9 July 2019

Despite increasing automation, lending decisions remain subjective and can be heavily influenced by internal cultural norms, write Vathunyoo (Ben) Sila of University of Edinburgh Business School, Duc Duy (Louis) Nguyen, and Linh Nguyen.
Wells Fargo Bank Machines

Does the corporate culture of banks matter? Many people think so. Several commentators attribute Wells Fargo's recent scandal to 'toxic' culture. Various regulators, including the UK's Financial Conduct Authority, De Nederlandsche Bank, and the Federal Reserve Bank of New York have increasingly emphasised that improving the culture of banks is the key to regaining public trust in the financial industry. Therefore, understanding how bank culture affects financial stability is a question of first-order importance.

In our recent paper Does Corporate Culture Affect Bank Risk-Taking? we examine whether and how the corporate culture of banks affects their risk-taking behaviour. We focus on bank lending as a specific channel through which culture can affect risk-taking decisions. Despite technological advances that allow banks to automate lending processes via credit scoring, credit officers remain highly involved in evaluating "soft information" such as managerial talent in business lending, or borrowers' personal circumstances in mortgage lending. In these cases, lending decisions remain subjective and can be heavily influenced by 'norms' of how loan applications are decided. Further, and perhaps more importantly, lending is a very fundamental activity of banks, and how lending decisions are made is likely to have a great impact on the wider economy.

We use Natural Language Processing on a large sample of bank annual reports to classify them into different cultural categories based on the Competing Value Framework (CVF), a framework which is widely used by practitioners to analyse and understand corporate culture. Banks that frequently mention words such as "aggressive" and "competition" were classified as having a compete-oriented culture. Compete-oriented banks embrace risk-taking through aggressive competition and focus on gaining market share.

At the other extreme, banks that frequently mention words such as "control", "risk-management", or "safety" were classified as having a control-oriented culture. Control-oriented banks focus on safety and place an emphasis on predictability, conformity, and compliance. Create-oriented banks and collaborate-oriented banks lie somewhere in-between; the former focus on innovation, and the latter focus on harmony of people within the organisation.

Our results echo the view of the regulators. We find that banks with a growth-focus culture are more likely to have borrowers with poorer credit ratings, while those with a safety focus are less likely to do so, with the effects concentrated on compete- and control-oriented banks. Specifically, borrowers of compete-oriented banks are significantly more likely to be sub-investment grade borrowers (those rated below BBB).

Consistent with these banks being profit-driven, they charge these borrowers a higher loan spread over safe borrowers, while imposing them with fewer covenants in the loan contracts. Consequently, these banks exhibit higher loan growth in normal times, but incur significantly greater loan losses in times when the economy is in distress. Further, using a commonly employed measure of bank systematic risk, we find that compete-oriented banks exhibit a significantly greater influence on the instability of the overall system.

In contrast, control-oriented banks are less likely to extend credits to risky borrowers. They reward safe borrowers with lower interest rates, and impose risky borrowers with more loan covenants. While these banks exhibit more conservative lending and profit growth, they are healthier when the economy faces difficult periods.

Importantly, even when we take into account many factors that have long dominated policy discussions such as executive pay, corporate governance, and bank business models, corporate culture of banks remains a very significant explanation for their risk behaviours and ultimately the overall stability of the financial system. Our results suggest that bank culture has a first-order effect on the economy.

Overall, we find that not only does bank culture affect risk-taking of individual banks, it also has far-reaching consequences for the overall stability of the financial system and the economy. Taken together, our results resonate the view of policymakers that bank culture indeed plays an important role in influencing bank behaviour and systemic stability. Thus, at the very least, this study serves as a justification for regulators to make corporate culture their regulatory priorities. It is hoped that our work will lead to a better understanding of how corporate culture in the financial sector can influence overall financial stability.

Ben Sila

Vathunyoo (Ben) Sila is a Lecturer in Finance at the University of Edinburgh Business School. His research interests include corporate finance, law and finance, and corporate governance.

Duc Duy (Louis) Nguyen is Senior Lecturer in Finance at King's Business School, King's College London. Louis' research interests are empirical corporate finance, financial intermediation, and labour issues in finance. His work has been published in the Review of Financial Studies and the Review of Finance. Louis earned his PhD in Finance from the University of Edinburgh.

Linh Nguyen is a Lecturer in Banking and Finance at the University of St Andrews School of Management. His research is in empirical banking and finance. Before joining academia, Linh was Head of Treasury of the first private bank in Vietnam.

This article first appeared in the LSE Business Review.