing and extending the rules of professional ethics, because they are not imposed from
above but reflect the shared feelings of those involved.
In the public interest and in conformity with the law, the supervisory authorities
lay down prudential standards and rules of conduct covering all intermediaries. The authorities
are careful not to impose costs that are not justified by greater benefits to the community as a
whole. They are guided by the best practices of the market. They check that intermediaries act
consistently with the principle of sound and prudent management.
Management that is sound - i.e. in accordance with the rules derived from
experience and the theory of enterprise (profitability), not subject to improper influences
(independence) and based on correct business relations - and prudent - i.e. sensitive to risk - will
have beneficial results in terms of the orderly and efficient operation of the economic and
financial system.
Sound and prudent management is an overarching criterion for supervisory
activity. It sums up the values of stability, efficiency, integrity and proper functioning of the
financial system. It is where systemic objectives and microeconomic goals meet. As a norm, it
requires that intermediaries' dealings with firms and households be constantly inspired by the
canons of business and professional ethics, transparency, legality, fair competition. Sound and
prudent management is at once a technical rule and an ethical canon.
Safeguarding competition also carries a deep ethical significance. Abuse of a
dominant position, price fixing, or collusive agreement on practices to the detriment of
consumers allows intermediaries to reap unjustified profits and excludes those who cannot pay
the fixed prices from enjoying the relevant services. Such practices generate both inefficiency
and inequity.
2. The non-profit and voluntary sector
An abiding school of thought embracing analysts of differing backgrounds holds
that a democratic political system, if it is to be deeply rooted in the social fabric, must be
articulated in a tightknit web of organizations positioned between the individual and the state:
collective actors that enable citizens themselves to "become the state" by directly administering
and providing socially useful services.
As the French sociologist Emile Durkheim stressed, a nation can be said to exist
only if between the state and private citizens there is a whole series of secondary groups close
enough to individuals to draw them forcefully into their field of action and so involve them in
the mainstream of social life.3
The grass-roots presence of associations, mutual societies, communities and
clubs, networks of civic commitment, is seen by some scholars as a decisive factor in
establishing a climate of reciprocal confidence and social cooperation, which is necessary to
launch a virtuous circle of economic development.4
The non-profit sector is defined essentially by two traits: private ownership and
control and a ban on distributing profits. The latter feature does not imply that a non-profit body
cannot ever generate profits; what counts is that any net profits must be reinvested in the pursuit
and expansion of the organization's activity, to finance its mandated purposes.
It may seem surprising that in a market economy one finds associations, clubs,
mutual societies, leagues and private cooperatives providing services without distributing profits
and almost always operating alongside other institutions, such as the family, the state, and
business corporations. Yet historical experience teaches that the state-market dichotomy does not
exhaust all the ramifications of a modern economic and social system. In economic theory the
most widely accepted explanations for the existence of non-profit enterprises bear on market
"failures", which are generally related to information asymmetries, i.e. cases in which the
independent contracting power of agents does not ensure sufficient transparency or
comparability of services and products.
Especially where service quality is difficult to ascertain, there is room for the rise
and growth of non-profit enterprises. For the consumer, the ban on distributing profits is a signal
that the provider will not raise the price of the service without just cause or reduce its quality.
Similar assurance is offered to those who wish to make donations to non-profit agencies that
assist the weak and the needy.
The ban on distributing profits fosters and strengthens the bonds of trust between
users, private donors and the service organization. It is a deterrent to the involvement of workers
and managers who would be inclined to pursue their own individual interests, those who are less
socially committed.
The private non-profit organization has comparative advantages not only as
against business corporations but also with respect to public provision of goods and services,
especially those earmarked for particular segments of society. By virtue of more efficient
collection and processing of "local" information, i.e. within circumscribed territories, non-profit
agencies cater more effectively to the particular needs of specific social groups or sectors.
These are services that require more of a grass-roots presence and a greater
capacity to target action to non-standardized needs. The state retains a comparative advantage in
the provision of undifferentiated public services, such as compulsory schooling, basic health
care, and social security.
The non-profit and voluntary sector can play a major role in supplementing public
programmes and in broadening the area of social protection. It must become a mechanism for
soliciting and raising additional private resources, over and above government appropriations for
these purposes, in order to meet those needs that state action is inefficient in facing.
Italy's unbalanced economic development has been accompanied by phenomena
of social distress and has not succeeded, to date, in narrowing regional disparities. The growth
and spread of social solidarity, volunteer service and the entire non-profit sector is highly
desirable to reinforce the pact of mutual support binding the national community at the
institutional level and to make for fruitful, complementary relations between private and public
social welfare activities.
