Tracking the origins and evolution of a corporation’s culture of risk

Why do some firms take so many risks while others seek certainty—often over many decades in business?

A study by Stephan Siegel of the UW Foster School of Business determines that a corporation’s leaders tend to share common attitudes toward risk and uncertainty. This commonality manifests itself in a distinctive “corporate risk culture” that drives a firm’s intensity of investment in research and development, and propensity to engage in mergers and acquisitions.

Moreover, the study establishes that an organization’s particular relationship to risk persists over time—often evolving little from the personal risk profile of its founder.

“We find that corporate attitude toward risk is significantly influenced by a company’s founder,” says Siegel, the Michael G. Foster Endowed Professor of Finance and Business Economics. “And then it remains fairly persistent—through hiring and promoting like-minded leaders—over many years.”

Novel approach

A corporation’s relationship to risk has enormous bearing on its actions in the market. But from a research perspective, it’s a tough nut to crack. Business decisions are made by a variety of senior executives and corporate directors, each bringing their own level of comfort with risk and uncertainty to this collective endeavor.

But how do you measure individual and organizational risk preference at a scale that allows for statistical analysis across a large range of companies?

Siegel and co-authors Yihui Pan (University of Utah) and Tracy Wang (University of Minnesota) went big, examining the leadership personnel and strategies of 6,000 U.S. public firms between the years 1996 and 2012.

To establish the risk preference of each senior executive and director, they expanded upon recent research showing that economic preferences of individuals—particularly attitudes toward risk, uncertainty and patience—are partly shaped by cultural heritage.

They inferred cultural heritage by matching each surname with its nation of origin, according to historic Ellis Island immigration records.

What’s in a name?

It turns out that a person’s last name contains a fair prediction of his or her relationship to risk and uncertainty.

In the 1980s, social psychologist Geert Hofstede developed a measure of aggregate national risk preferences that he called the Uncertainty Avoidance Index (UAI). According to the UAI, China and the Scandinavian countries are among the most-risk tolerant nations while the most risk-averse include Russia, Portugal and Greece. All others fall somewhere in between.

After inferring the dominant cultural heritage of the senior executives and directors in the study, the researchers simply assigned the corresponding UAI national rating to each.

Siegel admits that this is an imperfect way to measure individual risk tendencies. It’s entirely likely that a given individual does not match with the average risk profile of their national heritage. But other studies have shown that cultural assimilation in the United States is a slow process. Differences in income, preferences and attitudes persist over many generations.

And Siegel says that rigorous tests of the model have shown it to hold up statistically. “It is a useful tool to measure something that cannot be easily observed,” he says.

R&D and M&A

Once individual risk preferences were established, Siegel and his colleagues moved on to company-level observations. And several clear patterns emerged.

First, a significant commonality in risk preference among a firm’s CEO, executives and directors. This commonality persists across generations of leadership. Firms even use formal incentives to preserve risk culture when decision-makers begin to stray.

Second, this persistent shared attitude toward risk and uncertainty arises through the selection of corporate leaders. “Leaders are selected, in part, because of how their risk preferences sync up to the risk preferences of the firm,” Siegel says.

And finally, risk-averse firms invest less in R&D and make fewer corporate acquisitions than firms that are more tolerant of risk. Also, risk-averse firms tend to hold more cash and exhibit lower cash-flow volatility.

The caveat of culture

Siegel emphasizes that there is no inherently “correct” corporate attitude toward risk. Each firm’s approach is a remnant of its daring or cautious founder, propagated over time by like-minded hires and promotions, and incentives to approach strategic decisions in company character.

“Corporations are not just ad hoc, purely contractual arrangements between people who work together,” he says. “They also appear to foster shared norms and attitudes. And there is a strong connection between their attitudes and what they actually do.”

But while the preservation of a founder’s philosophy toward risk and uncertainty can serve a company well over its life, an enduring corporate risk culture can also have a downside.

“As much as it offers stability, continuity and predictability,” Siegel warns, “culture can also become a hindrance to acting differently when an opportunity presents itself.”

“Corporate Risk Culture” was published in the December 2017 Journal of Financial and Quantitative Analysis.