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How to Avoid the Next Financial Crisis

Jamie Dimon, Chairman and CEO of JPMorgan Chase, attends a hearing by U.S. Senate Banking, Housing and Urban Affairs Committee about "A Breakdown in Risk Management: What Went Wrong at JPMorgan", in Washington D.C.

Photograph by Xinhua/eyevine/Redux

Jamie Dimon, Chairman and CEO of JPMorgan Chase, attends a hearing by U.S. Senate Banking, Housing and Urban Affairs Committee about "A Breakdown in Risk Management: What Went Wrong at JPMorgan", in Washington D.C.

The recent Libor and money-laundering scandals, along with the trading losses at JPMorgan Chase (JPM), have brought further unwanted headlines for the banking industry. These scandals, coming after a financial crisis that was caused by inappropriate behavior by bankers, is leading politicians and regulators to increasingly ask: “Why do we see a disproportionate amount of inappropriate behavior emanating from the banking industry?”

As we search for a plausible explanation, it may be worthwhile to consider what the academic research in the field of social psychology tells us. After 50 years of research, there is one thing that we know for sure: What determines how we behave is not so much our education, attitudes, or personal values, but the underlying environment (or situation) in which we find ourselves. Much more than we’d like to believe, the environment influences our every move and determines how we behave. The implication of this finding is profound: If you want to change how people behave, don’t tell them. Instead, change the underlying environment that produced their “bad” behavior in the first place.

This may sound simple enough, but the truth is that we always underestimate the influence of the environment and focus instead on the instant gratification that comes with punishing the responsible individuals. Certainly we need to punish all guilty parties, but the evidence from social psychology will tell us that this won’t change “bad” behavior from other individuals operating in the same environment—and won’t therefore prevent the next scandal.

So what makes up our underlying environment? The prevailing culture and values in which we operate certainly constitute a major part, but so do the monetary and non-monetary incentives, as well as our organizations’ purposes and primary goals and objectives. As behavioral economists have found, the pressure to conform to what our peers are doing—and the time pressures we are under—are all important components of the environment. It is only by changing these things that we can hope to change people’s behaviors.

Now consider the current financial crisis. There is no question that “bad” behavior on the part of many people, including bankers, have led to this. Merely punishing the wrongdoers will not prevent another crisis from happening. We need to rethink and change the main elements that make up the business environment in which we all operate. For example, what is the primary purpose of business—is it really to maximize shareholder value? And how about the dominant culture, values, and incentives that determine how we operate every day? Don’t they also require serious rethinking?

Changing the prevailing culture and values in the banking industry will require that we install different leaders at the top of our banks—people who encourage alternate conduct by displaying different behavior themselves—which is exactly how we develop the culture and values in our families. Similarly, the incentive system in the banking industry is clearly dysfunctional. We need to reconsider the appropriate division between fixed and variable pay and also spread the variable pay over a longer period to encourage more long-term thinking from bankers.

There are many other things we can do to change the underlying environment in the banking industry. But it is by focusing on the environment—rather than putting bankers in jail—that we can hope to avert the next financial crisis.

Markides is professor of strategy and entrepreneurship and holds the Robert P. Bauman Chair of Strategic Leadership at London Business School , whose MBA program was ranked No. 1 by the Financial Times in 2009, 2010, and 2011. A native of Cyprus, he received his B.A. (Distinction) and M.A. in economics from Boston University, and his MBA and DBA from the Harvard Business School. His current research interests include the management of diversified businesses and the use of innovation and creativity to achieve strategic breakthroughs.

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