Delay in the development of the non-profit sector and excessive reduction of the
social role of the state, albeit for budgetary reasons, could place the whole burden of assisting
society's most vulnerable members on the family. Owing to the changes in society, the family is
no longer capable, unaided, of dealing with the complicated problems posed by the modern
world.
3. The fight against usury: a case of complementarity between government and voluntary action
Solidarity means disinterested assistance to those in need. The traditional ethical
condemnation of lending at interest, found in the Old Testament and in Aristotle, can be traced
back to the ethical principle of solidarity whereby one must help the needy person, not take
advantage of his need. Leviticus reads: "And if thy brother be waxen poor, and fallen in decay
with thee; then thou shalt relieve him; yea, though he be a stranger, or a sojourner; that he may
live with thee. Take thou no usury of him, or increase.... Thou shalt not give him thy money
upon usury, nor lend him thy victuals for increase."5
The passage from condemnation of charging of interest to the needy to the
outright condemnation of interest as such, found in other books of the Old Testament,6 is logical
in the historical context of a static, agrarian economy in which recourse to credit is not a normal
event for anyone engaging in economic activity but the last resort of victims of exceptional
adversity.
Even today, the exploitation of the weakness of those in need is an element in
usury, an odious and socially destructive practice that has taken on alarming dimensions in
recent years.
The problem is delicate, complicated, and because of its emotional impact proper
analysis of the issue requires an effort of intellectual lucidity to avoid the sort of crude
judgments that surface from time to time in the discussion.
The alleged inflexibility of legal intermediaries in granting loans is often cited as
a contributing cause of usury. But banks operate with the funds of their depositors, which it is
their duty to safeguard; accordingly they lend to those customers who are in a position to honour
their obligations. By using the savings it has collected in the most efficient manner and
protecting their value through sound and prudent management, the banking enterprise performs
its important economic function, combining private profit-seeking with the general interest.
It may be that some high-risk borrowers, at the margins of the credit market, find
it hard to obtain "legal" credit. These borrowers, who tend to be small businesses even more
commonly than households, may fall prey to usurers, through no fault of the legitimate
intermediaries subject to supervision.
Italy's 1996 anti-usury law accords official recognition to the role played by the
voluntary sector in sparing enterprises and households the risk of having to turn to usurers. The
main instrument for combating usury is government grants to non-profit foundations and
associations that already administer resources deriving from private donations, to be used as
security for bank loans at moderate rates of interest to persons in financial difficulty.
Italy counts a good number of associations engaged in the battle against usury.
There are eight officially recognized foundations active in prevention and assistance to victims.
Six operate in the central and southern regions, where usury is most widespread and perilous,
owing to its links with organized crime.
4. The banking foundations
As I mentioned, non-profit enterprises develop in sectors where pronounced
informational asymmetries between customers and service providers lead the public to prefer
services supplied by undertakings that do not distribute profits.
Informational asymmetries are a distinguishing feature of the banking and
financial sector.
These two points may help to shed light on the creation of banks in the form of
associations or foundations (savings banks first and foremost), which reached its peak during the
nineteenth century. These institutions served to counter usury and to overcome the aversion of
"first-generation" savers towards the banking system.
The great banking crises of the thirties fortified the role of the public banks,
which served to restore savers' confidence in the banking system and allowed an orderly flow of
financing to the economy.
The development of the Italian economy and decades of financial stability
safeguarded by an effective system of public supervision brought a considerable part of the
population into contact with the banking system. The evolution of markets and their increasing
openness brought the public banks' entrepreneurial features increasingly to the fore, with a
corresponding de-emphasis of their original social functions.
The reform of the public banks that Parliament enacted at the beginning of the
nineties in response to these tendencies sanctioned the passing of the public law model of
banking; the law separated the institutions' original social-welfare and charitable purposes from
banking activity, assigning the former to the foundations and the latter to companies limited by
shares
The most compelling reason for the reform, at the urging of the supervisory
authorities, was to allow the introduction of organizational and operational models able to ensure
higher standards of competitiveness and efficiency. An important factor was the central role
assigned to banks' capital by the supervisory system then being forged at Community level; the
limited scope for Italian public banks to raise funds directly in the equity market hindered their
growth and ability to compete.
The legislative solution adopted - the original institutions to remain in existence
after transferring their banking activity to companies limited by shares - also sought to exploit
the valuable social and civic function that most of the public credit institutions had historically
performed.
Initially, the reform legislation was basically neutral concerning the practical
options for the banking foundations; it defined the spectrum of activities open to them, clearly
drew the border between banks and foundations, and laid down what the latter could not do,
namely manage banks.
The remodeled foundations' sizable endowments fueled expectations that they
might satisfy the growing financial needs of the voluntary and non-profit sector. The banking
foundations, it was felt, could fill the gap left by the shrinking of the welfare state; but in order
to occupy a central position in the nonprofit sector, it was argued, they had to dispose of their
equity interests in banks at once.
