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Managing culture with risk management techniques

The interaction between governance, culture and performance is increasingly a topic around asset owner board tables. But little has been written about the relationship between culture and the financial crisis, and how to change culture in financial services organisations. Andrew Lo, professor of finance at MIT, has come up with a proposal to change culture by drawing on traditional risk management protocols used at major financial institutions.


Roger Urwin, head of content at Towers Watson has been integral to advancing the conversation on culture at asset owner organisations, advocating that an organisation’s culture lies at the heart of its ability to improve governance. And governance has a direct relationship with performance.

“Culture is the fuel to how organisations are powered: culture is hugely important,” he told delegates at the Fiduciary Investors Symposium at Oxford University in April.

He argues that culture is specific to individual organisations, ruling out any single best practice, although he says culture together with leadership are the two conduits to good governance.

Organisations need to nurture and encourage culture even once it is established, he warns. “Left to its own devices culture declines overtime. It regresses and people don’t understand this.”

He suggests organisations actively manage culture so that it is vibrant and established enough to withstand buffeting from the immediacy of business.

He also believes that incentives are the prerequisites for governance change within an organisation.

“Incentives have a profound impact on how institutions function. People respond to incentives, yet incentives in the investment industry are strange at times, acting perversely. There is work to do be done here.”

Like Urwin, Andrew Lo, professor of finance at MIT, is interested in the culture of financial services firms, its contribution to the financial crisis and specifically how it can be measured and managed.

He believes culture has received scant attention in the context of financial risk management and proposes that culture can be changed and managed via “behavioural risk management”.

Culture can be a choice, not a fixed constraint, he says, and that through the emerging discipline of behavioural risk management can be measured and managed.

In an article prepared for the Federal Reserve Bank of New York’s Financial Advisory Roundtable last year, Lo wrote a paper, revised last month, presenting a specific framework for analysing culture in the context of financial practices and institutions.

He applies his framework to five specific situations – Long Term Capital Management, AIG Financial Products, Lehman Brothers and Repo 105, Societe Generale’s rouge trader, and the SEC and the Madoff Ponzi scheme.

Through these case studies he outlines how corporate culture is clearly a relevant factor in “financial failure, error and malfeasance”, citing examples such as Lehman Brothers, which spent more time concealing the flaws in its balance sheet than it spent remedying them. And AIG which felt so secure in its practice of risk management that it allowed billions of dollars of toxic assets to appear on its balance sheet.

In this article, Lo looks at the advice of psychologist Philip Zimbardo who offers 10 key behaviours that will help minimise the effectiveness of destructive culture in spreading its values, including willingness to admit mistakes, refusal to respect unjust authority, the ability to consider the future rather than the immediate present, the individual values of honesty, responsibility and the independence of thought.

“Human behaviour is clearly a factor in virtually every type of corporate malfeasance, hence it is only prudent to take steps to manage those behaviours most likely to harm the business franchise. One this semantic leap has been made, it is remarkable how quickly more practical implications follow. By drawing on traditional risk management protocols used at all major financial institutions, we can develop a parallel process for managing behavioural risk,” Lo says in his paper.

He says the alignment of corporate values and mission with behaviour can be facilitated in a number of ways once behaviours, objectives and value systems are specified.

While economic incentives are the standard approach favoured by the private sector, there are other tools available to the behavioural risk manager, including changes in corporate governance, the use of social networks and peer review and public recognition or embarrassment.

“A more extreme measure to change risk-taking culture of an organisation is to make all employees who are compensated above some threshold, eg $1 million, jointly and severally liable for all lawsuits against the firm. Such a measure would greatly increase the scrutiny that such highly compensated individuals would place on their firm’s activities, reducing the chance of misbehaviour.”

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