LO 79.3: Describe the framework for analyzing culture in the context of financial

LO 79.3: Describe the framework for analyzing culture in the context of financial practices and institutions.
An alternative to the efficient markets hypothesis (EMH) is the adaptive markets hypothesis (AMH) (Lo, 2004, 2013).13,14 In the AMH, individuals compete for scarce resources. These individuals adapt to both their past and current environments. Like people sort themselves based on values into political parties, they also sort themselves into professions. For example, those who value fairness might choose jobs where they can fight for fairness (e.g., teachers of under privileged children or sports referees). In contrast, those
11. Luigi Guiso, Paula Sapienza, and Luigi Zingales, Does Culture Affect Economic Outcomes?
Journal o f Economic Perspectives 20, no. 2 (Spring 2006): 2348.
12. Ryan Goodstein et al., Contagion Effects in Strategic Mortgage Defaults (GMU Working
Paper in Economics no. 13-07, January 2013), ssrn.com/abstract=2229054.
13. Andrew W. Lo, The Adaptive Markets Hypothesis: Market Efficiency From an Evolutionary
Perspective, Journal o f Portfolio M anagem ent 30, no. 5 (2004): 15-29.
14. Andrew W. Lo, The Origin of Bounded Rationality and Intelligence, Proceedings o f the
American Philosophical Society 157, no. 3 (September 2013): 269-80.
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who do not believe in fairness above all, may choose high pressure sales jobs or choose to teach in expensive boarding schools.
Context is also important to behavior. For example, in a study by Cohn, Fehr, and Marechal (2014)15, the impact of context on financial culture, based on the honesty of participants from a large international bank, was gauged based on a coin-tossing experiment. The 128 participants were split into two groups. Half of the subjects were asked seven questions about their jobs at the bank prior to the exercise, while the other half were asked seven non- banking questions. The authors induced the participants to apply the cultural standards of the banking industry by asking them about banking prior to the experiment. Those who were asked banking questions were significantly more dishonest during the exercise than the group that was asked non-bank questions. The non-bank question group displayed a level of honesty equal to those working in other industries (i.e., nonfinancial). However, individual values can allow one to resist a bad norm.
A study by Dyck, Morse, and Zingales (2013)16 finds, using class action lawsuit data from 1996 to 2004, that fraud increased as the stock market increased in the first five or six years then declined after the dot.com bubble burst in 20012002. Ponzi schemes also increased during bull markets between 1988 and 2012, decreased after 20012002, and then increased again leading up to the 20072009 financial crisis (Deason, Rajgopal, and Waymire 2013).17 The authors note that Ponzi schemes are more difficult to sustain in bear markets. Also, regulation and enforcement budgets often increase after bubbles burst (i.e., the dot.com and the housing market bubbles). The authors find that Ponzi schemes are more likely when there is an affinity link (i.e., a strong connection) between the offender and the victim, such as they are members of the same religion or are part of the same ethnic group, indicating that shared culture can be used for ill. Both studies indicate that culture is often a product of the environment (e.g., good versus bad economic times, perceived moral character and changing character of leaders such as CEOs, movie stars, politicians, and so on).
There are several examples of corporate culture and the role it has played in company failures in the financial industry. They include: Long-Term Capital Management (LTCM). LTCM had a strong corporate culture that
was well-respected across the financial industry. Founders John Meriwether (a former head of bond trading at Salomon Brothers) and Robert Merton and Myron Scholes, future Nobel Prize in Economics winners, founded a company based on mathematical models that the industry perceived as ultra-safe and invincible, leading to extremely favorable credit terms and little to no margin requirements. In fact, the failure of LTCM may even be seen as the failure of the firms creditors corporate cultures, overconfident in their abilities to assess the risks of the firms to which they loaned money.
15. Alain Cohn, Ernst Fehr, and Michel Andre Marechal, Business Culture and Dishonesty in the
Banking Industry, Nature 516, no. 7529 (December 2014): 86-89.
16. Alexander Dyck, Adair Morse, and Luigi Zingales, How Pervasive Is Corporate Fraud?
(working paper, August 2013).
17. Stephen Deason et al., Who Gets Swindled in Ponzi Schemes? (unpublished paper, Goizeta
Business School, Emory University, Atlanta, GA, 2015).
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American International Group (AIG). AIGs culture centered on its original chairman,
Maurice Hank Greenberg. Compensation plans rewarded loyalty to the firm. Much of AIGs success was attributed to excellent insurance underwriting. That underwriting was monitored across divisions by Greenberg himself. When, in 2005, the board replaced Greenberg due to headline risk that Greenberg may have played a role in financial irregularities, the new chair, Martin Sullivan, assumed the vigorous risk management culture would remain without Greenbergs watchful eye. Without Greenberg, however, the companys actions grew more aggressive and risky [selling billions of dollars of credit default swaps (CDS)], ultimately leading to a government bailout in 2008. In fact, AIGs strong risk management culture may have led to its failure in the sense that firm leaders believed that strong risk management and high growth in a traditionally lower risk and lower growth industry like insurance, would translate into higher risk activities such as selling CDSs. As a result of its confidence in its own risk management practices, billions of dollars of toxic assets were allowed to appear on AIGs balance sheet.
Lehman Brothers. The culture at Lehman Brothers was such that flaws were not only

concealed from regulators and the public, but from those inside the organization as well. For example, the use of the accounting trick known as Repo 105 allowed the firm to show repurchase agreements, a source of financing, as a sale of an asset instead, making the firm look more financially sound than it was. The misleading accounting practice was hidden by an internal hierarchy within the firm, from both external and internal people who might have objected. The hierarchical corporate structure which chose secrecy above transparency (a global financial controller expressed concern about reputational risk regarding the Repo 105 accounting trick, but was shut down) contributed to Lehmans downfall. Lehman managers concealed flaws rather than attempted to remedy them. Societe Generale. In the case of French bank Societe Generale, inattention and neglect, inherent in the corporate culture, led to the bank losing nearly 6.5 billion due to rogue derivatives trader, Jerome Kerviel. The bank nearly failed. An investigation found a lack of attention to risks and to the processes and procedures intended to stem those risks, existed up to four levels of management above Kerviel. Looking at the banks history, though, reveals a bit more about its culture of inept managers. Like U.S. investment banks hiring Ivy League graduates, Societe Generale hired elite French graduates. But the graduates focused their attention on retail banking due to connections with policymakers in the public and private sectors, and not on the Corporate Investment Banking division in which Kerviel worked. Kerviel was not from an elite university and thus was paid little attention, despite the fact that he made large sums of money and traded with enormous sums at stake. The firm did not value trading in its culture and put low priority on managing the trading desk.
Sadly, regulatory culture is not immune to these cultural failings. For example, the Securities and Exchange Commission (SEC) had received several warnings about Bernie Madoff s Ponzi scheme but failed to act. The SEC had a hierarchical corporate structure that impeded the flow of information from one division to another. This fact meant that SEC offices that were getting complaints about Madoff, did not talk to each other and did not even know that they were each investigating Madoff (i.e., the Northeast Regional Office and the Office of Compliance Inspections and Examinations). Low morale, a distrust of management, and a compartmentalized, hierarchical, and risk averse culture that feared public scandal contributed to the shocking slowness with which the SEC caught on to Madoffs scheme. The SEC has since tried to remedy some of the failings in its corporate culture.
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