Thought of the Week - The cost of doing business

If you have never been to countries that are rife with corruption, you might think paying bribes is criminal or at least unethical, and should never be allowed. That is correct in theory and I do agree with you, but the real world isn’t so black and white.

First, corruption is often a matter of definition. If you are paying a doctor in a third world country to get better treatment, it is called corruption. But if you pay an insurance company for private health care to get better treatment, it is called capitalism.

In the past, the wealth management industry was considered rife with “corruption” because financial advisers were able to collect kickbacks for funds they recommended and sold to their clients. The result was that client portfolios were mostly filled not with cheap low-cost funds but with active funds that paid the largest kickbacks. This practice has by now been abolished in most developed countries or, at the very least, wealth managers have to disclose the fees they collect from the funds and their clients have the right to claim these kickbacks for themselves. The result was another margin squeeze for wealth managers.

Similarly, before the introduction of MiFID, institutional investors typically paid for sell-side research via soft dollars, e.g. by routing trades to a specific broker. That is no longer possible and today, sell-side research has to be unbundled and priced separately.

In other places, such referral fees and soft dollar arrangements are still common.

And this is the crux of the problem with corruption (whether outright corruption or incentive fees): in the end it is lost money that does not end up in productive use.

An international study on the link between paying bribes and growing your business showed that the more money a business pays in bribes, the more money it wastes and the lower the growth of the business. Businesses that pay fewer or smaller bribes show systematically higher growth in the long run.

But companies that refuse to pay any bribes show systematically lower growth than companies that do pay bribes. Paying no bribes at all is not an option in some countries because it will end in a shut-out of the business, with even the risk of its closure. In the end, paying bribes literally becomes the cost of doing business because, if you refuse, you will not do business at all and your employees will lose their jobs.

As a matter of practice, it is thus best for a company in a corrupt country to pay bribes but only as little as possible.

I don’t like that conclusion, but I have to accept the reality of doing business in these countries. Obviously, the solution would be to fight corruption at a national level but, let’s be honest, besides Greece, how many countries do you know that have successfully reduced corruption in the past decade? And Greece certainly didn’t fight corruption voluntarily.

In the world we live in, we sometimes have to accept that companies act unethically in order to help people make a living and improve their lives. It’s a moral dilemma ingrained in ESG investing that I have no answer for.

Thought of the Week features investment-related and economics-related musings that don’t necessarily have anything to do with current markets. They are designed to take a step back and think about the world a little bit differently. Feel free to share these thoughts with your colleagues whenever you find them interesting. If you have colleagues who would like to receive this publication please ask them to send an email to [email protected]. This publication is free for everyone.