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Honesty as a value that matters for business

Alexander F. Wagner.

Several theories exist to explain the causes for fraud. A well-known one is the fraud triangle. But there is a deeper question underlying that: what motivates people to be honest, and remain honest? This may shed light on why some companies encounter more fraud than others. Alexander Wagner, Associate Professor at the Swiss Finance Institute (SFI), University of Zurich, looks into why people are honest or dishonest in business.

Interview with Alexander F. Wagner, Associate Professor at the University of Zurich
By Derek Meijers and Gaston Moonen

Interdisciplinary approach giving new insights

As SFI Professor at the University of Zurich Alexander Wagner has built up a research portfolio on the topics of honesty, deception, and financial market communication. Some people would associate this topic more with psychology. But he relates this behavioural issue to business and explains the origins of this interest. ‘In the summer of 2002, when I was working at Lehman in London a number of scandals erupted, including accounting fraud scandals. This sent shocks through the market and suddenly fraud was a topic at even the largest corporations. Although you might think “Well, there are lots of controls in place…” it still happened.’

He says that he did not spent much thought about it at first. ‘But years later I ran into a colleague and now friend, Carmen Tanner, who is a psychologist. She happened to be working on the topic of taboo values, also called sacred values in people’s decision-making. We and another financial economics colleague and friend, Rajna Gibson, ended up talking what certain values might mean in economics. And these different inputs of observing the emergence of fraud became an interesting mix of how to understand what goes on in organisations.’

Regarding the research question of why some organisations succeed and why some fail as far as fraud is concerned Alexander Wagner points out that there is a lot or research on psychological observations but that economics also has something to add. ‘Take for example a notion economists emphasize, namely, that you need to conduct an experiment with real incentives to find out what is going on, instead of asking people ‘What do you think?’ That is a distinct economic paradigm.’ Another dimension he brings up is the linkage to market data — not just looking at individual choices but that you can see quickly how the market responds to certain actions by companies. ‘The market offers a great laboratory for measuring how much it matters.’

One out of seven companies committing fraud…

In his TED talk he certainly quickly gets the viewer’s attention by pointing out that research done in the US shows that one out of seven companies we deal with on a daily basis, commits frauds, costing shareholders and therefore society US$ 380 billion per year. More and more fraud seems to become a feature and not an bug of the financial services industry, according to the president of the American Finance Association. But Alexander Wagner also underlines the other side of the coin: six companies out of seven act honestly. Why such difference?

To approach this question, Alexander Wagner looks more at the broad statistical samples than at specific cases. ‘I look at how people respond to different situations, often in an experimental, fairly controlled setting. I would love to do a field experiment with a company or public institution that wants to know more about which incentives or other interventions to reduce fraud or corruption work in their specific setting.’

Box 1 — self-interest and other values

In his TED talk, Alexander Wagner brings out different interests that motivate people’s actions. In general, he distinguishes the norm of self-interest versus certain intrinsic values. He argues that research shows that people are motivated by self-interest and by certain intrinsic, or so-called ‘protected values.’ These can be protected values for love, for live, the environment, and he has focused on the protected values for honesty. People driven by such values will not only respond to the consequences of their behaviour, but will take into account what they feel is right or wrong as such. This may even lead to actions clearly against their direct owninterest. For organisations, it is important to know how different people respond to incentives and that not everybody responds the same to incentives. While the standard economic approach is for organisations to appeal to benefits and costs to try to get people to behave according to them, organisations can select people who have values that are in line with the ones the organisation wants to pursue.

It turns out that controls can backfire, especially if you have people who are inclined to be truthful…

Controls can work… but also backfire

Alexander Wagner was one of the speakers at the 2019 ACFE Fraud Conference Europe — also covered in the Journal — and spoke about the experiments he did in a controlled setting, as he did in his TED talk. An illustrative example is where people toss a coin secretly and then have to report the number of times tails came up — where people get paid more if they announce a higher number of tails throws. One natural question that comes up is how to motivate people to give an honest reply, going against their own financial interests. ‘In practice, many companies ask people to sign a conduct of conduct. We did an experiment where one group of participants had to sign an honour code at the beginning. It turned out that it did not work at all and increases in fact the extent of extreme lies.‘

Thoughtfully he explains that if you impose too stringent requirements on people to be truthful, people may resist . ‘That is a well-known phenomenon. It turns out that controls can backfire, especially if you have people who are inclined to be truthful — they might be insulted. People think: “Well, they do not trust me, so I will do the thing they expect me to do.” Perhaps this is not a conscious decision but sometimes rules and controls can result in the very thing they are trying to avoid.’ Wagner also emphasizes, however, that codes of conduct can work. ‘When the message is: “If you are behaving according to this code, then you are part of the group,” that is a signal of inclusion, and then it can be very positive.’

