Honesty That Benefits All

It seems that headlines too often highlight the bad deeds of players in financial markets. There are insider trading scandals. Traders collude on interest rate manipulation. Executives backdate options. We often hear the excuse, “Everyone else was doing it, so I didn’t think it was wrong.”

So if jail won’t keep people from committing illegal acts, what will? Economists of a newer breed say they believe they have some answers.

Sure, a good stare-down by the Federal Reserve chairman, Ben S. Bernanke, has never kept corporate and personal malfeasance at bay. But innovations being adapted from academia could make profound changes in the approach to these issues.

One avenue of attack is to decrease problematic behavior that is happening with help from behavioral economics. We now know that the traditional economics assumption â€" that everyone acts rationally when making decisions â€" is wrong.

Behavioral economists combine the social psychology of human interactions with the thought processes involved in making economic decisions. They predict and explain how people use faulty logic in building a framework for making decisions. Then they figure out how to make people behave properly by inserting new triggers for better behavior.

Some counteractions started in the mid-1950s, when brokerage firms could keep accurate trading records and time-stamped order tickets. Insider trading was outlawed soon after. (My father said it took the fun out of investing, but that was long ago.) Laws prohibiting nefarious practices like front running (trading ahead of a client), and price fixing have been strengthened.

In the early 1980s, traders were incensed when their managers told them that their phone calls were being taped. Now, just the knowledge that a transaction record exists reminds people that they are accountable.

My academic partners Nina Mazar from the University of Toronto and Dan Ariely from Duke University have studied how ordinary people rationalize cheating. Their findings highlight how people can justify lying if it’s “just a little bit.”

Their research found this rationalization being used when customers underreported annual miles driven when filling out their car insurance audit forms, or their income when filling out tax returns. Then they studied the effect of adding morality reminders by asking customers to sign forms attesting to the accuracy of their reports at the top of a page, instead of the bottom.

In our research and in interventions to change behavior, we have found that minor, even imperceptible changes to workflow can significantly affect honesty.

After more than one million behavioral interventions with clients, we concluded that human decisions can be influenced with small suggestions â€" say, a reminder that “over 99 percent of people truthfully answer these questions.” Or a group might be reminded of a collective cause-and-effect. (“You and your colleagues will not be eligible for bonuses if any of you engage in illegal behavior.”)

Employing similar behavioral psychology in financial transactions can discourage bad actions. Some examples:

■ Getting legal advice: Financial institutions rely on their lawyers to determine what traders can “get away with.” Legal opinions that seem to countenance aggressive trading can reinforce troubling behavior on the part of traders and their firms. Showing lawyers the profound influence they have on trading action might dissuade them from endorsing or seeming to endorse questionable decisions.

■ Making the costs clear to clients: Modern technology allows firms to automatically trade against clients who are unaware of the practice or oblivious to it. Clients generally lose money on these trades. Such actions are legal, even if they’re unseemly. This type of behavior has to be defined as immoral within the industry, or it won’t be long before it is made illegal.

In the case of foreign exchange, trading firms that don’t inform clients at the time of a trade that the firm is using its own capital are essentially saying: “We like to maximize profit. Mind if we bet against you again on this one?” Now, what if a dialogue box popped up on the client’s computer, stating just that? That would give a client pause. Similarly, stating, in dollars, what clients will pay to convert currency in excess of the interbank foreign exchange rate could instantly change economic decisions, in our opinion.

■ Setting the right tone: Simple and constant reminders of good behavior can reinforce the message. Most people have difficulty imagining their money’s use far in the future, and ignore saving for their retirement. The same concept of money received later rather than sooner could reinforce good behavior around bonus time. Rather than paying bonuses frequently on positive economic outcomes, companies might ask employees to wait longer, and pay bonuses based on their behavior as a group.

We learned in the financial crisis of 2008 that risk perception and reality differed widely. Efforts to use social psychology to change behavior are resulting in two changes at the same time.

The first is a change in the general perception of business risk, and how much risk a firm should assume to make returns to shareholders. The second is more important and more controllable. It involves personal perceptions of how much risk they should take when, say, trading securities, to impress their bosses and presumably get a larger bonus.

I remember looking for asset management clients in New York and was referred to a big potential buyer. I was selling discounted commissions for online stock trading. When I proposed what I would charge per share, the prospect, clearly startled, asked:

“With that commission rate, how can you afford the stuff?” he asked. I didn’t understand. Stuff?

“Yeah,” he went on, “How can you send me to a fishing camp, or get me other stuff to get my business?”

I still work in the business. He doesn’t.

Doug Steiner is a financial services strategy consultant and a partner at BEworks Inc., a behavioral economics firm.