Photo: Bloomberg
Photo: Bloomberg

Gordon Gekko, Goldman Sachs and culture’s role in high finance

Culture matters in economic life, and nowhere does it matter as much as in the world of finance

“The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money," wrote polemical American journalist Matt Taibbi in a scathing essay on the world’s most famous investment bank in 2009.

While several commentators disagreed with some of the details of Taibbi’s piece, the essence of his piece about a decaying culture at the investment bank seemed to strike a chord with many observers of the financial industry. That sentiment came alive again in 2012 when Greg Smith, a former Goldman Sachs employee, wrote how he could no longer identify with the changing culture in the organization. If the focus of Goldman executives earlier was to help clients make money, now the focus had shifted to making money off them, wrote Smith.

“It might sound surprising to a sceptical public, but culture was always a vital part of Goldman Sachs’s success," Smith wrote in a famous op-ed for The New York Times. “It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization. I am sad to say that I look around today and see virtually no trace of the culture that made me love working for this firm for many years."

Although many economists acknowledge the importance of culture in shaping the world of finance, and in determining financial outcomes, very few have actually researched this issue carefully. A recent research paper by Andrew Lo of the MIT Sloan School of Management fills this gap.

Lo shows how cultural factors may have a profound influence on the financial decisions of firms and actions taken by regulators. Lo points to examples such as Lehman’s use of accounting tricks to give a rosier picture of financial health to drive home his point about how certain types of behaviours engender systemic risks in the economy. Lehman’s hierarchical culture ensured that dissenting voices within the organization were effectively silenced when they voiced disapproval of such practices, wrote Lo.

Lo is, of course, not the only economist to worry about corporate culture and its impact on the wider economy. Economists Luigi Guiso of the Einaudi Institute for Economics and Finance (Rome), Paola Sapienza of the Northwestern University (Evanston, Illinois) and Luigi Zingales of the University of Chicago have written a number of influential research papers in recent years which analyse the links between culture and finance.

In a 2013 research paper, Guiso, Sapienza and Zingales show that corporate values do indeed affect productivity and profits, but the actual culture prevailing in a firm may differ significantly from what it may proclaim to the world.

While more economists have begun paying attention to culture now, it is still a relatively under-emphasized aspect of economic life. This was not always the case. Classical economists such as Adam Smith and Karl Marx wrote extensively on the links between cultural norms and economic activities. While Marx viewed religion as the byproduct of the relations of production, his compatriot, Max Weber, regarded religion as the basis of capitalism. Weber argued that the Protestant ethic was most conducive to business success.

Italian theorist Antonio Gramsci provided a synthesis of Marx and Weber, arguing that both economic interests and dominant culture influence political outcomes. While Weber and Gramsci influenced all varieties of social scientists, economists remained exempt from their influence for a long time.

In an excellent 2006 summary of the study of culture in economics, Guiso, Sapienza and Zingales point out that the increasing use of maths meant that qualitative variables such as culture were neglected in economic analysis.

“Not only did economics lose interest in its relation with culture, but as economics became more self-confident in its own capabilities, it often sought to explain culture as a mere outcome of economic forces," wrote Guiso, Sapienza and Zingales. “This movement, which is mostly associated with the Chicago school, is Marxian in spirit, but with no trace of class struggle. On the contrary, the Chicago school pursues a ‘rational’ Marxian agenda, where people’s beliefs, tastes and values are individual or societal rational choices and any element of conflict can be resolved through the price system."

As economists increasingly realized the importance of institutions in determining growth and stability, they started looking beyond formal institutions. As they began examining informal institutions, they were forced to contend with culture and cultural norms. Many of them followed the lead of political scientists such as Robert Putnam and Francis Fukuyama, who have written extensively on the role of trust and social capital in shaping economics and politics.

Among the institutional economists, the most prominent champion of cultural explanations in economics was Harvard University economist and historian David Landes. “If we learn anything from the history of economic development, it is that culture makes all the difference," wrote Landes in his famous 1998 book, The Wealth and Poverty of Nations.

One of the most illuminating explanations of how cultural norms and social relations impact economic transactions comes from the work of the economic sociologist, Mark S. Granovetter. Granovetter’s research on how behaviour and institutions are affected by social relations has tended to tread a middle ground between the under-socialized accounts of economists and the over-socialized accounts of sociologists. In a widely cited 1985 research paper, Granovetter posited that social relations and trust played a significant role in economic decision-making, which under-socialized narratives of rational choice under perfect information ignore.

In the real world, information is imperfect and the transactions between buyers and sellers are dependent as much on their rational interests as on their respective histories. Trust in economic interaction is based not on abstract faith in market-determined prices but on specific knowledge about those whom we are dealing with, Granovetter argued.

At the same time, Granovetter warned against viewing social or cultural influences as mechanical deterministic forces rather than as inputs that guide the actions of members of a community, class or profession. The accounts of both early sociologists and new institutional economists fall into that trap of over-socialization, wrote Granovetter.

