How to Do Good in Business?

Since the 1970’s, an extensive body of research has linked environmentally conscious and socially responsible behavior to firms’ long-term survival and superior financial performance. Business leaders increasingly argue for a capitalism that contributes to society’s greater good.

Examples of businesses that have grown to dominate their markets while publicly proclaiming a core conviction in corporate social responsibility are all around us. Google, one of the most successful companies of the 21st century famously had the motto “Don’t be evil”, which it has now adjusted to “Do the right thing”, following its restructuring under the conglomerate Alphabet. Investors also frequently rely on this mantra to justify their attention to environmental and social factors. 

There has been too much talk of doing well by doing good. Instead of blind adherence to this mantra, it is important to question it and to reinforce the mechanisms that actually make it work.

But what links social and financial performance, and when are market-based incentives insufficient to guarantee responsible behavior? After reviewing the evidence, Professors Afshin Mehrpouya and Imran Chowdhury identify the following 4 key factors that increasingly weaken the relation between firms’ responsible behaviour and their financial performance.

1. A large group of firms are inherently short-term 

The financial promises of responsible behavior are frequently over the long-term. However, not all firms can wait for those long-term benefits. Examples that Mehrpouya and Chowdhury cite are firms that operate in volatile sectors and/or geographical settings, or those in financial distress. In all these cases, corporate behaviors are primarily driven by short-term results. 

Attention to short-term results is further reinforced in all firms by intensifying pressures from shareholders, which are dominantly short-term (despite the expanding size and momentum of socially responsible investments). In the shift from managerial to shareholder capitalism we have seen increasing pressure from investors demanding higher quarterly returns; this makes it harder for businesses to adopt a progressive, long-term business strategy without demonstrating short-term financial value to shareholders. Recent research has shown that about 75% of corporate social responsibility proposals at shareholder meetings receive less than 20% of favorable votes. 

2. Increasing distance between consumers and producers erodes solidarity

Traditionally, the social cost of production and demand are both located within the same society, but in the modern global landscape of multinational corporations this is simply no longer the case. For a consumer, investor, or supplier to be able to support socially responsible business in a globalized business, they must alter their behaviors depending on a sense of solidarity with people on the other side of the world. In this sense, disaggregation of global supply chains means that it is increasingly difficult to engender the kind of connection that exists when the majority of company stakeholders are geographically co-located, or at least present in the same country. 

3. BtoB less image conscious than BtoC 

Vertical disintegration has become one of the most pervasive trends in business over the last three decades across a wide range of sectors. When in the past one entity might have employed all of the different elements needed to produce, distribute and sell a product, increasingly these functions are being carried out by different companies. Mehrpouya and Chowdhury take the example of an iPhone, where there are numerous hidden levels in the production chain, ranging from a mining company to electrical components manufacturers to assembly lines.

We therefore have seen a growth in business-to-business firms in relation to business-to-customer firms and, for this new expanse of B-to-B’s hidden way down the supply chain as they have become known, public image is of little consequence. “It’s a trend that has become a fast-expanding paradigm in all sectors of economy with quite prominent examples in the automotive industry, the pharmaceutical sector, in electronics, and consumer products. As a result, a bigger and bigger chunk of the global industrial system is B-to-B businesses that are not directly in touch with the customer, and are deeply hidden down the supply chains” says Mehrpouya.

In brief, as a result of vertical disintegration customer-facing companies’ share of the global market is shrinking, and, with it, the share of global capital markets that is public-image-conscious is shrinking as well.

4. Market concentration makes consumers and workers more vulnerable 

Yet another pervasive trend that has come to dominate the business landscape is the ongoing growth of oligopolies/monopolies. For stakeholders to be able to exert control over a firm’s behavior, they must have the freedom to replace one firm with another. When this is not the case, the stakeholder don’t have the power and mobility to translate the firms’ social behaviour to final implications for the firms.

“A company from an economic perspective has less motivation to be responsible if it has too much market concentration and power,” says Mehrpouya, citing the example of pharmaceutical companies that hold patents for products that customers are stuck with because their healthcare conditions mean they need medicine regardless of a company’s behavior. The same is true of financial crises and periods of high unemployment, during-which the freedom of consumers and workers to choose which businesses they buy from and work for is restricted. In all these situations, financial rewards are not sufficient to guarantee responsible behavior. 

