Is fraud contagious? Can even the most honest employees become more likely to commit misconduct if they work alongside a dishonest individual?
That was the question Will Gerkin and Stephen Dimmock set out to answer. Gerken is an assistant professor of finance at the University of Kentucky’s Gatton College of Business and Economics. His research focuses on financial advisers, financial misconduct, and governance.
He met with Tom Martin to discuss his findings.
Question: What did you and your colleague Stephen Dimmock at Nanyang Technological University in Singapore set out to learn and understand?
Answer: Steve and I have been looking at the financial advisory industry for some time. It’s an industry that’s been understudied by academics and there’s been a lot of contemporary interest in it with the recent fiduciary rules. Also, it’s just a very large and important industry. It’s a conduit through which most households invest in the financial markets. So, understanding whether we can trust financial advisors and what causes misconduct in this industry is of relevance and importance for ultimately getting people to trust and invest in the industry.
Q: And how did you go about investigating this question?
A: Our research looks at the question of whether your colleagues can encourage misbehavior. Essentially, are there peer effects in workplace misconduct?
Q: Previous studies have looked at the misconduct of firms. Yours, however, looks at the bad behavior of individuals. What are the advantages of taking that more granular approach?
A: Ultimately, people engage in actions, not firms. Firms are made up of people engaging in a whole bunch of decisions. So, understanding the decision-making of individuals allows us a richer understanding of the things that drive a corporate culture; desire to be good, to be bad; to engaging in innovative or creative endeavors; or engaging in extractive misconduct.
Looking at individuals gives us a lot more data points as well. So, we’re able to understand the actions of a single person in the context of the people that work around them. We can look at the actions of all these individuals and understand the differences within a single firm’s culture of why one employee chooses to engage in misconduct and another one does not.
Q: You mentioned peers. Is this similar to the peer pressure that many of us experienced in high school or college?
A: I think that’s a good way to think about it. Peer effects are often thought of as something common among young people. In our setting we’re looking at professionals; adults who have lucrative jobs. And even in this context, the behavior of their peers, their coworkers influences their behavior. It’s something that we don’t really grow out of.
Q: And for those coworkers who are falling under the influence of a bad actor, is this more or less ‘going along to get along’?
A: Yeah. One thing that we looked at is, do I just copy the behavior of my peers to fit in? Or am I learning from my peers? And we see a bit of an asymmetric effect. And by that, I mean when you put a well-behaving employee into a branch with a lot of misbehaving employees, that well-behaving employee tends to have a higher rate of misconduct going forward.
But the reverse isn’t as true. If you put an employee with a history of bad behavior with a bunch of employees that are doing the right thing, the influence is much less in that case. Essentially, what’s going on in this case, “I am updating my beliefs about what is the right actions. I see a colleague that’s engaging in some questionable activities and either they’re not being punished or they’re being rewarded for this.” And because I see this, I change my beliefs about how right these actions are and it changes and encourages me to engage in more misbehavior.
Q: How pervasive is this bad behavior in the financial advisory industry?
A: Estimates vary, but between 4 and 7 percent of financial advisers have some sort of regulatory mark on their record indicating some sort of misconduct. It’s not so pervasive that the typical financial adviser has one, but it’s not so rare that we can ignore the problem. Just a perception that there’s this chance that ‘this financial adviser might be out to exploit me’ discourages some people from engaging and participating in the stock market.
And this can have very severe effects on their financial well-being. They’re the people that aren’t participating in the stock market and they’re falling further and further behind. And because they don’t have trust in the markets, they’re not able to catch up and reap the gains that those who are actively participating in stock market are reaping.
Q: Were there any special circumstances that contributed to the spread of misconduct among coworkers; merged workplaces, for example?
A: We use the context of mergers to identify the causal effect of contagion. One issue is that there are multiple explanations for this. One could be that the firm just has incentives setup in a certain way that it makes it very beneficial to aggressively sell to clients. Or, it could be that certain areas are particularly susceptible to it. Maybe I’m down in South Florida. I have a lot of elderly clients and these clients might not be aware of some of the aggressive sales that are taking place. So, as economists we look for something that mimics a natural experiment.
I used to work in a biology lab cutting up snails and that type of setting is really nice because you can figure out how to setup a treatment and a control sample. We do an analogous thing in this research where we look at mergers of large financial firms that have many work sites. If you imagine Wachovia and Wells Fargo when they merged, there’d be a branch, say in New York, where the Wells Fargo advisers would be exposed to advisers from Wachovia and perhaps a group of those advisers engage in misconduct. You could compare that to another sample of Wells Fargo advisers say in Florida and they get exposed to Wachovia advisers, but these Wachovia advisors have no history of misconduct. And so, you can use that as a treatment sample. So, we mimic the natural sciences treatment control sample using this observational data that’s available to us in the financial advisory industry.
Q: What are the costs of having a problematic employee, especially if left unchecked?
A: For a long period of time in the financial advisory industry, the punishment for some of these actions was essentially a fine that reflected about the amount that they took. This wasn’t enough punishment to discourage these types of bad actions.
If I engage in misconduct and I cause say $100,000 worth of losses to my clients, if you just fine me $100,000, that’s enough to make me not engage in this misconduct.
But what we find in our study is that my bad actions are not just my own, they also have spillover effects that will cause many others in my branch to engage in these misconducts. And because of that, the fines should be much higher.
Also, the use of other types of techniques like barring people from the industry should be more prevalent, given the contagious nature of misbehavior.
Q: Your study concentrated on the financial advisory industry, but could your findings be applied more broadly to other lines of work?
A: I think so. One of the points that we’re making in the study is that peer effects are not just among juveniles. What we’re showing is in a professional context with regulators, with firms that are policing these individuals, you still see that peer effects are statistically important predictors of misconduct.
So, I wouldn’t be surprised to see this in other industries where you have professionals exposed to others who are in highly competitive environments and they get feedback about how certain actions that may be morally questionable are rewarded or punished and they can update their own beliefs. I would expect similar type of contagion effects there.
Q: People who make hiring decisions don’t have a crystal ball, so, how can they know whether a prospective employee could spell trouble down the line?
A: Past performance, while not a complete indicator of future behavior, is still a very strong predictor. But beyond that, think about where individuals get their training. What happens in a lot of these situations is that individuals start off learning the trade from others around them and this is a time when they might be more susceptible to influences. As they’re learning the ropes, if they’re around a lot of other individuals engaging in questionable practices, they might be more susceptible to engaging in those practices themselves.
We have some evidence that essentially your exposure to misconduct in your entire past history is predictive of your future misconduct, even if you’ve kept a clean slate yourself.
Tom Martin’s Q&A appears every two weeks in the Herald-Leader’s Business Monday section. This is an edited version of the interview. To listen to the interview, find the podcast on Kentucky.com. The interview also will air on WEKU-88.9 FM on Mondays at 7:35 a.m. during Morning Edition and at 5:45 p.m. during All Things Considered.