LO 79.2: Examine the role of culture in the context of financial risk management.

LO 79.2: Examine the role of culture in the context of financial risk management.
Firms, including financial firms, often hire go-getters, more aggressive people with higher levels of risk tolerance. The thought is that they have the personality and competitive nature to move a firm forward. This personality type is drawn to riskier activities, what sociologist Stephen Lyng refers to as edgework (Lyng 1990).9 Sports enthusiasts who skydive and do other dangerous activities get a certain pleasure from being one of the few who can, relative to the average person, navigate these dangerous waters. These individuals voluntarily take risks, without necessarily expecting a reward for that risk.
Sociologist Charles W. Smith recently used this idea of edgework to compare financial market traders to sea kayakers (Smith 2005).9 10 While people drawn to higher-risk activities view themselves as exceedingly independent, they actually, according to Lyng, feel solidarity with fellow edgeworkers and at odds with the broader culture. In finance, this can manifest as a split between the trading desk (and perhaps upper management) and the rest of the firm. While executives may encourage risk aversion, they often seek out risk in their own lives, resulting in a do as I say, not as I do situation.
Contrast risk management in the insurance industry versus the banking industry. Revenue in the insurance industry is in large part determined by regulation. Insurance companies have an incentive to manage risks and protect against the downside. Bank earnings are more variable and are tied to bank size and the use of leverage. This means historically that insurance companies are more conservative than banks.
In the financial culture, protestors, regulators, and other dissenting opinions are often ignored. Criticisms are diminished, discounted, and dismissed. But market participants,
9. Stephen Lyng, Edgework: A Social Psychological Analysis of Voluntary Risk Taking, The
American Journal o f Sociology 95, no. 4 (January 1990): 851-86.
10. Charles W. Smith,Financial Edgework: Trading in Market Currents, in Edgework: The
Sociology of Risk Taking, ed. Stephen Lyng (London: Routledge, 2005).
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Topic 79 Cross Reference to GARP Assigned Reading – Lo
whether investors, entrepreneurs, bankers, regulators, or executives, are all part of and shaped by the culture. After a crisis, such as that of 20072009, regulation is good, greed is bad. But when economic times are good, greed is good and regulation is unnecessary, and the cycle continues.
Provided an incentive to be good, individuals will be good, according to economists. Economic self-interest is a learned behavior. A Wall Street manager, driven by a bonus culture, will excel at some parts of the job (those that result in the reward, the bonus) and be less successful at those not rewarded, such as following the ethical guidelines of the firm. If the incentives change and reward ethical behavior, the same manager may behave differently. Behavior can be predicted based on a knowledge of incentives and economic self-interest. Spoken in the extreme, bad behavior results from incentive problems, and can be corrected once an appropriately designed system of rewards and punishments is constructed. Economists always look to incentives when investigating bad behaviors.
An example is the strategic defaults on mortgage loans during the financial crisis. As housing prices fell and borrowers were underwater (i.e., homes were worth less than their loans) on their mortgages, it made sense (i.e., there was an economic incentive) to default, whether one could afford to pay or not. However, what role did culture play in strategic defaults? A study by Guiso, Sapienza, and Zingales (2013)11 found that survey respondents were 31% more likely to strategically default if they knew someone else who had done so. The finding was confirmed by a study (Goodstein et al. 2013)11 12 13 14 that showed delinquency rates were influenced by zip code, controlling for income. The more delinquencies in the zip code, the greater the strategic defaults.
Incentives and culture are inextricably linked. It is not possible to single out one or the other as the culprit for bad behavior.
An a l y z in g a n d Im pr o v in g C u l t u r e

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