Editor’s note: Dr. Lo, developer of the Adaptive Market Hypothesis (AMH), prepared this paper for the Federal Reserve Bank of New York’s Financial Advisory Roundtable (FAR) meeting, October 17, 2014. The complete text is available at his web site. Below is an extract of the paper to highlight current issues in the market that technical analysts should be aware of.
Abstract: Culture is a potent force in shaping individual and group behavior, yet it has received scant attention in the context of financial risk management and the recent financial crisis. I present a brief overview of the role of culture according to psychologists, sociologists, and economists, and then present a specific framework for analyzing culture in the context of financial practices and institutions in which three questions are addressed: (1) What is culture?; (2) Does it matter?; and (3) Can it be changed? I illustrate the utility of this framework by applying it to five concrete situations—Long Term Capital Management; AIG Financial Products; Lehman Brothers and Repo 105; Société Générale’s rogue trader; and the SEC and the Madoff Ponzi scheme—and conclude with a proposal to change culture via “behavioral risk management.”
Introduction: In the 1987 Oliver Stone film Wall Street, Michael Douglas delivered an Oscar-winning performance as financial “Master of the Universe” Gordon Gekko. An unabashedly greedy corporate raider, Gekko delivered a famous, frequently quoted monologue in which he eloquently described the culture that has since become a caricature of the financial industry:
The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA.
Despite the notoriety of this encomium to enlightened self-interest, few people know that these words are based on an actual commencement speech, at what is now the Haas School of Business of the University of California at Berkeley, delivered by convicted insider trader Ivan Boesky in 1986, only eighteen months before his conviction.
Millions of people saw Wall Street, and Gekko’s monologue became part of popular culture. Hundreds, perhaps thousands of young people were inspired to go into finance as a result of Douglas’s performance. This dismayed Stanley Weiser, the co-writer of the screenplay, who met many of them for himself, Weiser wrote in 2008, at the height of the Financial Crisis, “A typical example would be a business executive or a younger studio development person spouting something that goes like this: ‘The movie changed my life. Once I saw it I knew that I wanted to get into such and such business. I wanted to be like Gordon Gekko.’ After so many encounters with Gekko admirers or wannabes, I wish I could go back and rewrite the greed line to this: ‘Greed is Good. But I’ve never seen a Brinks truck pull up to a cemetery.’”
What makes this phenomenon truly astonishing is that Gekko is not the hero of Wall Street—he is, in fact, the villain. Moreover, Gekko fails in his villainous plot, thanks to his young protégé- turned-hero, Bud Fox. The man whose words Weiser put into the mouth of Gekko, Ivan Boesky, later served several years in a federal penitentiary for his wrongdoings. Nevertheless, many young people decided to base their career choices on the screen depiction of a fictional villain whose most famous lines were taken from the words of a convict. Culture matters.
This is a prime example of what I propose to call “the Gekko effect.” It is known that some cultural values are positively correlated to better economic outcomes, perhaps through the channel of mutual trust. Stronger corporate cultures, as self-reported in surveys, appear to have better performance than weaker cultures, through the channel of behavioral consistency, although this effect is diminished in a volatile environment.
What Is Culture?
What do we mean when we talk about corporate culture? There are quite literally hundreds of definitions of culture. In 1952, the anthropologists A.L. Kroeber and Clyde Kluckhohn listed 164 definitions that had been used in the field up to that time, and to this day we still do not have a singular definition of culture. This paper does not propose to solve that problem, but merely to find a working definition to describe a phenomenon. Kroeber and Kluckhohn settled on the following: “Culture consists of patterns, explicit and implicit, of and for behavior acquired and transmitted by symbols, constituting the distinctive achievements of human groups, including their embodiments in artifacts.”
A corporate culture exists as a subset of a larger culture, with variations found specifically in that organization. Again, there are multiple definitions. The organizational theorists O’Reilly and Chatman define it as “a system of shared values that define what is important, and norms that define appropriate attitudes and behaviors for organizational members,” while Schein defines it in his classic text as “a pattern of shared basic assumptions that was learned by a group… that has worked well enough to be considered valid and, therefore, to be taught to new members as the correct way to perceive, think, and feel in relation to those problems.”
