It is now becoming increasingly clear that corporate culture in banking matters. While those immersed in corporate culture issues have known this for a while, the recent financial crisis has brought corporate culture to the forefront as an important topic for bank regulators to wrestle with. This is, in part, due to the growing recognition that the risk management failures at so many leading global financial institutions were not merely isolated events—a rogue trader here and a deviant employer there—but rather reflections of systematic breakdowns in corporate culture.

In my paper, Corporate Culture in Banking, published recently in The Federal Reserve Bank of New York Policy Review (August 2016), I start with the observation that “[i]nattention to the significance of culture has limited our ability to design regulations that proactively cope with foreseeable problems. It is unlikely, however, that future banking regulation will operate in a culture vacuum.” I then discuss banking culture from two perspectives—economics and organization behavior.

The economics literature focuses mainly on the role of culture as a coordinating mechanism when there are multiple equilibria, as a facilitator of knowledge sharing, and as a way to achieve employee sorting and beliefs convergence. The organization behavior literature has focused on theoretically categorizing different cultural orientations and developing approaches for the practical implementation of culture change initiatives in organizations.

In my paper, I describe in detail one particular approach in organization behavior—The Competing Values Framework (CVF)—that I have personally been involved in using to diagnose and change culture in numerous organizations. The CVF asserts that there are four categories of activities that firms use to create value: Collaborate, Control, Compete and Create. Collaborate refers to investments in human capital development within the firm, Control refers to investments in internal processes, Compete refers to activities the firm undertakes to improve its competitiveness and interactions with external stakeholders (competitors, customers, shareholders, creditors and regulators), and Create refers to organic innovation. A key insight of the CVF is that Collaborate and Compete are “diagonal opposites” in the sense that they represent activities that pull the organization in opposite directions at the margin. Ditto for Control and Create—these two categories are also in diagonal opposition. The diagonal oppositions among activities generate organizational tensions and force the organization to make choices of strategy and culture that may skew its resource allocation in favor of one set of activities. One role of culture is to define what the organization wants to focus on.

In a companion working paper, “Bank Culture”, Fenghua Song and I develop a formal economic model of bank culture and theoretically show how a bank’s culture can help reduce the inefficiencies that explicit wage contracting (executive compensation) cannot. For analytical tractability, we combine Collaborate and Control to represent “safety” and Compete and Create to represent “growth”, so the bank’s choice is between a safety-oriented culture that focuses on minimizing errors and having high credit quality, and a growth-oriented culture that emphasizes asset growth.

Some of the key results from these two papers are as follows. First, a bank’s culture must support the execution of its growth strategy, so that culture affects all aspects of decision-making. That is, culture is more than a statement about ethical behavior. It is about its overall operations—how employees are hired, rewarded and fired, how resources are allocated, and how risks and opportunities are managed. Second, a strong culture can act as an “associative matching” device, linking banks with employees who have similar beliefs about market opportunities and risks. Third, culture can change an employee’s “identity” in a positive way and allow the bank to rely less on incentive compensation to induce the desired behavior. Fourth, banks have an economic tendency to emphasize a growth-orientation in their culture choices because this helps resolve internal agency problems more effectively, and this propensity is exacerbated by interbank competition. Regulators can attenuate this tendency of banks to herd on a growth-focused culture by raising capital requirements and reducing the probability of bailing out failing banks. Thus, the analysis indicates how bank regulators can use familiar tools of microprudential regulation even without explicitly measuring bank culture.

Anjan Thakor is Professor of Finance at Washington University in St. Louis.