Creating and sustaining cultures of compliance: insights from psychology and beyond.

Dec 16th '16

Understanding the social and psychological influences on decision making is important to improving regulatory compliance, according to Financial Conduct Authority (FCA) economist Peter Lukacs.


The scale of individual and corporate wrongdoing we have seen in financial services in recent years has profoundly affected public perception of the types of penalty deemed ‘suitable’ for severe misconduct.


In addition to calls for stricter penalties for offenders, we have seen notably higher fines imposed since the pre-crisis period, while scrutiny of the culture in financial service firms has also increased markedly.


Penalties can go a long way to deter wrongdoing. But to rely on them alone is to overlook one of the fundamental drivers of all our behaviour: social and psychological influences.


Obvious as it may seem, it is worth emphasising that in order for regulatory measures to be effective regulated firms must comply with them.


But as today’s occasional paper on ‘behaviour and compliance in organisations’ spells out, without an understanding of the social,  psychological and other influences on decision making in any given organisation, regulators could be missing a trick when it comes to improving effective compliance. This understanding underpins the substantial work on improving corporate culture that the FCA and other regulators have undertaken in recent years.


Social influence in action

One area particularly relevant in this regard is behavioural bias.


There has been extensive discussion around the behavioural biases consumers demonstrate in choosing financial products and services. But less commented on is the fact that people are equally susceptible to such biases in the workplace.


As with consumers out shopping, employees may use rules of thumb, discount future losses excessively and under or overestimate the risks of their actions, all with the consequence of moulding their approach to compliance.


Similarly, we know that people behave differently in group situations, so it naturally follows that culture is an important determinant of compliance. Recent history tells us that groupthink in firms, where cohesive groups take poor decisions with limited scrutiny, can lead to poor governance and insufficient challenge.


In view of this, it is only logical that regulators complement credible deterrence with approaches that use insights from psychology and other disciplines.


In order to improve the environment for compliance decisions, and so produce better outcomes, regulators must change the situational factors that determine how decision makers respond to incentives to break rules.


How effective a deterrent is depends on how vivid and salient detection and punishment is to an individual. This involves increasing the expected costs of non-compliance.


The Senior Managers Regime, for example, aims to make the risks of wrongdoing more tangible by highlighting the individual’s personal area and degree of responsibility. The salience of the individual’s decisions is heightened.


Changing communications about enforcement can also help. For example, by highlighting individual penalties the deterrent becomes more vivid in people’s minds and so assists compliance.


Kidding ourselves

In addition to the external incentives to comply with rules, such as penalties, behavioural literature suggests that people’s behaviour is constrained by their desire to view themselves as virtuous, moral people. This supplies individuals with their own internal incentives.


The interaction of these external and internal incentives, that is, an individual’s ability to rationalise their rule breaches as consistent with their own virtue, determines whether rule-breaking takes place.


Where moral considerations are absent, behaviour is more likely to be determined by external incentives.


Studies have shown that having people sign up to honour codes can reduce wrongdoing, even when the probability of detection is very low. Similarly, having people sign declarations that they will report truthfully before they fill in tax returns or make insurance claims can reduce dishonesty.


Conversely, there is some evidence from financial services markets that having sellers disclose conflicts of interest can lead them to give more biased advice. We can attribute this to ‘moral licensing’, when people feel that they have been absolved of the need to hold themselves to ethical standards (because their self-interest has already been publicly declared), leaving to them feeling free to pursue their own agenda.


Another example relates to the Financial Services Authority’s pre-crisis approach of taking responsibility itself for certifying that employees were fit and proper under the Approved Person Regime. There is evidence to suggest that making the regulator responsible for vetting staff ethics may have reduced the internal incentives that would otherwise have constrained rule-breaking.


Out of sight, out of mind?

Distance, both from the act of rule-breaking and its negative consequences, can make such wrongdoing easier to justify.


The separation of financial services from the real economy can create distance, as the effects of rule-breaking may not be readily apparent to rule breakers.


Within larger organisations, such distance may be created by diffusing responsibility, with one set of individuals making decisions on whether to comply with rules and another group acting in line with those decisions.


This can be clearly seen in the case of LIBOR manipulation, for example, where the trading departments initiated the conduct (making requests to LIBOR submitters), while it was the submitters who carried out the action (to alter their submissions).


Environment of misconduct

As seen in the LIBOR scandal, the extent of rule-breaking among peers has a strong influence on the likelihood that an individual decides to break rules. In such examples, the culture of the organisation, what people see, hear and experience every single day, normalises misconduct.


In some notable cases, like that of PPI mis-selling, misconduct is even incentivised.


Incentives are an important driver of culture, as the way that individual group members respond to incentives can shape the norms of the group as a whole. For example, poor culture in the banking industry in the period leading up to the financial crisis has been attributed, including by some within the industry, to the structure and levels of employee compensation.


Organisations often seek to motivate their staff through appeals to the greater good of the organisation. While this may have positive effects it can also make wrongdoing more likely: it is easier to break rules for the benefit of others, and see oneself as a moral person, than it is when breaking rules for one’s own benefit.


Moving forward

What these examples show is that firms and regulators alike can learn a lot from the social, psychological and other influences on decision making.


In a nutshell, combatting ideologies that trivialise poor behaviour – from ensuring that staff remuneration does not promote poor behaviour to ensuring that moral considerations are part of individual decision-making – is a logical and necessary enterprise in the pursuit of good conduct.


Note: The views expressed in this article are those of the authors alone, and should not be taken as an official FCA position.



Source: FCA website.


What do we do?

At LS Consultancy, we offer a complete solution with a range of cost effective, regulatory compliance and marketing products and solutions that are uniquely suited to supporting firms.


Explore our full range today.