The key point here is that the distinctive assumptions and values of a corporate or organizational culture define the group. They will be shared within the culture, and they will be taught as the correct norms of behavior to newcomers to the culture. People who lack these values and norms will not be members of the shared culture, even though they may occupy the appropriate position on the organizational chart. In fact, these outsiders may even be viewed as hostile to the values of the culture, a point to which we will return.
It is clear from these definitions that corporate culture propagates itself less like an economic phenomenon—with individuals attempting to maximize some quantity through their behavior—and more like a biological phenomenon, like the spread of an epidemic through a population. Gordon Gekko, then, can be considered the “Patient Zero” of an epidemic of shared values (most of which are considered repugnant by larger society, including Gekko’s creator).
This biologically inspired model of corporate culture can be generalized further. Three factors will affect the transmission of a corporate culture through a group: its leadership, analogous to the primary source of an infection; its composition, analogous to a population at risk; and its environment, which shapes its response. The next sections will explore how the transmission of values conducive to corporate failure might occur, how such values emerge, and what can be done to change them.
Editor’s note: Sections 3 to 5 have been omitted.
Values from Economists: Responding to Incentives
Economists have traditionally looked at theories of cultural values with skepticism, whether such theories have come from psychology, anthropology, ethnography, sociology, or management science. Part of this skepticism is due to the culture of economics, one that prizes the narrative of rational economic self-interest above all else. Given two competing explanations for a particular market anomaly, a behavioral theory and a rational expectations model, the vast majority of economists will choose the latter—even if rationality requires unrealistically complex inferences about everyone’s preferences, information, and expectations. The mathematical elegance of a rational expectations equilibrium usually trumps the messy and imprecise narrative of corporate culture. For example, Schein breaks down an organizational culture into its observable artifacts, espoused values, and unspoken assumptions. In the pure economist’s view, this is much too touchy-feely. An economist will measure observables, but look askance at self-reported values, and ignore unspoken assumptions in favor of revealed preferences. Gordon Gekko’s motivation—and his appeal to moviegoers—is simple: wealth and power. He is Homo economicus—the financial equivalent of John Galt in Ayn Rand’s Atlas Shrugged—optimizing his expected utility subject to constraints. From the economist’s perspective, Gekko’s only fault is optimizing with fewer constraints than those imposed by the legal system
However, the economist’s view of rational self-interest is not simply axiomatic—economic self-interest is a learned and symbolically transmitted behavior. We do not expect children or the mentally impaired to pursue their rational self-interest, nor do we expect the financially misinformed to be able to maximize their self-interest correctly. Therefore, this view of economic behavior fulfills the textbook definition of a cultural trait, albeit one that economists believe is universal and all-encompassing, as the term Homo economicus suggests.
Through the cultural lens of an economist, individuals are good if they have an incentive to be good. The same motivation of self-interest that drives a manager to excel at measurable tasks in the Wall Street bonus culture may also induce a manager to shirk the less observable components of job performance, such as following ethical guidelines.
There are a few notable exceptions to this cultural bias against culture in economics. Hermalin (2001) presents an excellent overview of economic models of corporate culture as: gametheoretic interactions involving incomplete contracts, coordination, reputation, unforeseen contingencies, and multiple equilibria (Kreps, 1990); a store of common knowledge that provides efficiencies in communication within the firm (Crémer, 1993); an evolutionary process in which preferences are genetically transmitted to descendents and shaped by senior management like horse breeders seeking to produce championship thoroughbreds (Lazear, 1995); and the impact of situations on agents’ perceptions and preferences (Hodgson, 1996). Yet the same manager might behave impeccably under different circumstances, i.e., when faced with different incentives.
Despite these early efforts, and Hermalin’s (2001) compelling illustrations of the potential intellectual gains from trade between economics and culture, the study of culture by economists is still the exception rather than the rule. One reason is that the notion of rational self-interest, and its rich quantitative implications for behavior, has made economics the most analytically powerful of the social sciences. The assumption that individuals respond to incentives according to their self-interest leads to concrete predictions about behavior, rendering other cultural explanations unnecessary. In this framework, phenomena such as tournament salaries and Wall Street bonuses are a natural and efficient way to increase a firm’s productivity, especially in a high-risk/high-reward industry in which it is nearly impossible to infer performance differences between individuals in advance. If a corporate culture appears “greedy” to the outside world, it is because the world does not understand the economic environment in which it operates. The economist’s view of culture—reducing differences in behavior to different structures of incentives—can even be made to fit group phenomena that do not appear guided by rational self-interest such as self-deception, over-optimism, willful blindness, and other forms of groupthink.
