By Elena Zharikova

 

Consumer decision-making processes have been at the centre of attention of a variety of public and private actors, from public regulators to non-profit initiatives. Insights of behavioural science are being used to encourage better choices in areas ranging from food to financial planning and organ donation. Within the private sector, behavioural knowledge is being employed in marketing and investment. However, the area of corporate decision-making remains mostly unaffected by the advances of behavioural economics. Rectifying this can help businesses become more efficient and more responsible.

Neoclassical roots of the rational corporation

The traditional perception of relationships between corporate actors is based on agency theory, transaction cost economics, and stakeholder theory. As well as the traditional view of consumer behaviour, it is heavily influenced by 20th century developments in the fields of economics and finance . As a result, the traditional understanding of corporate relationships incorporates key assumptions of neoclassical theory. The market efficiency presumption suggests that market mechanisms work to align the interests of managers and shareholders and restrict exploitative behaviour. The neoclassical view of rationality creates a picture of relentlessly opportunistic individuals striving to achieve the objectively most beneficial outcome. Decision-making is seen as an individualistic process of evaluation of alternate choices . This theoretical foundation is what lies behind the expectation of rational, calculating behaviour we tend to attribute to high-profile corporate decision-makers.

How are those theoretical roots relevant to the reality of business?

The world of corporate governance theory seems to be far removed from the real-life corporate environment. Despite that impression, corporate arrangements typical to the modern Anglo-American public company are based around the assumptions described above.
Some examples of the reliance on neoclassical presumptions in corporate contexts include: equity-based managerial compensation designed to ensure managers’ commitment to improving share performance; reliance on neutral monitors motivated by reputational concerns; reliance on disciplinary market forces to constrain managerial behaviour.

Do corporate scandals suggest otherwise?

The flaws of the neoclassical economic theory and its presumptions have been widely criticised in academic literature since its conception. The 2008 financial crisis, as well as the advances of behavioural economics, caused a major re-evaluation of concepts and policies based on the neoclassical approach to economic behaviour. The area of financial regulation has been the one to experience the most change, as public regulators moved away from the reliance on market forces. Corporate interactions and corporate actors have been less affected by this shift. Still, the assumptions of normative rationality are no more correct in relation to corporate directors and managers than to consumers.

Corporate scandals spanning the end of the 20th century to more recent times illustrate the flaws of the traditional approach. As an early example, the biased behaviour of Enron’s auditors undermined the reliability of seemingly independent evaluations . During the 2008 crisis, management of such banks as UBS and Lehman Brothers demonstrated miscommunication, inadequate information sharing, lack of coordination, and excessive risk taking. The respective boards were not able to provide the required monitoring and strategic oversight. Banks involved in the LIBOR scandal as well as the recent Volkswagen debacle all demonstrate failures of internal controls. Market mechanisms presumed to ensure the efficiency of corporate governance arrangements did not fulfil their function. A number of researches suggest that behavioural factors play a significant role in the breakdowns of internal governance .

Behavioural influences on corporate decision-making

Corporate governance research has been increasingly dipping into the behavioural and cognitive fields. Langevoort’s work considers behavioural factors in the context of securities markets, corporate boards, and monitoring. Understanding behavioural biases that affect businesses is particularly important for big organisations. Multinational corporations and financial institutions are particularly vulnerable to biased decision-making – the complexity of the organisation complicates the acquisition and processing of information .

There are several heuristics and biases that are regularly discussed in relation to corporate decision-making:

Overoptimism is considered to be a particularly strong influence, not in the least due to the corporate selection that generally favours optimistic individuals. Generally, optimism and confidence are beneficial for the organisations and facilitate effective and energetic working culture. However, overoptimism and overconfidence can lead to excessive risk-taking with potentially disastrous consequences. Arguably, overoptimism of the CEOs and senior management at major financial institutions was the driving force behind their aggressive risk-taking during the run-up to the 2008 financial crisis .

Escalation of commitment is another powerful factor that can distort allocation of resources in a company. It reflects a behavioural pattern where an individual, when confronted with the negative outcome of a previous decision, tends to downplay the adverse consequences and increases risk-taking to avoid suffering a loss. In the corporate context, this bias results in significant degree of commitment to the decided upon course, which does not falter even at signs of trouble. The individuals involved in the decision-making process will tend to interpret negative information positively, which will threaten effective internal communication and information processing in a company. Communication problems undermined effective risk management processes at UBS between 2005 and 2007 .

The confirmation bias leads decision-makers to misinterpret neutral information in a way that supports their previously formed beliefs . This bias may provide explanation for the merger decisions that have no or negative effects on profitability. Studies suggest that the way data is collected by the acquiring firms shifts the focus towards information favourable to the merger .

Groupthink is especially relevant in relation to board-level decision-making. It is a commonly shared view that group decision-making improves the decision quality. However, this bias can effectively silence any dissent by imposing a presumption of unanimity within the group. To avoid the stress of re-evaluating a chosen stance, the group will tend to exclude or rationalise away any information contradicting it. This behavioural pattern weakens the evaluation of available information by the board members .

Pluralistic ignorance is another factor potentially affecting boardroom decision-making. This social psychological bias causes all members of a group to uphold norms or rules that they themselves privately reject, but believe that all other members accept. This phenomenon provides insight into the failure of many boards to change the strategy in response to falling corporate performance .

Awareness of these behavioural factors would allow senior corporate decision-makers to ‘debias’ decision-making processes and ensure adequate dissemination and processing of information. That would likely lead to a significant increase in the efficiency of corporate governance arrangements.

Could behavioural science improve corporate decision-making?

Outcomes of corporate misconduct differ in their severity. From loss of profits to public condemnation and legal consequences for the employees involved, consequences of flawed decision-making can be disastrous. There might be a way to rectify those flaws by correcting systematic decision-making pitfalls, instead of focusing on individual failings.

The use of behavioural science does not have to primarily apply to consumers and other areas of public regulation. Behavioural analysis of the corporate environment can inform the optimisation of internal information processing and decision-making. Some business services and consultancy companies are advocating the value of incorporating cognitive biases into strategic decision-making . Adapting behavioural insights to enhance compliance is heavily advocated by the FCA in the UK. Ensuring that managers and directors make better choices would enable businesses to achieve their goals more effectively. It would also improve compliance, which is especially important for heavily regulated industries, such as banking. Those are key areas where contributions of academic researches can deliver value for the private sector as well as making it more responsible. Development of specific behavioural solutions requires empirical research into internal corporate processes. The problem of access is key for allowing this to happen. One can argue that providing that access is in the best interest of the business community.

Elena Zharikova

Elena Zharikova

PhD Candidate at The University of Manchester
Elena is a PhD Candidate at The University of Manchester School of Law. Her focus is on the financial regulation of corporate governance of financial institutions in the UK and the US, with a special emphasis on risk governance. The research project investigates the potential applications of behavioural economics in this area of financial regulation.
Elena Zharikova
Elena Zharikova

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