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Ethics

In financial services, branch managers are a powerful predictor of fraud

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In the wake of financial scandals, attention bends upward. Congressional committees invite CEOs for a public grilling. The media and academics scan corporate leadership for the source of the scandal. Was it the culture that executives cultivated? Was it the strategies or incentives they approved? Was it their investment (or lack thereof) in compliance and controls?

A new paper by MIT Sloan associate professor of accounting, with two coauthors, looks much lower on the management ladder. Investigating local branches of major investment firms, he and his coauthors find that the actions and traits of branch managers, or “supervisors,” are powerful predictors of fraud.

“Our main finding is that when it comes to explaining variation in misconduct, individual supervisors are over twice as important as their firms,” Sutherland said.

The misconduct under consideration ranges from smaller infractions — for example, financial advisors who selfishly steer customers toward high-commission investments — to major transgressions, like forged signatures and outright theft. And though their study focuses on the finance sector, the results raise critical questions for the role of supervisors in overseeing misconduct in other industries.

The research

In their work, the researchers exploited a January 2010 change to the Series 66 investment advisor qualification exam that many supervisors take. Before that date, the exam devoted 80% of its questions to rules and ethics material, and 20% to technical material. Starting in 2010, the two sections received an equal weight.

Study guides recommend 75-100 hours of preparation for the exam, and moreover, pass rates are low. Therefore, exam preparation represents a meaningful investment in a  supervisor’s human capital: Anybody who took the older exam was more informed about professional ethics and industry rules.

The researchers matched branch supervisors based on the exam they had taken — information maintained by the Financial Industry Regulatory Authority — against a database that reports customer and legal complaints involving individual employees and their firms. Comparing two supervisors of different branches of the same firm at the same time, the researchers found the one who took the old exam with more ethics coverage had one-fifth less misconduct at their branch, on average.

One acknowledged concern with this method is that the researchers were also measuring level of experience: Those who passed the old exam were more experienced than those who passed the new exam. However, the authors were able to control for experience because supervisors took the Series 66 at different times in their careers, which provides a way to disentangle career length and exam type.

Why ethical managers matter

How, precisely, do supervisors exert influence on their branch? First, supervisors with more training in rules and ethics were less likely to keep bad actors on their payroll. This is a particularly important finding given the high rate of recidivism among employees who commit misconduct: An employee with a misconduct record is five times more likely than their peers without a record to do something wrong the following year.

Second, less-experienced employees are particularly sensitive to their supervisor’s training. That is, whether the supervisor passed the old or new Series 66 only affects the misconduct of the branch’s junior employees. Given much of what supervisors do is hire and train new employees, and given new employees more heavily rely on their supervisors to resolve novel or complex investment questions, it’s natural to connect employee misconduct to the person responsible for their training and guidance.

Despite these findings, “the point of the paper is not to mandate more ethics training or banning employees who engage in misconduct,” Sutherland said. “There is a tradeoff to consider.” Supervisors have a limited amount of time, and training in ethics comes at the expense of training in other topics, like investment products or tax rules. A question worth asking, and one Sutherland hopes to study, is whether those with more training in areas besides ethics are able to deliver better returns to their clients.

Also of interest is how the connection between training and performance might extend to other settings. Is there a similar relationship between, for example, intensive Occupational Safety and Health Administration training for managers on a factory floor and workplace accidents? Sutherland pointed out that supervisor responsibilities are alike in many sectors: hire and train employees, deal with customer feedback, identify and resolve employee infractions, and monitor industry regulations. To date, very little work has examined the effects of a supervisor’s training on their subordinates.

And yet, supervisors are critical to understanding the prevalence of misconduct. As a recent PwC survey reveals, middle management and operations staff are responsible for at least 65% of internal fraud incidents; and nearly half of incidents resulting in losses of more than $100 million are internal ones. Supervisors deserve far more attention than they currently receive. “Most research on white-collar misconduct has studied the CEO or CFO — it looks up to the top,” Sutherland said. “But our study suggests that supervisors are at least as important as executives or other firm-level factors to explaining misconduct.”

Sutherland’s co-authors on the paper, “Supervisor Informal Authority and Employee Financial Misconduct,” are Zachary Kowaleski of the University of Notre Dame and Felix Vetter of the University of Mannheim.