This is, of course, a caricature of the economist’s perspective, but it is no exaggeration that the first line of inquiry in any economic analysis of misbehavior is to investigate incentives. A case in point is the rise in mortgage defaults by U.S. homeowners during the Financial Crisis of 2007–2009. Debt default has been a common occurrence since the beginning of debt markets, but after the peak of the U.S. housing market in 2006, a growing number of homeowners engaged in “strategic defaults,” defaults driven by rational economic considerations rather than the inability to pay. The rationale is simple. As housing prices decline, a homeowner’s equity declines in lockstep. When a homeowner’s equity becomes negative, there is a much larger economic incentive to default irrespective of income or wealth. This tendency to default under conditions of negative home equity has been confirmed empirically. In a sample of homeowners holding mortgages in 2006 and 2007, Cohen-Cole and Morse (2010) found that 74% of those households who became delinquent on their mortgage payments were nevertheless current on their credit card payments, behavior consistent with strategic default. Moreover, homeowners with negative equity were found to be more likely to re-default, even when offered a mortgage modification that initially lowered their monthly payments. As Geanakoplos and Koniak (2009) observed in the aftermath of the bursting of the housing bubble:
Every month, another 8% of the subprime homeowners whose mortgages…are 160% of the estimated value of their houses become seriously delinquent. On the other hand, subprime homeowners whose loans are worth 60% of the current value of their house become delinquent at a rate of only 1% per month. Despite all the job losses and economic uncertainty, almost all owners with real equity in their homes, are finding a way to pay off their loans. It is those “underwater” on their mortgages—with homes worth less than their loans—who are defaulting, but who, given equity in their homes, will find a way to pay. They are not evil or irresponsible; they are defaulting because…it is the economically prudent thing to do.
Economists can confidently point to these facts when debating the relative importance of culture versus incentives in determining consumer behavior.
However, the narrative becomes more complex the more we dig deeper into the determinants of strategic default. In survey data of 1,000 U.S. households from December 2008 to September 2010, Guiso, Sapienza, and Zingales (2010, Table VI) have shown that respondents who know someone who strategically defaulted are 51% more likely to declare their willingness to default strategically. This contagion effect is confirmed in a sample of over 30 million mortgages originated between 2000 and 2008, observed from 2005 to 2009 by Goodstein, Hanouna, Ramirez, and Stahel (2013), who found that mortgage defaults are influenced by the delinquency rate in surrounding zip codes, even after controlling for income-related factors. Their estimates suggest that a 1% increase in the surrounding delinquency rate increases the probability of a strategic default up to 16.5%.
These results show that there is no simple dichotomy between incentives and culture. Neither explanation is complete because both are inextricably intertwined and jointly affect human behavior in complex ways. Reacting to a change in incentives follows naturally from the unspoken assumptions of the economist. Economic incentives certainly influence human decisions, but they do not explain all behavior in all contexts. They cannot, because humans are incentivized by a number of forces that are non-pecuniary and difficult to measure quantitatively. As Hill and Painter (2015) have discussed, these forces may include status, pride, mystique, and excitement. In addition, as they point out, “what confers status is contingent, and may change over time.” These cultural forces often vary over time and across circumstances, causing individual and group behavior to adapt in response to such changes.
However, economists rarely focus on the adaptation of economic behavior to time-varying nonstationary environments—our discipline is far more comfortable with comparative statics and general equilibria than with dynamics and phase transitions. Yet changes in the economic, political, and social environment have important implications for the behavior of individual employees and corporations alike as Hermalin (2001) underscores. To resolve this problem, we need a broader theory, one capable of reconciling the analytical precision of Homo economicus with the cultural tendencies of Homo sapiens.
