Measuring and Managing the Gordon Gekko Effect

Culture is a potent force in shaping individual and group behavior, yet it has received scant attention in the context of financial risk management and the recent financial crisis. In my paper, The Gordon Gekko Effect: The Role of Culture in the Financial Industry, I propose a specific framework for analyzing culture in financial practices and institutions. Some cultural values are positively correlated to better economic outcomes. However, not all strong values are socially positive ones. Some corporate cultures may transmit negative values to their members in ways that make financial malfeasance significantly more likely. I propose calling these values “the Gordon Gekko Effect,” after the fictitious villain of the hit movie Wall Street. Rather than discouraging moviegoers from finance through the portrayal of Gekko’s rapacious and criminal behavior, this movie apparently had the counterintuitive effect of motivating a generation of viewers to join the financial industry, and turned Gekko into a cultural icon along the way! To better understand the Gekko Effect, and to formulate remedies to address it, I start by asking what culture is, how it emerges, and how it is shaped and transmitted over time and across individuals and institutions.

There is a rich but non-quantitative literature in the social sciences on the role of culture in organizations that has remained largely untapped by financial economics. Culture is defined provisionally, following Kroeber and Kluckhorn (1952), as acquired and transmitted values and patterns of behavior, shared by members of a group. I present a brief overview of the possible origins of corporate behavior, taking insights from psychology, sociology, anthropology, ethnography, and management science, and classifying them into three groups: from the top down, via leadership; from the bottom up, via composition; and from the environment. All three can be witnessed to some degree in the disturbing psychological study of authority by Milgram (1963) in which randomly chosen volunteers were instructed to administer lethal doses of electrical shocks to other individuals. Though no actual shocks were delivered in reality, the actions of the unsuspecting volunteers elicited screams of pain and entreaties to stop from actors hired by Milgram which were broadcast into the volunteers’ booths. Although a number of participants refused to continue after the first of these reactions, several participants continued delivering increasingly strong shocks at the urging of the experimenter. This chilling experiment, and the even more troubling prison-guard experiment of Haney, Banks, and Zimbardo (1973), demonstrate the dark power of leadership and culture, even in the absence of significant financial incentive. None of these explanations are complete theories, however, and most accounts of culture ignore intrinsic variation between individuals and their receptivity to shared values.

Within this framework, the classical economic perspective of behavior as the outcome of agents motivated through incentives and rational self-interest is reanalyzed as an acquired and transmissible cultural trait. The assumption of rational self-interest has made economics the most analytically powerful discipline of the social sciences. The adoption of rational self-interest as a cultural value, however, is subject to the same diffusional, compositional, and environmental influences as other cultural traits. There is no simple dichotomy between incentives and culture. Neither explanation is fully complete, because both are inextricably intertwined. To resolve this problem, a broader theory is needed, one capable of reconciling the analytical perfection of Homo economicus with the natural cultural tendencies of Homo sapiens.

The key insight to resolving this dilemma is the observation that culture is an adaptation, transmitted imperfectly between individuals in a given population and shaped by natural selection within and for a given environment. In other words, culture is a product of evolution, analogous to the evolution of biological organisms. This evolutionary perspective has a direct instantiation in financial economics in the form of the Adaptive Markets Hypothesis (AMH) (Lo, 2004, 2013), a theory of financial market dynamics in which a population of individuals compete for financial resources while adapting to past and current market environments. The AMH implies that the Efficient Markets Hypothesis arises as a limiting case in which the environment is stable over long periods of time and a large population of individuals becomes exquisitely adapted to this stationary environment.

In this framework, individual behavior that appears to be coordinated is simply the result of certain common factors in the environment—“systematic risk” in the terminology of financial economics—that impose a common threat to a particular group of individuals. Within specific groups subjected to systematic risk, natural selection on individuals can sometimes produce group-like behavior. This evolutionary, adaptive framework not only accommodates recent neurophysiological discoveries on the brain regions involved in ethical behavior, but it also explains many empirical observations from the social sciences quite naturally, such as Douglas and Wildavsky’s (1982) observation that a culture’s values are mirrored in its risk management.

Since the dynamics of the financial environment are constantly changing, regulators face a dual adaptive challenge in combating the Gekko Effect. Not only must regulators anticipate changes in the financial landscape that make financial misconduct more probable, they must also be on guard against an internal regulatory culture that systematically overlooks or acquiesces to misconduct.

What does this adaptive framework tell us is the best way to safeguard institutions, both financial and regulatory, against the Gekko Effect? The first requirement is measurement—you can’t manage what you don’t measure. A “Capital Markets Safety Board,” analogous to the highly effective National Transportation Safety Board, should be dedicated to investigating, reporting, and archiving every major “accident” of the financial industry. It is impossible to safeguard against any sort of risk, cultural or otherwise, without knowing the facts of the situation.

The second requirement is feedback. Since financial systems adapt dynamically, it is important to promote worthwhile financial and regulatory behavior for the system as a whole, to “resist situational influences,” while dampening tendencies that might promote systemic failure. To implement this notion, I propose a concept called “behavioral risk management,” analogous to financial risk management. For the first time in regulatory history, we have the intellectual means to construct behavioral risk models, quantitative measures and models of the systematic and idiosyncratic factors underlying fraud, malfeasance, and excessive risk-taking behavior, as in Haidt (2007), Dyck, Morse, and Zingales (2013) and Deason, Rajgopal, and Waymire (2015). A behavioral risk manager can learn a great deal simply by documenting the reward structure for individuals within an organization.

This proposal is not merely speculative. The Dutch Central Bank has already launched such an effort, using organizational psychologists to monitor the Netherlands’ large financial institutions and create new supervisory methods (De Nederlandsche Bank, 2009), while the Federal Reserve Bank of New York has begun systematically documenting and disseminating the practices and behavior of bank supervisors for large financial institutions with an unprecedented level of transparency (Eisenbach, Haughwout, Hirtle, Kovner, Lucca, and Plosser, 2015). This emerging discipline may provide the means by which the Gekko Effect is quantified and, ultimately, managed.

The preceding post comes to us from Andrew W. Lo, the Charles E. and Susan T. Harris Professor and Director of Laboratory for Financial Engineering at the MIT Sloan School of Management.  The post is based on his paper, which is entitled “The Gordon Gekko Effect: The Role of Culture in the Financial Industry” and available here.