The professor indicates that sometimes very subtle things can make quite a difference. ‘In the experiment, when we just asked people to think how others might behave in that particular situation, this already changed things and seemed to shift the distribution of behaviour towards integrity. This is still the subject of ongoing research but very exciting. It is this sort of soft intervention which I want to pursue in the context of a real organisation.’

Incentives matter, but some resist

When it comes to direct, more personal encounters with fraud, Alexander Wagner has none. ‘Fortunately not, neither in the private sector nor in the academic world.’ However, he points out that it is a topical issue, also in research institutions. He thinks that the sources for that are rather similar to what is happening in corporations. ‘There are incentives. They do not come in the form of multimillion-dollar bonuses. They come in the form of opportunities of rising through the ranks and becoming famous. We like to have impact and there is an incentive to tilt the numbers in a certain way, to massage the data. And then some people actually end up manipulating data in a direct way.’

… our research confirms that while there are a lot of incentives to lie most people actually stay honest.

This also makes clear to him that incentives matter. ‘There is the economic theory of crime, which says people trade off benefits and costs and think about the probability of being caught. There is probably a lot to that. But our research confirms that while there are a lot of incentives to lie most people actually stay honest. There seems to be a level of intrinsic motivation to try to discover and report the truth that makes systems still survive.’

Box 2 — example given by Alexander Wagner of an experiment showing that honesty is fragile

Say we have a group of people who do not know each other. Person A is sending a message to person B. A knows the truth of something and B does not know if it is true or false and has to decide whether to trust A. And suppose A has an incentive to lie to B. Then B finds out whether A has lied or not. Immediately afterwards B will send a message to person C. If A lied to B, we find that B is much more likely to lie to C. Especially if B had initially expected A to tell the truth.

If we live in an environment where B knows that A tells the truth with only 60% probability, then you do not mind being lied to. It’s expected. But in another situation where 90 %, i.e. 9 out of 10, actually, tells you the truth and you happen to meet the 10th guy who lies to you that induces you very strongly to lie as well.

This experiment tells us is that honesty is fragile. We may never attain 100 %. Even generally honest people may in a certain situation behave dishonestly.

When asked whether his research is more about ensuring that the number of honest people prevails to make sure that they do not become fraudulent, or more to stop fraudulent people from being dishonest Alexander Wagner thinks for a while. ‘That is a very valid question. First and foremost, I want to know what’s going on. I am trying to understand human nature. The second element is that I think we cannot hope to change people’s preferences but we can hope to address the drivers. For example, recent research we have done shows that honesty is fragile when expectations are violated (see Box 2). Overall, I think my research touches more on how to ensure that the number of honest people prevails and prevent they become fraudulent.’

Based on experiments (see Box 2) Alexander Wagner argues — referring back to this concept of protected values — that someone with strong protected values will be less inclined to pay forward lies received from others. He concludes: ‘So values can protect against these ripple effect of deception. An organisation needs to build in safeguards on various fronts. It needs to select the right people and to make sure that the right social norms are in place. These are all failure points.’

Absolute values… are also relative

When it comes to the protected values mentioned earlier, the question arises whether they belong to an absolute value, as argued by Immanuel Kant. ‘It seems that there are no absolute values for most people. When we increase the incentives and the costs of being truthful more people start lying. The good news is that not everybody starts lying at the first euro or dollar they can earn. Some sustain their truthfulness even in the face of quite steep incentives to lie. But one should really think of the protected values as measuring not some absolute value, but the extent to which somebody is willing to resist temptations.’

… not everybody starts lying at the first euro or dollar they can earn.

One of the characteristics of Alexander Wagner’s research is that it is very interdisciplinary. As to whether there is a lot of interest from the business world in the topic the answer is affirmative. ‘There is great interest in how to select the right people. But that is not my greatest area of expertise. My co-author, Carmen Tanner, who is a psychologist, is probably more into that. There is also great interest in how can we tell as investors on which CEOS are truthful or not. I have not yet exactly worked on that topic but I have used textual analysis tools to screen what managers say and how. That is something investors are very interested in.’

Box 3 — Checking on inconsistencies

Alexander Wagner recalls a story of when he presented research on the analysis of corporate conference calls:

‘One gentleman came up to me and told me about his background. He used to be the chief homicide officer of a major English city and is now working for a hedge fund. They recruited him because he is very good at finding inconsistencies in what people say. They hired him specifically to just go through spoken statements of CEOs and companies they are investing in. He is doing that manually but there is a lot of interest in using modern technology like text analysis, big data analytics, etc.’

Public sector different from the private sector?

When asked whether he sees a significant difference in behaviour of employees employed in a business environment and those in the public sector he points to some differences but also some similarities. ‘One of the first pieces of independent research I did was about how in public agencies managers hire people to insure that these people remain loyal to them and do not become too ambitious themselves. It turns it that this model also has an analogy in the corporate world. Of course, monetary incentives prevail in the corporate world but non-monetary incentives can be just as important. For example the reward that comes from following social norms.’ He observes that from an abstract point of view the challenges are quite similar. ‘However, the public sector does not have the financial market as a disciplining device. It has the electoral market as a disciplining device. But that one is sometimes more indirect.’