Values from Evolution: The Adaptive Markets Hypothesis
If corporate culture is shaped from the top down, from the bottom up, and through incentives in a given environment, the natural follow-on question to ask next is how? A corporation’s leadership may exert its authority to establish norms of behavior within the firm, but a corporation’s employees also bring their preexisting values to the workplace, and all of the actors in this drama have some resistance to cultural sway for non-cultural, internal reasons. None of them are perfectly malleable individuals waiting to be molded by external forces. This resistance has never stopped corporate authority from trying, however. Notoriously, Henry Ford employed hundreds of investigators in his company’s Sociological Department to monitor the private lives of his employees, to ensure they followed his preferred standard of behavior inside the factory and out. The success or failure of such efforts depends critically on understanding the broader framework in which culture emerges and evolves over time and across circumstances.
Determining the origin of culture, ethics, and morality may seem to be a hopeless task more suited to philosophers than economists. However, there has been surprising progress from anthropology, evolutionary biology, psychology, and the cognitive neurosciences, work that has important implications for economic theories of culture. For example, evolutionary biologists have shown that cultural norms such as altruism, fairness, reciprocity, charity, and cooperation can lead to advantages in survival and reproductive success among individuals in certain settings. E. O. Wilson has argued even more forcefully, when he coined the term “sociobiology” in the 1970s, that social conventions and interactions are, in fact, the product of evolution. More recent observational and experimental evidence from other animal species such as our close cousins, the chimpanzees, has confirmed the commonality of certain cultural norms, suggesting that they are adaptive traits passed down across many generations and species. A concrete illustration is the notion of fairness, a seemingly innate moral compass that exists in children as young as 15 months as well as in chimpanzees.
This evolutionary perspective of culture has a more direct instantiation in financial economics in the form of the Adaptive Markets Hypothesis, an alternative to the Efficient Markets Hypothesis in which financial market dynamics are the result of a population of individuals competing for scarce resources and adapting to past and current environments. The Adaptive Markets Hypothesis recognizes that competition, adaptation, and selection occur at multiple levels—from the subtle methylation of sequences in an individual’s DNA, to the transmission of cultural traits from one generation to the next—and they can occur simultaneously, each level operating at speeds dictated by specific environmental forces. To understand what individuals value, and how they will behave in various contexts, we have to understand how they interacted with the environments of their past.
The Adaptive Markets Hypothesis explains why analogies to biological reasoning are often effective in the social sciences. Darwinian evolution is not the same process as cultural evolution, but they occur under similar constraints of selection and differential survival. As a result, one can fruitfully use biological analogies, as well as biology itself, to explain aspects of culture, even of corporate culture, a phenomenon that did not exist until the late nineteenth and early twentieth centuries. These explanations fall into two categories: explanations of individual behavior by itself, and explanations of the interactions between individuals that lead to group dynamics into the nature of moral and ethical judgments. These judgments arise from one of two possible neural mechanisms: one instinctive, immediate, and based on emotion; and the other more deliberative, measured, and based on logic and reasoning. The former is fast, virtually impossible to override, and relatively inflexible, while the latter is slow, much more nuanced, and highly adaptive. This “dual-process theory” of moral and ethical decision-making—which is supported by a growing body of detailed neuroimaging experimental evidence—speaks directly to the question at hand of the origin of culture. At this level of examination, culture is the amalgamation of hardwired responses embedded in our neural circuitry, many innate and not easily reprogrammed, and more detailed complex analytic behaviors that are pathdependent on life history, which can be reprogrammed (slowly) and are more in tune with our social environment.
Apart from its pure scientific value, the dual-process theory has several important practical implications. Current efforts to shape culture may be placing too much emphasis on the analytical process, while ignoring the less malleable and, therefore, more persistent innate process. A deeper understanding of this innate process is essential to answering questions about whether and how culture can be changed. One starting point is the work of social psychologist Jonathan Haidt, who proposed five moral dimensions that are innately determined and whose relative weightings yield distinct cultural mores and value systems: harm vs. care, fairness vs. cheating, loyalty vs. betrayal, authority vs. subversion, and purity vs. degradation. Since the relative importance of these moral dimensions is innately determined, they naturally vary in the population along with hair color, height, and other traits.
