Bad corporate culture, more than individuals’ misconduct, are responsible for bad and illegal behaviors in the financial industry, according to a paper.
Calling the phenomenon the “Gekko effect”—after the villain in the 1987 film Wall Street—MIT’s Andrew Lo detailed how managing behavioral risk in financial institutions and regulatory groups could help prevent another Bernie Madoff Ponzi scheme.
“The Gekko effect highlights the fact that some corporate cultures may transmit negative values to their members in ways that make financial malfeasance significantly more probable,” Lo said.
“Human behavior is clearly a factor in virtually every type of corporate malfeasance, hence it is only prudent to take steps to manage those behaviors most likely to harm the business franchise.” —Andrew LoLike an epidemic spreading through a population, corporate culture is likely to define and shape employees’ behaviors, as its values become accepted as “the correct norms,” he added.
However, Lo argued that the same culture that promotes performance and teamwork could also easily push people to “goals without a moral, ethical, legal, profitable, or even rational basis.”
Bad culture could derive from a variety of factors including leadership that encourages risk, a company that hires the same kinds of employees with similar values, and inadequate risk management, the paper said.
According to Lo, these qualities of corporate culture helped bring down institutions during the financial crisis.
AIG, for example, relied too heavily on its past success and secure risk management policies under the tenure of Hank Greenburg, the paper said. This complacent culture allowed the company to make riskier bets, placing billions of dollars of toxic assets on its balance sheet.
Lehman Brothers exhibited another type of bad corporate culture: hiding its flaws and irregularities from the public, the regulators, and others within the firm.
“An internal hierarchy within Lehman’s management deliberately withheld information about its misleading accounting practices to outsiders who might have objected, even within the firm, because it believed that it was its proper role,” Lo said.
Furthermore, the author argued that the culture of inattention and neglect allowed Société Générale to turn a blind eye to a rogue trader’s fraudulent and unauthorized trades in 2008.
Regulators are also guilty of exhibiting poor corporate culture, Lo said.
Despite receiving tips of Madoff’s impropriety as far back as 1992, the US Securities and Exchange Commission (SEC) failed to discover and prove the Ponzi scheme until 2008. Its hierarchical culture had prevented different divisions from communicating and working together, Lo said.
“The SEC’s culture had grown more risk-averse over time, a majority of both staff and senior officers explicitly agreeing that this was due to the fear of public scandal,” he continued.
To fix such poisonous and permeating corporate culture, Lo recommended a forensic analysis and management of behavioral risks.
The process would be parallel to traditional risk management tools used to manage portfolio risk at all financial institutions, the paper said. This would include quantitatively identifying factors underlying “fraud, malfeasance, and excessive risk-taking behavior,” and creating a healthy reward structure tied to the stability of the institution.
“Human behavior is clearly a factor in virtually every type of corporate malfeasance, hence it is only prudent to take steps to manage those behaviors most likely to harm the business franchise,” Lo said.
Read the full paper “The Gordon Gekko Effect: The Role of Culture in the Financial Industry”.
Related: Integrity Is Still Lost on Wall Street, Survey Finds