“Social influence here is an external force that, like the deists’ God, sets things in motion and has no further effects—a force that insinuates itself into the minds and bodies of individuals (as in the movie Invasion of the Body Snatchers), altering their way of making decisions," wrote Granovetter. “… More sophisticated (and thus less over-socialized) analyses of culture make it clear that culture is not a once-for-all influence but an ongoing process, continuously constructed and reconstructed during interaction. It not only shapes its members, but is also shaped by them."

Nowhere else do cultural mores and inter-personal relations matter as much as in the world of finance. After all, financial firms offer very little variety when it comes to products: a loan is a loan, whether it is offered by Citibank or State Bank of India. Culture then comes to the aid of brand differentiation.

Culture also seems to play an important role in determining the demand for financial products. In an analysis of intra-country differences in Italy, Guiso, Sapienza and Zingales show that in areas with high levels of mutual trust or high social capital, households are more likely to use cheques, invest less in cash and more in stock, have higher access to institutional credit and make less use of informal credit. It is culture that explains why even the wealthiest of individuals in countries characterized by low trust invest so little in financial markets, they argue.

Culture assumes importance within organizations for two key reasons. First, because of the incomplete nature of contracts (between firms and employees), it is impossible for firms to lay down all that is expected of their workers in different situations. In the absence of complete contracts, cultural norms or values (such as “customer satisfaction") play an important role in regulating the conduct of workers, and giving them guiding principles on how they are expected to operate.

Secondly, the development of corporate culture helps lower transaction costs. Given how expensive it is to monitor the behaviour and work effort of employees, corporate values can drive a diverse body of workers to pursue a common set of goals in a cost-effective way.

Does corporate culture really affect the profits of corporations and financial firms? Guiso, Sapienza and Zingales argue that they do. In the 2013 paper cited earlier, the authors match data from financial databases and employee surveys to show higher integrity levels raise profitability of firms over the long run. However, given that there are no short-run benefits, publicly listed firms find it harder to sustain values such as integrity than privately held firms do.

Even if chief executives of publicly listed firms place importance on values such as integrity and honesty, they may fear taking appropriate action against offenders. In a privately held firm, strict action against an offender serves as a message to all employees, and tends to reinforce the values the firm holds dear. For a publicly held firm, it is much more difficult to take harsh disciplinary action even when malfeasance comes to light because the market may interpret such action as evidence of some deeper rot in the organization. The message in this case goes out not just to employees but also to shareholders. Thus, action tends to be less stringent, which dilutes the impact of the signal that the executive wants to send out to employees.

Therefore, Guiso, Sapienza and Zingales find greater divergence between the advertised values (as, for instance, available from company websites) of a firm and the values that actually prevail within the firm (as deduced from surveys of employees) if the firm’s stock is publicly traded.

Market mechanisms or traditional balancing forces such as the board of directors of a firm are often unable even to detect, leave alone arrest, the decline in values of the firm, writes Lo in the research paper cited earlier. Thus, some corporate cultures may transmit negative values to their members in ways that make financial malfeasance significantly more probable, Lo argues, calling it the “Gordon Gekko effect", inspired by the movie character from Wall Street.

While regulators can be expected to perform a balancing role in theory, in reality they are themselves not immune to the zeitgeist. In a world where light-touch regulation is fashionable, it does not take long for a regulatory officials to make the switch from being non-obtrusive to being deferential towards regulated entities, especially if cushy post-retirement jobs in such organizations await them at the end of their terms.

This is precisely what seemed to have happened at the US Federal Reserve, as the explosive revelations of a former New York Fed executive, Carmen Segarra, showed. Segarra’s story, based on secretly taped conversations during her stint at the Fed, which was corroborated by ProPublica journalist Jake Bernstein last year, revealed an astonishing culture of deference in the Fed towards regulated firms such as Goldman Sachs.

It would have been easy to dismiss Segarra’s allegations as that of a disgruntled employee, or an individual case involving just one specific Fed team, but for the fact that many of the issues she highlights were identified as key problem areas by a 2009 committee appointed by the New York Fed itself. The committee led by Columbia University professor of finance David Beim had first identified the culture of deference towards regulated entities as one of the key weaknesses of the organization.

The Beim report urged the Fed to change the way it regulated banks, which had so far been driven by the flawed assumption that markets will self-correct, and hence that internal controls would be enough to discourage excessive risk-taking in banks. Beim found that the regulatory lapses leading to the great financial crash of 2008 flowed more from cultural problems at the Fed than from the lack of technical expertise to deal with banking innovations.

In large banks, Fed teams are located onsite and the physical proximity had led to a cosy relationship between Fed supervisors and the supervised. The revolving doors between the world of investment banks and the world of regulators only complicated the problem of regulatory capture.

There are no easy answers to such cultural challenges in the world of high finance, but the first step towards addressing them is to acknowledge their importance.

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

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