Haidt and his colleagues discovered that, far from being distributed in a uniformly random way across the population, these traits had strong correlations to political beliefs (see Figure 1). For example, people in the U.S. who identified themselves as liberal believed that questions of harm/care and fairness/cheating were almost always relevant to making moral decisions. The other three moral foundations Haidt identified—loyalty/betrayal, authority/subversion, and purity/degradation—were much less important to liberals. However, those who identified themselves as conservative believed that all five moral foundations were equally important, although none were given as high a level of importance as liberals gave to fairness/cheating or harm/care. These innate traits had predisposed people to sort themselves into different political factions.
It takes little imagination to see this sorting process at work across professions. Someone who believes that fairness is the highest moral value will want to choose a vocation where they can exert this value, perhaps as a public defender, a teacher of underprivileged children, or a sports referee. Those who believe, instead, that fairness is an unimportant value might find themselves drawn to the prosecutorial side of the law, or high-pressure sales, or indeed, Gordon Gekko’s caricature of predatory finance. This is not to say that everyone in those professions shares those values, of course, but rather that individuals with those values may find such professions more congenial—a form of natural selection bias—and will, therefore, eventually be statistically over-represented in that subpopulation.
At the same time that evolution shapes individual behavior, it also acts on how individuals relate to one another. We call the collective behavior that ultimately emerges from these interactions “culture.” Many forms of collective and group behavior have been conceptually difficult for classical evolutionary theory to explain since it is primarily a theory centered on the reproductive success of the individual, or even more reductively, of the gene. Recent research in evolutionary biology, however, has revived the controversial notion of “group selection,” in which groups are the targets of natural selection, not just individuals or genes. Although many evolutionary biologists have rejected this idea, arguing that selection can only occur at the level of the gene, an application of the Adaptive Markets Hypothesis can reconcile this controversy, and also provide an explanation for the origins of culture.
The key insight is that individual behavior that appears to be coordinated is simply the result of certain common factors in the environment — “systematic risk” in the terminology of financial economics—that impose a common threat to a particular subset of individuals. Within specific groups under systematic risk, natural selection on individuals can sometimes produce grouplike behavior. In such cases, a standard application of natural selection to individuals can produce behaviors that may seem like the result of group selection, but are, in fact, merely a reflection of systematic risk in the environment.
For example, consider the extraordinary behavior of Specialist Ross A. McGinnis, a 19-year-old machine-gunner in the U.S. Army during the Iraq war who sacrificed himself when a fragmentation grenade was tossed into a Humvee vehicle during a routine patrol in Baghdad on December 4, 2006. He reacted immediately by yelling “grenade” to alert the others, and then pushed his back onto the grenade, pinning it to the Humvee’s radio mount, and absorbing the impact of the explosion with his body, saving the lives of his four crewmates.
Although this was a remarkable act of bravery and sacrifice, it is not an isolated incident. Acts of bravery and sacrifice have always been part of the military tradition, as documented by the medals and other honors awarded to our heroes. Part of the explanation may be selection bias—the military may simply attract a larger proportion of altruistic individuals, people who sincerely believe that “the needs of the many outweigh the needs of the few.”
A more direct explanation, however, may be that altruistic behavior is produced by natural selection operating in the face of military conflict. Put another way, selfish behavior on the battlefield is a recipe for defeat. Military conflict is an extreme form of systematic risk, and over time and across many similar circumstances, our military has learned this lesson. On the other hand, altruistic behavior confers survival benefits for the population on the battlefield, even if it does not benefit the individual. Accordingly, military training instills these values in individuals—through bonding exercises like boot camp, stories of heroism passed down from seasoned veterans to new recruits, and medals and honors for courageous acts—so as to increase the likelihood of success for the entire troop. Military culture is the evolutionary product of the environment of war.
Now consider an entirely different environment; imagine a live grenade being tossed into a New York City subway car. Would we expect any of the passengers to behave in a manner similar to Spc. McGinnis in Baghdad? Context matters. And culture is shaped by context, as Milgram and Zimbardo discovered in their experiments with ordinary subjects placed in extraordinary contexts.
