We find that a firm’s tendency to engage in financial misconduct increases with the misconduct rates of neighboring firms. This appears to be caused by peer effects, rather than exogenous shocks like regional variation in enforcement. Effects are stronger among firms of comparable size, and among CEOs of similar age.
If one firm is on the fiddle, chances are, a lot of other similar firms are too.
Misbehavior of a firm’s management is mainly influenced by local peers of similar size and/or age groups, and cities tend to have corresponding waves of political and corporate corruption.
The same applies to investment:
We find that a firm’s investment is highly sensitive to the investments of other firms headquartered nearby, even those in very different industries.
I wrote about this a while ago, when the Libor scandal first broke. It’s not just companies that have shared cultures. Sometimes whole sectors do. Assumptions and beliefs are often shared across entire industries. It usually takes an outsider to point them out and question them.
Some years ago, a friend of mine got a new job in a sector where he had not worked before. He was going through the months orders when he spotted something which looked wrong. The conversation went something like this.
“What we sent out wasn’t what the customer ordered.”
“Yes but it was adequate for what they needed. Customers always over spec and order higher quality stuff than they need.”
“But we charged them for the higher quality stuff.”
“Yes, we always do. If they spot it, we’ll just say it was a mistake and send them what they ordered but 99 percent of the time, they don’t notice.”
“Hang on, though, that’s wrong. We should send them what they’ve paid for.”
“If we did that, our margins would be screwed. Everyone in this industry does it. If we put our prices up to maintain our margin, we’d look more expensive than everyone else. If we sent people what they ordered our costs would go up and we’d be uncompetitive.”
In short, bad practice had become an industry standard and no-one was going to break ranks. Things like this happen even in sectors where there are lots of firms. It took regulation to curb the worst practices of the broadband providers and they are still displaying cartel-like behaviour, even though the market has lots of players. Mis-selling in financial services and then in the claims management companies helping people seek redress are other examples of sector-wide spivvery. Sometimes, whole industries seem to adopt similar bad practices. Occasionally, it’s corrupt or criminal, more often, it’s just old-fashioned customer-screwing oligopoly.
Libor rigging was just another example of a sector-wide culture and peer effects. Lots of people were at it and ‘everybody knew‘ it had been going on for years. A lot of people didn’t even think they were doing anything wrong.
As ever, going against group norms is risky. It can mean being ostracised or sidelined by everyone else. So most of the time, no-one does. Sometimes a new firm comes into the market and overturns to cosy consensus. More often than not, though, the system is only challenged when there is some sort of crisis. Losses, regulation and, very occasionally, punishment follow. Sometimes, though, even that is not enough and, after a seemly period of contrition, people just go back to their old ways.