Faced with the widespread failure of self-regulation of environmental and social impacts by businesses, linked in large part to the 4 factors explored above, how can we ensure businesses keep themselves in check moving forward? Mehrpouya and colleagues point to the need for better media coverage of firms’ behaviour leading to more rigorous public debates, more effective regulatory and civil society activity, and better ethical training for managers.

Whistleblowers expose illegal and unethical behaviour within organisations – they ‘blow the whistle’ on wrongdoing. In recent years, they have played important and well-publicised roles in revealing fraud and misdemeanour in large international corporations. 

For example, it was the action of whistleblowers that enabled the Enron and WorldCom scandals to come to light. With this in mind, you would think that whistleblowers would be heralded for exposing organisational crimes. Instead, Professor Hervé Stolowy reports, “They are often chastised and risk job loss, career annihilation and can even find their personal safety threatened”. 

Society scorns whistleblowers 

Despite efforts made by policy makers to improve the status and perception of whistleblowers internationally, Professor Luc Paugam says, “Society continues to view whistleblowers as traitors or snitches. Their actions are not seen as legitimate. US legislation failed to protect the whistleblowers who attempted to expose the opening of fraudulent accounts at Wells Fargo in 2016. They were fired.”

This apparent ineffectiveness of policy spurred Stolowy, Paugam, Gendron, and Moll to try to understand more about the role of whistleblowers and what they can do to improve their legitimacy.

Key findings: 4 narrative success factors for whistleblowers

The team looked at 7 high-profile cases where the whistleblowers were generally positively viewed by society: Bowen and Citigroup; Casey and Madoff; Cooper and WorldCom; Markopolos and Madoff; Smith and HealthSouth; Watkins and Enron; and Woodford and Olympus. The team paired an in-depth analysis of whistleblower discourse recorded in books, interviews and presentations, with analysis of the press coverage each case received. This enabled the team to identify 4 standout features common to the successful storytelling of whistleblowers: 

1. Trigger(s): The event(s) that led them to blow the whistle

2. Personality traits: Their morality, resourcefulness, and determination. For example, they may talk about how they aimed to do good for society and were determined to bring down fraudsters at all costs, even if their personal safety was under threat

3. Constraints: The barriers that were in their way. They highlighted how these require regulatory and organizational change

4. Consequences: The long-term positive impact of the whistleblowing act 

A proven model for building more impactful stories 

Stolowy, Paugam and co-researchers used these findings to create a model that shows how storytelling can build the legitimacy of the whistleblower role. The model describes how, without a story, the whistleblower does not seem legitimate, but telling their stories using the 4 narrative patterns outlined above can build their legitimacy in the eyes of evaluators such as the public and the press.

The narrative patterns use symbolic, analogical, and metaphorical explanations to frame the situation and allow others to better understand the role of whistleblowers.

“The narrative patterns use symbolic, analogical, and metaphorical explanations to frame the situation and allow others to better understand the role of whistleblowers,” explains Paugam.

For example, a whistleblower will often describe how they wrestled internally with the idea of blowing the whistle on their company, but their sense of moral duty compelled them to speak out about the unethical behaviour going on. This helps the evaluators of the situation feel empathetic and more supportive towards the whistleblower. “In one case, the whistleblower described how he feared for his life and slept with a gun under his pillow,” says Stolowy. Such displays of self-sacrifice for the greater good appeal to people’s sympathies. 

The team’s analysis of press coverage showed that, overall, this method of storytelling was successful in enlisting public support. “We created a model that shows us exactly how role legitimacy is created and sustained through storytelling,” Stolowy concludes.

The goal moving forwards? Better support for whistleblowers 

Overall, the team’s work shows how the stories of whistleblowers can increase the legitimacy of their role by highlighting their fight against adversity to tackle wrongdoing and achieve a morally accepted outcome. This helps outline the significance of their role and the part it can play in corporate governance. But the researchers note that far more work remains to be done, particularly on the part of companies and company leaders.

Managers need to better understand the effectiveness of whistleblowers and how their actions can help the firm, not hinder it.

“Corporations and the public need to stop perceiving the whistleblower as something bad - a snitch or a traitor. Instead, they must be put in a positive light and the benefits of their role highlighted,” concludes Stolowy.

Corporate whistleblowers: a quest for legitimacy, credibility and protection

Find here an interview of Professor Hervé Stolowy at the March 4th's Accounting Conference that took place at the Fundacion Areces, where he presented: “Corporate whistleblowers: a quest for legitimacy, credibility and protection”.

The event was organized by the Universidad Autónoma de Madrid (UAM), the Department of Business Administration at Universidad Carlos III de Madrid (UC3M Business), and the Foundation of the Autonomous University of Madrid (Fundación UAM).