Context matters not only on the battlefield, but also in the financial industry. Recently, Cohn, Fehr, and Maréchal (2014) documented the impact of context on financial culture in an experiment involving 128 human subjects recruited from a large international bank. These subjects were asked to engage in an exercise that measured their honesty, using a simple cointossing exercise in which self-reported outcomes determined whether they would receive a cash prize. Prior to this exercise, subjects were split into two groups, one in which the participants were asked seven questions pertaining to their banking jobs, and the other in which the participants were asked seven non-banking-related questions. By bringing the banking industry to the forefront of the subjects’ minds just prior to the exercise, the authors induced the subjects to apply the cultural standards of that industry to the task at hand. The subjects in the former group showed significantly more dishonest behavior than the subjects in the latter group, who exhibited the same level of honesty as participants from non-banking industries. The authors concluded “the prevailing business culture in the banking industry weakens and undermines the honesty norm, implying that measures to re-establish an honest culture are very important.” However, innate variation determines how much the individual is influenced by context. Gibson, Tanner, and Wagner (2015) have shown that even in cultures where there has been a crowding-out of honest behavior by situational norms, individuals with strong intrinsic preferences to honesty as a “protected” value resist the bad norm, and may potentially be able to form the nucleus of a good norm in an altered situation.
Two recent empirical studies of fraud provide additional support for the impact of context on financial culture. Dyck, Morse, and Zingales (2013) used historical data on securities class action lawsuits to estimate the incidence of fraud from 1996 to 2004 in U.S. publicly traded companies with at least $750 million in market capitalization. They document an increasing amount of fraud as the stock market rose, which eventually declined in the wake of the bursting of the Internet Bubble in 2001–2002 (see Figure 2). This interesting pattern suggests that the business environment may be related to changes in corporate culture that involve fraudulent activity and corporate risk-taking behavior. Deason, Rajgopal, and Waymire (2015) found a similar pattern in the number of Ponzi schemes prosecuted by the U.S. Securities and Exchange Commission (SEC) between 1988 and 2012 (see Figure 3): an upward trend during the bull market of the late 1990s, a decline in the aftermath of the Internet Bust of 2001–2002, and another increase as the market climbed, until the Financial Crisis and the subsequent stock market decline between 2008 and 2009, after which the number of Ponzi schemes declined sharply. In fact, Deason, Rajgopol, and Waymire estimate a correlation of 47.9% between the S&P 500 quarterly return and the number of SEC-prosecuted Ponzi schemes per quarter, which they attribute to several factors: Ponzi schemes are harder to sustain in declining markets; SEC enforcement budgets tend to increase after bubbles burst; and there may be more demand for enforcement by politicians and the public. They also found that Ponzi schemes are more likely when there is some affinity link between the perpetrator and the victim, such as a common religious background or shared membership in an ethnic group, or when the victim group tends to place more trust in others (e.g., senior citizens), reminding us that culture can also be exploited maliciously.
These two studies confirm what many already knew instinctively: culture is very much a product of the environment, and as environments change, so too does culture. Therefore, if we wish to change culture, we must first understand the forces that shape it over time and across circumstances. This broader contextual, environmental framework—informed by psychology, evolutionary theory, and neuroscience, and quantified through empirical measurement—will play a key role in Section 11 where we consider what can be done about culture from a practical perspective.
Examples from the Financial Industry
Moving from the general to the specific, several recent financial debacles demonstrate the role of corporate culture in financial failure. Let us start with a control case, the fall of Long-Term Capital Management (LTCM). In organizational theorist Charles Perrow’s terminology, its collapse was a “normal accident.” That is, it was caused by a combination of “tight coupling” in the engineering sense—in which the execution of one process depends critically on the successful completion of another—and complex interactions within the financial system. To summarize a well-known story very briefly, LTCM’s sophisticated models were caught offguard by the aftermath of Russia’s default on its GKO bonds on August 17, 1998, triggering a short and vicious cycle of losses and flights to liquidity, and ultimately leading to its bailout on September 23, 1998.
On paper, LTCM’s corporate culture was excellent. Its composition was elite: founded by John Meriwether, the former head of bond trading at Salomon Brothers, and future Nobelists Robert C. Merton and Myron Scholes. Its culture was individualistic, as many trading groups are, but it derived its authority from a legal-rational basis, the superiority of its mathematics. Its corporate culture played little direct role in its failure. In fact, with much of their personal fortunes invested in the business, LTCM’s managing partners were perfectly aligned with their investors. Not a single client has sued them for inappropriate behavior. Not a single regulator has cited them for violations of any sort.