However, realizing the full potential of the banking foundations requires that they
cease being regarded as a pool of resources to be dipped into indiscriminately or as a body of
assets whose composition can be altered in order to pursue the most diverse purposes.
The foundations are non-profit operators themselves and can actively contribute
to the non-profit sector's development by identifying areas for intervention and nurturing
socially useful initiatives. In deciding how to go about pursuing their objectives, the foundations
can adopt a directly operational setup and manage one or more socially useful activities
themselves, under arrangements already adopted elsewhere and not new to Italy.
If they should decide instead to continue in the role of grant-making institutions,
in order to make a truly effective contribution they must develop sufficient skills in selecting
initiatives, monitoring the use of funds and assessing results.
Grant-making plainly entails a degree of specialization, not only geographic but
also by sector of socially useful activity. In effect, the data assembled by the Association of
Italian Savings Banks (ACRI) via reclassification of the banking foundations' annual accounts
and a survey of the grants made by the 81 ex-savings bank foundations offers evidence of
growing specialization. Sorting the foundations by sectoral concentration of grants shows that
60.5 per cent allocated over half of their funding to a single sector or more than sixth tenths to
just two sectors in 1995.
There is some tendency away from small grants, although these are still very
common among the smaller foundations, and considerable growth in multi-year grants, whose
share in total disbursements rose from 7.7 per cent in 1994 to 11.6 per cent in 1995. According
to the ACRI report, disbursements amounted to 211 billion lire in 1995, equal to a little less than
one third of the foundations' net operating results and 7.8 per cent up on the 1994 figure of 196
billion.
The banking foundations' activities are hampered by their low return on assets.
ACRI calculates that the ex-saving bank foundations' overall ratio of net operating results to
assets was 2 per cent in the 1994-95 financial year. This poor performance, though an
improvement on 1.43 per cent in the previous financial year, reflects the modest return on
holdings of bank shares, dividends from which account for 80 per cent of the result. Thus, the
ability of the foundations to fulfil their institutional purposes depends largely on cyclical
conditions in the banking industry.
It is incumbent on the foundations to seek an optimal return on their capital, in
order to preserve its real value and ensure the continuity of their activities. This will require
greater asset diversification, a necessary condition for the foundations' assuming a more fertile,
autonomous role in the social sphere.
Fostering such a role is the basic objective of the provisions for the revision of the
civil-law and tax treatment of the banking foundations in the Government's recent enabling bill,
which are meant to encourage them to dispose of their bank shares. The proposed legislation
would provide tax incentives for the operations connected with privatization; unlike earlier
proposals, it sets no deadline for the sale of bank shares.
The decision to encourage rather than order such disposals and to allow them to
be spread out over time appears appropriate. It is compatible with the objective of respecting the
decision-making autonomy of the parties involved and improving the profitability of banks so as
to enhance the attractiveness of their shares. And it creates scope for the stock market to be able
to absorb the shares of the banks, without excess supply depressing the placement price. The
foundations will have a better chance to dispose of their bank equity with the necessary
gradualness. The incentives for the sale of bank shares will facilitate the reorganization of the
banking system and foster an increase in bank size, especially if the sales bring in authentic fresh
capital.
However, the breadth of the delegation of powers contemplated by the enabling
bill and, above all, the diversity of its objectives are such that a well-defined legislative
framework is not yet discernible. The parliamentary debate will have to fill in gaps and resolve
uncertainties. The proposed establishment of a regulatory authority for non-profit institutions,
including the banking foundations. deserves some comment. This authority would be assigned to
oversee the legitimacy of the actions of the foundations' governing bodies, their sound and
prudent management, the return on assets, and their effective pursuit of the aims specified in the
bylaws. Its powers would also include authorizing transformations and combinations, passing on
amendments to bylaws, removing the governing bodies and dissolving foundations in the event
of repeated management irregularities, setting a minimum proportion of income (not less than
one half) that must be allocated to institutional purposes, and acting in lieu of the governing
bodies for individual acts.
Beyond a certain point, it is not easy to reconcile the intensity of the planned
administrative controls with the degree of autonomy that recognition of the institutions' private
nature would imply. Nonetheless, the experience of foreign jurisdictions with longer traditions in
this field shows that some form of supervision on the foundations and non-profit sector in
general remains appropriate, especially as regards entitlement to favourable tax treatment.
However, supervision should be calibrated so as to avoid stifling the initiative of the non-profit
institutions, draining their capacity to act and ultimately reducing the benefits to civil society.
5. Financing the non-profit and voluntary sector
There are four possible sources of funds for the non-profit sector: private
donations, government transfers, debt capital and self-financing.