The media can play an important role in shaping a company’s reputation. Journalists may neutrally report the facts or add positive or negative spin that influences how a company is perceived by its stakeholders and the public. Researchers Georg Wernicke, Jean-Philippe Vergne, and Steffen Brenner set out to explore why some companies are criticized by the press for CEO compensation, while others – despite paying similar amounts – escape that criticism.

A company’s positive, altruistic activities actually increase the level of criticism they receive about CEO greed.

Their investigation revealed that when a company engages in activities that can potentially be perceived as contradictory, they are more likely to receive media criticism. “Contrasting activities, such as paying a large sum to the CEO and simultaneously engaging in corporate philanthropy, can generate confusion as to the character of a firm, potentially resulting in perceptions of hypocrisy or greenwashing and thereby sparking higher levels of disapproval among observers,” Wernicke explains. 

To study how incongruent behavior can lead to media disapproval, the team isolated two corporate behaviors at opposite ends of the ethical spectrum: greed and altruism. 

Media attention on CEO greed

CEO compensation receives a lot of media attention. Inexplicable excessive compensation — where CEOs are seen to be paid more than what they deserve – is usually thought of as greed. Although this overcompensation is largely subjective, the amount a CEO should earn can be estimated based on a firm’s size, industry, profitability, and the CEO’s duration in the job.

In some cases, the media will pick up on CEO overcompensation and report on it in a negative light. When comparing two CEOs that are overcompensated by the same amount, however, one may receive negative media attention, while the other will not. For example, among CEOs overcompensated for two consecutive years, media criticism only occurs in 36.5 percent of cases (in year 2).

A contrast to greed: Altruism through corporate philanthropy 

In stark contrast to CEO greed, a company engaging in corporate philanthropy will attempt to give back to society in a number of ways, such as by making donations to charities and facilitating employee volunteering opportunities. They act altruistically. Wernicke asks the question, “If two firms are both perceived as overpaying their CEOs by the same amount, but one engages in corporate philanthropy and one does not – is one criticized more by the media?”

To answer this, the team investigated how CEO compensation packages of S&P 1500 index companies between 1995 and 2006 were perceived by the media.

Contrasting behavior leads to media criticism 

Overall, the study revealed that, indeed, companies that engage in more corporate philanthropy are more criticized for CEO compensation. In Wernicke’s words, “A company’s positive, altruistic activities actually increase the level of criticism they receive about CEO greed.” More specifically, the researchers found that when a company has low philanthropic involvement, CEO overcompensation will be reported on negatively in 14% of news articles, instead of 37% in cases of high philanthropic involvement. 

Remember, however, that they are not being criticized for doing good but rather for sending out contrasting messages.

The team’s work also revealed that when criticized by the media, certain companies that engage a lot in corporate philanthropy will reduce CEO overcompensation in the following year. Here, media disapproval can lead to a lowering of CEO overcompensation. However, this reaction to negative press is only true for a small proportion of the companies studied – those that are very strongly engaged in corporate philanthropy. In most circumstances, even if a company is involved in some philanthropic activities, they will not respond to negative press by lowering CEO compensation. 

Overall, Wernicke and co-researchers have shown that to avoid negative media attention, company actions must be coherent. “To an extent, the study’s findings may seem counterintuitive, as companies that engage in ethical practices are reprimanded more severely than those that do not,” Wernicke concludes.

“Remember, however, that they are not being criticized for doing good but rather for sending out contrasting messages.” The study also shows that media accounts actually influence corporate actions in the context of compensation paid to CEOs.

Engagement in philanthropic activities can improve a company’s reputation, help them in times of crises, and has generally been found to improve firm performance on many dimensions.

Banking is a risky business. If financial institutions make rash bets on lousy investments, isn't it only fair that they sometimes crash and burn? It only appears like sound business logic. But some banks have an escape clause. They provide liquidity for so many companies, have such tight ties to other financial institutions, and buy such large fractions of government debt, that their bankruptcy would have dramatic social and economic impacts.

These banks are known as SIFIs: Systemically Important Financial Institutions, or more colloquially, “too big to fail”. When they teeter on the brink of disaster, governments prefer to bail them out rather than risk seeing them take down the rest of the economy in a disastrous domino effect. 