However, Wall Street’s corporate culture was apparently caught off-guard by LTCM’s predicament. It had perceived LTCM to be a paragon of Wall Street’s highest values—a combination of intelligence, market savvy, and ambition that was sure to succeed—when a more accurate assessment of LTCM might have been as an experimental engineering firm, working daringly (or hubristically, as some have argued) on the cutting edge. Their creditors notoriously gave LTCM virtually no “haircut” on their loans, on the assumption that their trades were essentially risk-free. In addition to these very low, or even zero, margin requirements, LTCM was able to negotiate other favorable credit enhancements with its counterparties, including two-way collateral requirements, rehypothecation rights, and high thresholds for loss. These were often made on the strength of their reputation, rather than detailed examination of LTCM’s methods. Daniel Napoli, then Merrill Lynch’s head of risk management, was quoted as saying, “We had no idea they would have trouble—these people were known for risk management. They had taught it; they designed it [emphasis in original].” (Napoli himself lost his position shortly after LTCM’s collapse.) LTCM’s failure may be viewed as akin to the failure of a bridge whose experimental materials were exposed to an unfamiliar stress, but the behavior of LTCM’s creditors is more likely a failure of their corporate culture.
Corporate cultures can be overconfident in their abilities to assess risk. This can be seen in the fall of the large multinational insurer, American International Group (AIG), in 2008. Under its original chairman, Maurice “Hank” Greenberg, AIG was run not merely hierarchically, but almost feudally, with reciprocal chains of loyalty and obligation centered on Greenberg. In fact, Greenberg had structured AIG’s compensation plan deliberately to promote lifetime loyalty to the firm. Greenberg was, in Weberian terms, a charismatic authority, overseeing each division of his large multinational organization personally. In particular, in regular questioning sessions Greenberg demanded to know exactly what risks each unit of AIG was taking, and what measures were being used to reduce them. Many observers ascribed AIG’s continued growth to AIG’s excellent practice in insurance underwriting, closely monitored by Greenberg.
However, the “headline risk” of Greenberg’s possible role in financial irregularities caused AIG’s board of directors to replace him with Martin Sullivan in early 2005. Sullivan had risen through the ranks of AIG, originally starting as a teenage office assistant. Sullivan assumed that AIG’s vigorous culture of risk management would maintain itself without Greenberg at the helm. Meanwhile, Joseph Cassano, the head of AIG’s Financial Products (AIGFP) unit, had a working relationship with Greenberg that did not transfer to Sullivan. Cassano’s conduct grew more aggressive without Greenberg’s check on his behavior.
AIGFP’s portfolio contained billions of dollars of credit default swaps on “toxic” collateralized debt obligations. This was not the only toxic item on AIG’s balance sheet, which also had significant problems in its securities lending program, but it was the largest, and it created the most visible effects during the financially dangerous autumn of 2008. While AIGFP’s first sales of credit default swaps on collateralized debt obligations began in 2004, during Greenberg’s tenure, they accelerated into 2005, before executives within AIGFP convinced Cassano about declining standards in the subprime mortgage market. AIGFP’s final sale of credit default swaps took place in early 2006, leaving a multibillion-dollar time bomb on its balance sheet. Cassano defended his actions in an increasingly adverse environment until his ouster from AIG in early 2008.
It is probably too easy to ascribe AIGFP’s extended period of credit default swap sales to Greenberg’s departure. As noted, Cassano’s unit began selling credit default swaps well before Greenberg’s exit. However, Robert Shiller’s insight into the Milgram experiment is pertinent here. Greenberg’s culture of risk management, which was accompanied by consistently high growth in the traditionally low-growth insurance industry, led Cassano and Sullivan to believe that AIG’s risk management procedures were consistently reliable in conditions where they were not. Paradoxically, the moral hazard of past success may have led AIG to make much riskier investments than a company with a poorer track record of risk management.