Government contributions bulk large in Italy, whereas private donations are
marginal. The relationship between the two is specular, and in fact in countries where private
donations play a larger role they are encouraged by favourable tax treatment.
Banks can help to increase the flow of private donations to non-profit enterprises
by offering their customers specially designed financial instruments; for example, the so-called
"ethical" funds and accounts that some financial intermediaries have promoted, whose rules
require subscribers or depositors to assign all or part of their income from the investment to
nonprofit institutions.
These products can involve financing as well as donations; alongside the
assignment of customer earnings or capital gains, there is often an obligation for the
intermediary to invest the monies received only in undertakings that conform to certain ethical
standards or pursue specific objectives.
The organizational and opportunity costs of launching such initiatives are
compensated for by the enhanced reputation and standing that the intermediary enjoys among
socially aware customers.
The specific advantage of banks' interposition with regard to charitable donations
stems from their placement power: branch networks, which give banks an edge in supplying
their own financial products and those of others, also put them in a strong position to sell
"ethical" products to their customers.
Where profit-seeking intermediaries offer customers financial products earmarked
to fund the non-profit sector, organizational and accounting controls are necessary to ensure
transparency.
Other conditions being equal, two factors may handicap non-profit undertakings
in raising debt capital. First, the rule prohibiting distribution of profits may strike the prospective
lender as likely to erode operating efficiency in the long run. Whereas for commercial
enterprises the profit motive is the mainspring of survival and growth, for non-profit institutions
there is a problem of ensuring that the altruistic drive does not flag over time. On the other hand,
the ban on distributing profits is also a point of strength, since it allows non-profit enterprises to
screen and select collaborators, workers and managers who share their altruistic objectives of
service.
The second adverse factor is linked to the eventuality of the non-profit
undertaking failing to repay the loan. In this event, a bank bringing action for forced recovery
would run the risk of appearing to put its own interests before the social, humanitarian or
charitable purposes of the distressed undertaking.
Financial support can be provided to the non-profit and voluntary sector by
intermediaries that exclusively, prevalently or even only occasionally engage in such lending
(so-called "ethical" intermediation). The record shows a variety of such experiences in many
countries.
To cite a few significant examples, Ökobank in Germany, which focuses on
environmental and peace issues, had 63,000 customers and 170 billion lire of deposits in 1993;
in the Netherlands, Triodos Bank, of the eponymous association for social development and
environmental protection, accounts for 2.5 per cent of the country's total bank deposits; in
Switzerland, the banner experience is that of Alternative Bank ABS, which in 1992 had around
106 billion lire of loans outstanding to local non-profit enterprises and associations for
thirdworld development.
Other intermediaries concentrate on fostering small business in the third world or
in economically depressed areas of the industrialized countries.
The best-known example is Grameen Bank of Bangladesh, which lends to farmers
in the poorest rural areas. The key to its success is its technique of forming small groups of
customers who take part in training workshops that also serve to select the creditworthy. The
small loans disbursed to them are gradually scaled up if each member of the group meets the
repayment terms. The bank's high credit quality testifies to the efficacy both of the method used
for assessing creditworthiness and of the system of cross-monitoring among members of a
group. The high risk that nonetheless characterizes the bank's activity made it advisable for it to
fund its loans primarily with public contributions and the bank's own resources, part of which
was paid in by the beneficiaries of its lending.
In the United States, a very interesting case is that of the Illinois Neighborhood
Development Corporation, created by non-profit shareholders and licensed to engage in banking
since the seventies. The bank initially operated in one of the worst slums of Chicago, the South
Shore, and endeavoured to redevelop the area particularly by giving minority groups more
access to credit. The programme's success allowed it to be extended to other rundown, outlying
neighbourhoods. Thanks to its skilled and highly-motivated staff, this bank has combined
rigorous lending standards with a variety of assistance and promotional services, operating in
compliance with the normal banking supervisory requirements.
A complete review of the experiences in various countries would also have to
include the cases of failure and those demonstrating the difficulty of transplanting successful
initiatives to different social and institutional settings.
For an "ethical" intermediary actually to achieve comparative advantages in
financing the non-profit and voluntary sector, various conditions, not always easily satisfied,
have to be met: a highly motivated staff, for one, and savers receptive to the ethical aims
pursued and willing to support them over time with deposits.
The affinity of ideals between the bank and the borrower must not tempt the
former to relax its technical standards of customer selection or neglect to heed the principle of
operating profitability. Specialization in the non-profit and voluntary sector must be compatible
with the key principle of the banking system. Operating losses could not only cause the bank to
fail but also have adverse repercussions on similar initiatives.
The success of such projects essentially depends on devising techniques to limit
the credit risk while simultan