I think the evidence that corruption brings a huge social cost is rather strong.

One of the areas he highlights is corruption, in many parts of the world linked also to the public sector. Alexander Wagner points out that particularly public procurement is prone to corruption. ‘I think the evidence that corruption brings a huge social cost is rather strong. But hopefully institutions like the ECA can put a stop to the most egregious cases here.’

As to the issue whether the reputational damage to an organisation — the breach of trust — is bigger in the public sector than in the private sector in the case of dishonesty Alexander Wagner gives some nuances. ‘It all depends. If you are a financial advisor and you breached the trust of your client, in most areas there is a regulator and you go on record that you were caught in a scandal.’ He refers to a recent paper that shows that a financial advisor’s career will be hampered by this. ‘There are some negative labor market effects. But these people tend to work for firms that sometimes seem to specialise in having previously fraudulent financial advisors.’

[if caught in a fraud] The real problem is that the individual does not pay the full price.

Alexander Wagner adds: ‘The real problem is that the individual does not pay the full price. So if an advisor is caught in a fraud, her or his career might be damaged to a certain extent but it’s nowhere near the damage the institutions has to deal with. Her or his incentives to be careful are much lower than they should be.‘ He believes the same applies in top management. ‘If you are the CEO of a company you are never going to lose as much as the company. You may lose the equity and your reputation, but that is often a tiny part of the damage that has been done. In short, there is a classic agency problem. And that also applies in the public sector.’

He doubts whether one can address that issue in a fully satisfactory way with an appropriate incentive scheme. ‘Of course you could create an incentive scheme for the president of the ECA that says: ‘If the public opinion of the ECA goes down by 5% we will take your house. But I am not sure it would achieve the goal. This gives rise to incentives for manipulating a specific issue — in this case, trying to create favourable public opinion — instead of focusing on what the organisation really should be doing. Incentives may work out in different ways then foreseen.’

Gaining trust as a constant challenge

The general thinking is that trust is easily shattered and difficult to get back. Alexander Wagner agrees with this observation. ‘Trust is constant labour, it is never done. This is clearly visible in the corporate world, for example. A company needs not only to report what is absolutely required by law but, for trust building purposes, also talk about the non-financials, talk about how they actually create value and how they do business.’ One of the issues in such reporting, this value reporting, is that it needs to have substance. ‘But is not an easy task to explain how you are adding value.’

Trust is constant labour, it is never done.

Box 4 — maximising profits and trust

In his research, Alexander Wagner found that firms that do not manage earning as much as they legally could turn out to receive higher levels of trust from the financial market. The market responds more to news that these companies have. ‘So suppose I have some corporate news, I am announcing earnings and you need to figure out: ‘Okay can we trust CEO Alex and how much should we respond to this news.’ If you do not trust me, you will discount the news I have and say: “Yes he is exaggerating, let’s just not move the price so much.” If you think: ‘’Hey, this is a straight shooter,’ then you will take what I said at face value and incorporate that into prices more quickly and in a stronger way. So how do you tell if I am a straight shooter or not? You look at my history, my previous behaviour and you find that in the past I might have had an incentive to massage earnings little bit in order to increase my bonus. If I in fact did that, then you know I am very much motivated by my own incentives and not a man of principles; so you would not trust me too much. If, however, I consistently did not follow those temptations in the past, then you can say: ‘Aha, he is reliable, and his announcements can be trusted.’

When it comes to CEOs and other decision-makers in the financial world, what drives their behaviour? Are they embracing an integrity-driven approach? Alexander Wagner: ‘I would say that the financial services industry by and large is still often driven by a compliance-oriented approach, saying: “What is it that we minimally have to do?” I think few firms go beyond that and establish practices that go beyond the necessary legal minimums.’ However, he sees some change happening: ‘The notion that if you are perceived as a financial services provider with a particular integrity level, you can create value for your company is gaining some traction.’ He indicates that some players really like to position themselves like that, perhaps more even relatively newcomers.

Alexander Wagner.

Alexander Wagner also points out that there is financial market evidence that firms who engage in Corporate Social Responsibility Practices (CSR) that go beyond the minimum are more resilient in times of crises. ‘Looking at the 2007/2008 crisis we see that for companies which had been engaging in CSR — and not just banks — that they came back much more quickly and also did not even decline as much. It may be that the customers are not running away as much but it may also simply be that the investors are more inclined to trust those companies and stay with them. This would be the positive signal you can send. And would indicate that having trust in the longer run pays off.’

This article was first published on the 2/2019 issue of the ECA Journal. The contents of the interviews and the articles are the sole responsibility of the interviewees and authors and do not necessarily reflect the opinion of the European Court of Auditors.

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