Some corporate cultures actively conceal their flaws and irregularities, not only from the public or from regulators, but also from others within the corporation itself because of the risk that this knowledge might undermine their position. For example, let us look at Lehman Brothers’ use of the so-called “Repo 105” accounting trick. Briefly, this was a repo, or repurchase agreement, valued at $1.05 for every dollar, which was designed to look like a sale. Lehman Brothers paid more than five cents on the dollar to temporarily pay down the liabilities on its balance sheet before it repurchased the asset. Lehman Brothers used this accounting trick in amounts totaling $50 billion in late 2007 and 2008 to give the firm a greater appearance of financial health—which of course was ultimately a failure.
Was this tactic legal? No American law firm would agree to endorse this practice, so Lehman Brothers engaged in regulatory arbitrage, and found a distinguished British law firm, Linklaters, willing to give the practice its imprimatur. Linklater’s endorsement of Repo 105 was kept secret from the outside world, except for Lehman’s outside auditors, Ernst & Young, who also allowed the practice to pass. However, Lehman’s use of Repo 105 was also kept from its board members. Lehman Brothers omitted its use of Repo 105 in its quarterly disclosures to the SEC, and also neglected to tell its outside disclosure counsel.
In contrast to LTCM, the corporate culture at Lehman Brothers resembled less a cutting-edge engineering firm experiencing an unforeseen design failure, and more like Zimbardo’s Stanford experiment. 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 was its proper role. When Lehman’s global financial controller reported his misgivings to two consecutive chief financial officers that Repo 105 might be a significant “reputational risk” to the company, his concerns were ignored. Lehman’s hierarchical culture defended its values against voices from its border, even though they occupied central positions on its organizational chart. Instead of taking measures to avoid headline risk, it instead buried its practices in secrecy.
The case of rogue trader Jérôme Kerviel illustrates another possible type of failure of corporate culture, that of neglect. In January 2008, Kerviel built up a €49 billion long position on index futures in the corporate and investment banking division of the French bank, Société Générale, before his trades were detected. For comparison purposes, Société Générale’s total capital at that time was only €26 billion. Unwinding his unauthorized position cost Société Générale €6.4 billion, an immense loss that threatened to take down the bank. Kerviel’s legal difficulties are still ongoing, but he has stated Société Générale turned a blind eye to his activities when they were making money—and Société Générale’s own internal investigation reports that he made €1.5 billion for the bank on his unauthorized trades in 2007.
However, the internal investigation paints a very different, if equally unflattering, picture of Société Générale’s corporate culture. Kerviel’s first supervisor did not notice his early fraudulent trades or their cover-up, but in fact allowed Kerviel to make intraday trades, a privilege well above Kerviel’s status as a junior trader. In January 2007, Kerviel’s supervisor quit, and his trading desk was left effectively unsupervised for three months. During this time, Kerviel built up a futures position of €5.5 billion, his first very large position. His new desk manager, hired in April 2007, had no prior knowledge of trading activities, and did not use the monitoring programs that would have detected Kerviel’s trades. Moreover, Kerviel’s new manager was not supported by his supervisor in assisting or supervising his new activities. The Société Générale report found that a culture of inattention and managerial neglect existed up to four levels above Kerviel’s position, to the head of Société Générale’s arbitrage activities. Ultimately, it was the attention and perseverance of a monitor in Société Générale’s accounting and regulatory reporting division which caught Kerviel, after the monitor noticed an unhedged €1.5 billion position while calculating the Cooke ratio for Société Générale’s Basel compliance requirements.
This is Douglas’s individualistic culture taken to a point of absurdity. Mark Hunter and N. Craig Smith believe that the roots of Société Générale’s Corporate and Investment Banking division’s inept management culture can be found in its complex corporate history. Société Générale was a private retail bank nationalized after the Second World War, and then privatized again in 1986. Throughout its postwar history, however, it was a proving ground for French elite graduates, similar to the way Wall Street investment banks recruit from Ivy League universities in the U.S. The key difference is that the elite focused on Société Générale’s retail banking oversight because of its close connection to French policymakers in the public and private sectors, rather than its proprietary trading desks. Société Générale’s corporate culture viewed the Corporate and Investment Bank as a “cash machine,” not central to its elite outcomes. Kerviel was a graduate of provincial universities, and was not expected to rise in the elite hierarchy. Therefore, little attention was paid to his activities, even when he made surprisingly large amounts of money.
Editor’s note: the remaining sections and references have been omitted but are available at Dr. Lo’s web site.
