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The principal approach taken by the FCA towards ensuring firm compliance has largely been based on a detection and punishment approach. However, a new study conducted by the FCA suggests this can be complemented by changing the ways in which firms make compliance decisions, or more specifically the thought processes which are responsible for those decisions being reached. The ways in which firms make decisions are based on a complex range of factors; and both regulators and firms have a role to play in improving the decision making processes of firms. This report will provide an overview of the FCA report under the following key headings which have shown to impact decision making processes: incentives, behavioural biases, morality and group behaviour.
Incentives and compliance in organisations
Every firm has private information which the regulator cannot access: without the right incentives, firms can use this information to adopt profit-maximizing behaviours and cause significant damage to consumers and the wider market. The regulator is therefore required to influence firms’ behaviour by imposing rules and giving firms incentives to follow them. These rules can vary from precise instructions (such as disclosure) to overarching conduct principles.
Studies have shown that when a firm considers how much to spend on compliance (from both a costs and time perspective), those responsible at the firm will factor in the probability of being discovered by the regulator, as well as the nature of the punishment in the event that they are discovered. Regulators can therefore deter firms from cutting corners in their internal compliance operations by ensuring that they are well connected with the markets, that they share appropriate information with other regulators, and that potential breaches are investigated swiftly with proportionate sanctions imposed for rule breakers.
A firm is a complex network of social relationships, with the most important being between junior and senior employees, and between shareholders and the board of directors. Rule breaking can take place at any level of the firm, and can be overlooked by the senior level if a firm does not adopt the correct internal governance procedures.
Behavioural biases and compliance decisions
Firms are in direct competition with each other to present suitable products which consumers will value. How consumers will react to a product is not always immediately obvious and this uncertainty can bring additional difficulties to the decision making process which can in turn give rise to decisions being made subjectively and without due consideration of all the facts.
The FCA report lists the most common biases that can be found at all levels of the firm structure:
- Present bias – the benefit from breaking certain rules is usually immediate (normally financial), while future punishment of breaking that rule is uncertain and less important in the eyes of the decision maker at that time;
- Omission bias – this refers to the tendency for decision makers to deliberately overlook omissions rather than pay commissions, despite the fact the outcome is the same;
- Loss aversion bias – many people value something more that they own than something that they do not own which is exactly the same. Therefore, the act of possession creates its own value and can distort decision making principles;
- Overconfidence – in particular the tendency for firms to believe that their knowledge of a certain area is better than it actually is. This can be particularly problematic at board level where over-confidence in their own systems can give rise to insufficient monitoring and scrutiny;
- Confirmation bias – the approach taken by firms whereby information is sought to back-up a pre-conceived idea, while ignoring any evidence to the contrary;
- Emotional bias – information which stirs emotion or is vivid for any particular reason is likely to be at the forefront of decision making and given a disproportionate level of importance; and
- Group bias – decisions made by groups can tend to be close minded as individuals within that group are more likely to follow the status quo rather than apply their own level of thought to the decision making process.
Morality and rule breaking
Studies have demonstrated that morality plays an important role in the thought processes of the decision maker. Some of the key findings in the FCA report were as follows:
- When the decision maker is reminded of his or her moral obligations (such as the requirement to sign a report), the likelihood of rule breaking is significantly reduced;
- Decision makers who are distanced from consumers and who are less likely to see the impact of their decisions are more likely to break rules;
- Rule breaking is more likely to occur when compliance decisions are made higher up in an organisation but the rule breaking itself is carried out by subordinates;
- In situations where a conflict of interest is disclosed, giving biased advice is more likely as it is widely believed that the recipient of that advice can choose to take the conflict into account;
- Taking a first step towards wrongdoing can make subsequent rule breaking more likely.
Social context and group behaviour
Group situations often change the behaviour of individuals by altering preferences, beliefs and consequently the ways in which those decisions are reached. People are also more likely to change their behavior to gain acceptance from others in a group situation. The key findings from the FCA here were:
- Organisational culture and social norms have a significant influence on rule breaking: for example the more widespread the rule breaking within an organisation, the more likely that individual will decide to break rules. Furthermore, the ways in which members of a group respond to particular incentives can affect the behaviour more generally within the group.
- Ideologies can provide justification for rule breaking, such as references to the ‘the evils of price cutting’ and ‘fair’ prices or profits. Also principles that put the group’s goals ahead of other groups or wider society can have a damaging impact, such as the firm’s ‘cause’ or a duty to an individual or individuals.
- While firms often promote the importance of the greater good to their employees, this can have a negative effect because it is easier to justify rule breaking when it benefits others.
Both firms and regulators have a responsibility to change the decision making culture within firms. The FCA has announced that it wishes to make its detection and punishment policies more ‘salient and vivid’ so firms are aware of the dangers of rule breaking. In those areas of decision making where the role of morality has been reduced, new legislation can be expected to strengthen these areas. The FCA also vows to publicize examples of good behaviour and enhance the role of morality in individual decision making processes.
Firms meanwhile should develop and strengthen their internal decision tools to minimize the impact of behavioural biases on decision making, as well as make employees more aware of existing moral codes and the consequences of non-compliance. Firms should identify and tackle ideologies within firms which drive non-compliance and ensure staff have the right incentives to comply with the regulations.
Timothy Anson, London, Paralegal also contributed to this article.