The Economics of Why Companies Don't Fix Their Toxic Cultures

Firms engage in an often informal risk management assessment of intangible cost-benefit trade-offs.

They appear to conclude that the relative penalties of getting caught and then embracing the costly disruption of change are lower than the relative benefits of tolerating cultural and misconduct risk. JL


Kevin Stiroh reports in Harvard Business Review:

Analyses of misconduct suggest that misconduct is a form of risk just like liquidity or operational risk. Economic theory (explains) why firms may operate with sub-optimal levels of cultural capital (which increase) misconduct risk. Because the costs of misconduct are not always paid by the firm, it may underinvest in the cultural capital required to prevent it (and) firms with low cultural capital may attract and retain employees and clients more inclined to take inappropriate risks.
Over the last decade, industries, academics, and the public sector have turned their focus toward culture and ethics in response to the financial crisis as well as misconduct at a broad range of corporations. But what role does culture play in corporate misconduct, and why do these problematic cultures persist?
My perspective and approach to misconduct risk are influenced by my work as a bank supervisor, and by my background and training as an economist. In my view, bank supervision must include attention to the culture at financial firms, not just to their financial safety and soundness. The justification for this attention comes from relatively simple economics. By thinking of a company’s culture as a form of investment subject to market failures, we can better understand why companies sometimes tolerate misconduct, and why they can’t always fix it on their own. Though my experience is in the financial sector, these lessons apply to other industries as well.

The economics of corporate culture

Analyses of recent cases of misconduct in the financial sector suggest that misconduct is not just the product of a few individuals or bad processes, but rather the result of wider organizational breakdowns, enabled by a firm’s culture. One way to think about the underlying factors involved is as “cultural capital.” The possibility of employee misconduct—the potential for behaviors or business practices that are illegal, unethical, or contrary to a firm’s stated values, policies, and procedures—is a form of risk just like liquidity risk or operational risk. Investments in cultural capital is one way to reduce that risk.
A firm’s cultural capital is a type of asset that impacts what a firm produces and how it operates. Cultural capital is analogous to physical capital, like equipment, buildings, and property, or to human capital, like the accumulated knowledge and skills of workers, or reputational capital, like franchise value or brand recognition. In an organization with a high level of cultural capital, misconduct risk is low, and its organizational structures, processes, formal incentives, and desired business outcomes are consistent with the firm’s stated values. Unspoken patterns of behavior reinforce this alignment and drive corporate outcomes.
By contrast, in an organization with low levels of cultural capital, formal policies and procedures do not reflect “the way things are really done” — that is, the stated values of the organization are not reflected in the behavior of senior leaders or the actions of the organization’s members. Misconduct then results from norms and pressures that drive individuals to make decisions that are not aligned with the values, business strategies, and risk appetite set by the board and senior leaders. Rules may be followed to the letter, but not in spirit. All of this increases misconduct risk and potentially damages the firm and the industry over time.
As with other forms of tangible and intangible capital, a firm must invest in cultural capital or it will deteriorate over time and adversely impact the firm’s productive capacity.
When viewed through this economic lens, the question becomes: If misconduct risk is bad for firms, why don’t they invest in cultural capital and reduce the risk themselves? Why do regulators and supervisors need to get involved?

Market Failures and Misconduct Risk

It’s worth noting that many large financial firms have increased their attention to misconduct risk and cultural drivers in the wake of serious frauds and enforcement actions over the past several years. But the degree of commitment and progress in these efforts has not been even across the industry, and serious and persistent misconduct continues in some businesses.
So, why wouldn’t a firm do more to invest in cultural capital? Traditional economic theory may offer a few explanations. Namely, firms may operate with sub-optimal levels of cultural capital due to different types of market failures. Three well-known phenomena—externalities, principal-agent problems, and adverse selection—may help explain why misconduct risk persists.
Externalities. Externalities are the impact that a transaction between actors has on other unrelated actors. If a company pollutes when making a product, neither the buyer nor the seller bears the cost of that pollution – the cost falls on the rest of society. Externalities can drive a wedge between private- and socially-optimal outcomes and lead firms to underinvest in their own resiliency by ignoring the broader impact of bad outcomes on the financial sector and the real economy.
Does a firm’s toxic culture create an externality? Yes, because the impact of employee misconduct extends beyond the individual and even the firm — in finance it can affect the safety, soundness, and effectiveness of the financial sector and the broader economy.
If a firm commits fraud or another type of misconduct, for instance, much of the cost of that misconduct does fall on people involved – managers, employees, and investors – in the form of fines, diverted management attention, or even bankruptcy.  But this can also impose costs on people not directly connected to the company.  Customers might lose confidence in the firm or the industry as a whole and financial intermediation could decline.  In such a case, misconduct has created an externality.
And there is evidence that financial misconduct can have broader impact, imposing costs beyond the industry. Recent surveys, for example, have found that confidence in the financial sector has fallen by half over the last decade, which can impede the efficient intermediation of credit and the provision of financial services.
In the case of pollution, externalities motivate government intervention. In banking regulation, externalities are the conceptual driver behind the enhanced prudential standards for capital, liquidity, and risk management that are currently applied to the largest, most systemically important financial institutions. The same reasoning suggests a possible role for regulators and supervisors to consider company culture and the potential misconduct. Because the costs of that misconduct are not always paid by the firm, it may substantially underinvest in the cultural capital required to prevent it.
Principal-agent problems. Principal-agent problems occur when the incentives of employees don’t align with the broader interests of management or shareholders. This can lead to excessive risk-taking, underinvestment in risk-reduction and risk-control mechanisms, and a focus on short-term returns at the cost of long-run viability. Think about the trader who is compensated on short-term profits and losses and not long-term value creation.  The misalignment of incentives can tilt the firm toward excess risk-taking unless curbed by the appropriate culture and focus on risk management.
These issues can be amplified by the opacity intrinsic to many financial activities that allows misconduct to persist and erodes the cultural capital of the firm.
Adverse selection. Adverse selection occurs when those particularly ill-suited for something are the most likely to participate. This could occur in the context of culture and misconduct if conduct-related events change the composition of a firm’s workforce. Firms with relatively low cultural capital (and a relatively high tolerance of misconduct risk) may attract and retain employees and clients more inclined to take inappropriate risks and push beyond internal limits and controls. Further, high-quality directors, executives, and employees might leave such firms or decline to join them, depleting the firm’s human capital and contributing to the deterioration of cultural capital.

Role of the Public Sector

These market failures suggest a role for the public sector to encourage resiliency, including investment in cultural capital, beyond what the firm would choose to do on its own. That is, if firms don’t have sufficient incentives to overcome these forces, then the public sector should push toward a better overall outcome.  Given my role as a bank supervisor, my focus is on financial firms, but these types of phenomenon can lead to inefficient outcomes in any industry.
While misconduct risk poses clear threats to both firms and the overall financial system, addressing culture reform across an entire industry is a complex challenge, and there is no one action or approach that will fully address it. The work bank supervisors do in this area is critical because there are limits to the regulatory or deterrence and enforcement approach. To understand how a firm manages misconduct risk—and to improve resiliency and reduce the potential for unwanted disruptions to financial intermediation—we must increase our focus on firms’ decision-making practices and behaviors as a core aspect of good governance.