In the wake of the 2008 financial meltdown, and to avoid taxpayers being again “held hostage by bank[s] that [are] too big to fail” (in former US President Barack Obama's words), international banking regulations were toughened. In particular, the 2010 Basel III Accords imposed minimum amounts of equity capital for SIFIs, so as to increase their capacity to weather unexpected losses. 

“The rationale for increasing the regulatory capital of the financial institutions that contribute most to the risk of the system is to force such banks to internalize the costs they inflict on the system and thereby create incentives for them to reduce such externalities,” explains Professor Christophe Pérignon, who co-holds the Chair in Regulation and Systemic Risk at HEC Paris.

The current systemic-risk scoring system...

Mandatory levels of buffer capital are decided by the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board. Their methodology is simple and intuitive. They assess each bank's systemic risk, as opposed to the risk posed by an institution in isolation, by aggregating information about five broad categories: size; interconnectedness; substitutability, or the presence of readily available substitutes for the services the bank provides; its cross-jurisdictional activity; and complexity. For non-eurozone banks, categories are converted into euros. 

According to their scores, banks are sorted into five buckets, each with additional requirements in terms of regulatory capital, from 1% in the first to an extra 3.5% in the fifth. Compared to the 8% default capital ratio, these extra capital charges appear sizable.

Increased regulatory capital can cut lending, which is an issue of course, as it negatively affect household consumption and firm investment levels and, eventually, economic growth.

Higher regulatory capital effectively limits the amount of risky assets a bank can invest in, because one percentage point or a half actually translates into more than 10 billion euros for the largest SIFIs. Such protection comes at a cost: “There is empirical evidence showing that increased regulatory capital can cut lending, which is an issue of course, as it negatively affect household consumption and firm investment levels and, eventually, economic growth,” says Christophe Pérignon. 

...and its flaws

More worryingly, he and two fellow researchers identify two major shortcomings in the current systemic-risk scoring system. 

Firstly, it biases scores towards the categories which are the most volatile (without going into details of statistics, because the system aggregates variables without standardizing them, it gives more weight to categories where values show the highest dispersion across banks).

To correct for the statistical bias, the BCBS uses one of two possible methods, which is to trim outliers, or extreme values, for the substitutability category. Although this method works in theory, it could encourage risk-taking among banks, because there is no incentive to reduce risk once the cap is exceeded, according to the researchers. 

“An analogy would be to give speeding tickets to anyone driving faster than 80 km/h, and to increase the fine as the speed increases from 80 to 120 km/h, but to give the same fine to anybody driving faster than 120 km/h, including at 200 km/h! Guess what would be the effect of capping the fine on the speed of the fastest drivers and on the number of fatal accidents.” explains Professor Pérignon. 

The other flaw is a foreign exchange effect: any depreciation of a currency with respect to the euro mechanically lowers the score of banks headquartered in this currency zone and increases the score of eurozone banks; and vice versa. “Japanese banks complain about the fact that the main driver of their regulatory capital is the yen/USD exchange rate, which is not under the operational control of banks,” says Christophe Pérignon, again pointing out that such fluctuations translate into billions of yens of equity capital.

Will improvements to the risk scoring system ever be applied?

In their forthcoming paper, the team of researchers offers possible corrections for these shortcomings. 

Regarding the foreign exchange effect, they suggest using a constant reference exchange rate, which could be calculated for example as the average rate over the past three years. 

Regarding the first statistical bias, the researchers suggest standardizing each category by its own volatility; a process akin to that by which the grades of essays in a national exam are smoothed so as to eliminate any unfairness caused by the varying strictness of the teachers grading the papers. "We didn't invent a new technique, it's just Stats 101".

The researchers empirically tested their improved methodology on data collected from more than 100 of the world's largest banks. Overall, the three systemic-risk scores – the BCBS's, one adjusted for volatility and another for volatility and foreign exchange – were strongly correlated, but 11 banks switched buckets (7 upwards, 4 downwards). 

Based on the new scheme, the total extra capital requirement was higher (276 billion euros) than the current level (259 billion euros). Besides the sheer magnitude of the discrepancy in amounts, what Christophe Pérignon believes is most important is the correction in the statistical distortion: “So far, we have not been asking the right banks to contribute.” 

Will the researchers' advice be heeded? Hopefully. Professor Pérignon testified before the Basel Committee in November 2017 to explain the problems and ways to fix them. But he points out that the process is also a political game, with regulators not only regulating but sometimes also acting as “lobbyists” for the institutions of their own countries: “The capping method currently used offers a lot of flexibility, in the sense that you can put the cap on any dimension and massage the outcome of your regulation to protect the banks you want.”