Diversifying to Mitigate Risk: Can Dodd–Frank Section 342 Help Stabilize the Financial Sector?

Abstract

Congress identified a major blind spot on Wall Street when it enacted section 342 of the Dodd-Frank Act — a culturally homogeneous elite prone to herd behavior, group-think, and affinity bias.These maladies exacted a heavy cost upon the rest of the nation in the context of the financial crisis, which was marked by a mindless real estate bubble, dubious ethics, outright violations of laws and regulations, and the worst risk mismanagement in our nation’s history. There is no certainty that a more culturally diverse financial sector would have entirely prevented the crisis or dramatically lessened its effects. Embracing the full spectrum of cultural diversity should allow firms to access and balance the full spectrum of perspectives and experiences that support superior cognition, especially with respect to risk, ethics, and compliance. Empirical studies strongly suggest that a more culturally diverse financial sector could have reduced subprime lending, limited the extent of the real estate bubble, limited the essential lawlessness of the financial sector, and enhanced ethical decision making. These empirical studies are primarily either based upon actual learning from the financial crisis or sophisticated experiments simulating market behavior. In all events, a thoroughgoing embrace of cultural diversity will certainly yield superior social and economic outcomes relative to the financial crisis yielded by culturally monolithic financial firms. Viewed from the perspective of that crisis in capitalism, it is impossible for cultural diversity to fail.

Consequently, we suggest that the financial regulators modify the basic approach of their Joint Diversity Guidelines and fully integrate them into all aspects of their examination and supervisory processes. Firms should face legal obligations with respect to diversity to the extent that mismanagement of diversity contributes to unsafe and unsound practices or creates an environment and culture of unlawful conduct. The regulators should also proactively require stronger diversity measures for firms sanctioned for unlawful behavior or risk mismanagement.

Keywords: Financial Crisis, Cultural Diversity, Diversity Guidelines

JEL Classification: D22, E02, E44, F38, G01, G18