Misconduct can have a significantly negative impact on a business; for example, leading to a loss of clients or even ruining a company’s reputation.
If you’re a CEO of a major company, with thousands of employees and offices all over the country, it’s a tall task to ensure all those people are on the up and up.
But what if you had a tool that would help you to hone your focus on the places where misconduct is most likely to happen?
For the financial industry, that might be possible. Amir Shoham, professor of finance and strategic management at the Fox School, studied environments where financial advisers are more likely to commit misconduct—for example, investing a client’s portfolio in more volatile stocks than the clients were willing to risk.
According to the data set he is using, nearly 10% of financial advisors have had a mark of misconduct on their records over the course of their careers.
“Financial advisors are usually paid through fees made on clients’ investments,” says Shoham. “So that gives you a lot of motivation. You may want to increase the portfolio, because that would increase your profits, but sometimes it’s going against the client’s wishes or needs.”
In their paper, “Does local competition and firm market power affect investment adviser misconduct?” published in the Journal of Corporate Finance, Shoham and his fellow researchers looked at 12 years’ worth of data in the financial industry, specifically analyzing the variables within a particular locality where misconduct occurred.
“Most people who invest their money have their financial advisors in their own local county,” explains Shoham. “We may invest in the New York Stock Exchange, but it’s a very local market.”
Shoham and his co-authors found two specific variables—market structure and market power—that make a financial advisor more or less likely to behave inappropriately.
“Market structure is, do we (an investment firm) have more competition with many small advisors or do we have some big advisors in the county that are more concentrated? We also looked at the market power, so for example, the market could be very competitive but you’re relatively big in the county,” Shoham says.
As in any situation, financial advisors do a cost/benefit analysis of their environment when choosing how to act. The researchers found that an advisor might make different decisions when employed by a big firm amid a lot of smaller local competitors versus being in one of several large competing firms in the region. Despite the differences, the researchers found a common denominator in an advisor’s calculations: job stability.
“When working for a big company, people tend to want to stay there,” explains Shoham. If a financial advisor misbehaves, gets caught and gets fired, there’s a high probability that their next job will be a downgrade—because their original firm had the highest market power in terms of percentage of clientele, or the market is structured in such a way that the firm was the biggest in the region.
“You are at a big company, you have good fees. Work stability causes you to be more cautious because you know you’re in a good position at a good company.”
Shoham says that the impact this can have is great.
“As a result of financial advisors’ misconduct, people might invest less. This would mean less money in the stock market, less liquidity, companies could have a harder time getting capital,” says Shoham. “It could have major micro- and macroeconomic impact.”
Interestingly, misconduct doesn’t just impact the perpetrator. Shoham also found honest advisors were more likely to leave a company after a colleague was disciplined. This is a significant price in the honest advisor’s career because many times they have to leave their clients behind and start again.
“We found a significant effect in honest advisors willing to pay a very high price to leave a disreputable company and colleagues behind.”
So what can executives do with these insights?
“If I’m looking from a company perspective, let’s say a huge company like Merrill Lynch with offices and advisors all around the United States, I could map the offices in counties where there is potentially a higher probability of misconduct.”
With Shoham’s research, leaders would know what to look for, by analyzing their offices within local market structures and powers that might create more or less tempting circumstances for advisor misconduct.
Using data, executives can allocate resources to more efficiently monitoring those localities and hopefully prevent misconduct before it happens.
This article originally ran in On the Verge, the Fox School’s flagship research publication. To check out the full issue of On The Verge: Business With Purpose, click here.