The 2008--09 financial crisis was in part a consequence of inadequate formal rules for bank capitalisation and liquidity, of failures of regulatory cooperation, and of ineffective insolvency regimes for banks. Policy makers have focused much of their reforming energy on these problems. But cultural factors are also an extremely important determinant of outcomes in financial markets, and there is widespread agreement that dysfunctional behaviour in financial markets can be attributed to undesirable cultural standards. An emerging consensus therefore holds that policy should attempt explicitly to address cultural factors.

Policy can only be effective if it is built upon firm foundations. But culture is complex, tacit, and hard-to-codify; in some circumstances, it may even be impossible for outsiders to observe aculture. The regulatory and industry bodies that are attempting to address perceived cultural failings therefore face a very difficult task.

In this working paper, Joel Shapiro and I present a conceptual analysis of culture in the financial services sector. We believe that a useful contribution should build upon more than one social science, and our work draws upon prior sociological, managerial and economic work. We use our foundational work in an analysis of recent scandals in the LIBOR and Forex markets, and we discuss the governance and regulation of culture.

Cultures are habits, skills, and ways of seeing the world that facilitate social cooperation. They evolve in response to economic and social challenges. But cultures are long-lived, and can survive long after the problems that inspired them have been solved. Hence, for example, the private languages and rituals that facilitated communication in the pre-internet LIBOR and foreign exchange markets did not die when the new internet technologies generated alternative means of communication and commitment. The business environment within which those cultures exist has changed dramatically: businesses in which trust and relationships were historically central became far more transactional and arm's-length as they adopted new information technologies. As a result, the small groups that understood the cultural devices employed in those businesses were able instead to use them to coordinate collusive activities that were privately profitable but socially very damaging. Precisely because cultures are hard for outsiders to measure, this type of collusion was extremely hard to detect. For example, a senior banker who participated in foreign exchange markets described the languages used by market participants as "crushingly boring and pure garbage," before noting that "they are difficult to decipher."

Given the tacit nature of cultural understandings, they are not susceptible to direct regulation. Appropriate policy responses must instead focus upon observable artefacts that drive culture formation. In this context, Shapiro and I identify compensation policy, compliance training, "tone from the top", and manipulation of market networks as crucial tools in the regulatory arsenal. We also discuss the possibility that industry self-regulation might work via such mechanisms as a professional standards or licensing body.

 

Alan Morrison is Professor of Law and Finance at Saïd Business School, University of Oxford, and a Fellow of Merton College.