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P2.T9.807. The role of culture in the financial industry (Lo)

Nicole Seaman

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Learning objectives: Explain how different factors can influence the culture of a corporation in both positive and negative ways. Examine the role of culture in the context of financial risk management. Describe the framework for analyzing culture in the context of financial practices and institutions. Analyze the importance of culture and a framework that can be used to change or improve a corporate culture.


807.1. In his discussion of the role of culture in the financial industry, Andrew Lo asserts EACH of the following as true EXCEPT which statement is inaccurate?

a. Three factors affect the transmission of corporate culture through a group: leadership, composition, and environment.
b. Edgeworkers have risk-taking personalities whose success in the face of risk often tends to reinforce a sense of solidarity or belonging to an elite culture
c. The Adaptive Markets Hypothesis borrows from physics to reject the dual-process theory in favor of a model where individual agents logically alter their environment
d. Although no singular definition of culture exists, a credible definition of corporate culture is: a system of shared values that define what is important, and norms that define appropriate attitudes and behaviors for organizational members.

807.2. In reviewing classic case studies in risk management, Andrew Lo considers the role of culture in Long-Term Capital Management's (LTCM's) collapse, American International Group's (AIG's) crisis, Lehman Brother's "Repo 105" failure, and Société Générale's rogue trader.

In regard to the role of culture in each of these case studies, according to Lo which of the following is TRUE?

a. Long-Term Capital Management's (LTCM's) collapse implicated the failure of its creditors' and counterparties' cultures
b. American International Group's (AIG's) problem was not its culture but rater a specific toxic product, namely credit default swaps (CDS)
c. The Repo 105 at Lehman Brothers was a legitimate (and legal) accounting convention such that the firm's risk culture could not be realistically expected to alter the accounting approach
d. In the case of Société Générale, it is unreasonable to implicate culture as a primary culprit because Jérôme Kerviel was a rogue trader who conducted, and covered up, fraudulent trades

807.3. Andrew Lo offers a framework that he claims can actually change culture. He says, "The first step is a subtle but important semantic shift. Instead of seeking to 'change culture,' which seems naïve and hopelessly ambitious, suppose our objective is to engage in 'behavioral risk management.' Despite the fact that we are referring to essentially the same goal, the latter phrase is more concrete, actionable, and unassailable from a corporate governance perspective. Human behavior is a factor in virtually every type of corporate malfeasance; hence, it is only prudent to take steps to manage those behaviors most likely to harm the business. Once this semantic leap has been made, it is remarkable how readily more practical implications follow."

His framework includes the application of SIMON--a process typically used to manage financial risk--to the management of behavioral risks. SIMON is a mnemonic that stands for Select, Identify, Measure, Optimize and Notice. Which of the five SIMON steps does he perceive as indispensable but also the "weakest link" [in the chain], without which behavioral management will remain more aspirational than operational?

a. Select
b. Identify
c. Measure
d. Notice

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