Investors, Governance and Culture, Part I

Maureen O’Hara, Robert W. Purcell Professor of Finance, Johnson Graduate School of Management, Cornell University

This is being published from the New York Fed by a guest writer as part of Reforming Culture and Behavior in the Financial Services Industry: Expanding the Dialogue. The views of the author are her own and are offered by the New York Fed to contribute to discussions on this topic.

Over the past eight years, the topic of ethics in finance — or the lack thereof — has been well documented. Lehman Brothers’ attempt to cover up its debt; JPMorgan Chase’s maneuvers in California’s energy markets; Goldman Sachs’ complex financial contract with the Greek government; Bernie Madoff’s pyramid scheme; the rigging of LIBOR and the FX market; Wells Fargo’s sham accounts — the list keeps growing. The common denominators have been the willingness of individuals in finance to stretch the boundaries of ethical behavior, and the weaknesses in the cultures of the firms that allow for such behaviors.

What is it about finance? Is it inherently unethical? If so, how do we change the internal culture at firms and move toward more responsible behaviors — respecting the consequences that our decisions have on customers, communities and society?

Much has been made in regulatory circles for broad industry reform, and the need for senior management and boards to improve their own internal cultures. What I am particularly interested in hearing at the upcoming culture conference is what role, if any, is there for investors in influencing the culture at a financial institution? By investors, I mean the largest owners of banks: mutual funds, pension funds, sovereign wealth funds, etc. The type of investors who control enough of a vote to make a difference to the board and senior management. Should they care about culture per se or only about its effects on long-run profitability? What can they do about the serial misconduct we’ve witnessed in banking?

On Thursday, October 20, I look forward to hearing from my esteemed panelists as they share their perspective on how feasible it is to expect investors to play a meaningful role in changing culture. I want to discuss passive versus activist investors, and the role of each in influencing change.

In order to influence culture change within an organization, investors must be well informed on the issues. They also must have thoughts on whether or not culture can be reformed with better controls and incentives and more draconian punishments for rule-breaking, or if a more holistic and humanistic approach is necessary. Should investors simply demand that management fix the problem, or is it too intractable? Do we need more rules? Or fewer rules with more standards that foster the desired culture? If the former is the path forward, can institutional investors simply rely on regulators to exogenously change the focus? Or must real change arise endogenously reflecting pressure from investors on senior management and the board?

It is perhaps easier to diagnose cultural problems in hindsight. Lately, we’ve had a lot of practice doing this. The challenge, however, is identifying and addressing these issues on an ex ante basis. How can investors gain adequate insight into the culture of an organization to make informed observations going forward? And how can they use that knowledge to influence change?

Finally, while at the conference, I am also hoping to gain more insight into what business schools can do to promote a more ethical culture for the next generation of leaders in finance. At Cornell, we have introduced a new finance and ethics course into our MBA curriculum, and I certainly spend more time focusing on ethical issues in our banking class. I worry that we’ve gone too far down the path of teaching finance from an amoral perspective, with not enough focus on how to recognize when financial activities cross lines of acceptable behavior. So I will take back to my classroom insights from the day, especially about the obligations that bankers have to their customers and society in general.

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