Does individualistic culture impact operational risk?

• DOI: http://doi.org/10.1111/eufm.12246
• Author: Zhe Cao,Zhe An,Zhian Chen,Donghui Li
• Date: 01 June 2020
• Published date: 01 June 2020

Eur Financ Manag. 2020;26:808–838.wileyonlinelibrary.com/journal/eufm808

|

© 2019 John Wiley & Sons Ltd.

DOI: 10.1111/eufm.12246

ORIGINAL ARTICLE

Does individualistic culture impact

operational risk?

Zhe An

1

|

Zhe Cao

2

|

Zhian Chen

3

|

Donghui Li

4

1

Monash Business School, Monash

University, Caulfield East, Australia

2

Sun Yat‐sen Business School, Sun

Yat‐sen University, Guangzhou, China

3

UNSW Business School, The University of

New South Wales, Kensington, Australia

4

College of Economics, Shenzhen

University, Shenzhen, China

Correspondence

Zhe Cao, Sun Yat‐sen Business School, Sun

Yat‐sen University, Guangzhou, China,

510275.

Email: caozh5@mail2.sysu.edu.cn

Donghui Li, College of Economics,

Shenzhen University, Shenzhen, China,

518060.

Email: guangzhousjz@hotmail.com

Funding information

National Natural Science Foundation of

China, Grant/Award Number: 71873058

Abstract

Employing a sample of 2,957 operational‐risk events across

31 countries from 1990 to 2011, we find that financial

institutions located in countries with higher individualism

tend to have higher operational risk. This positive relation

is achieved through the risk‐taking channel and the

earnings‐management channel. In addition, the magni-

tude of operational losses is higher in more individualistic

countries. The results suggest that individualism serves as

an important informal institutional determinant of opera-

tional risk in an international context. Endogeneity tests

and various robustness checks confirm our findings.

KEYWORDS

individualism, national culture, operational risk

JEL CLASSIFICATION

G20; G32; G15

1

|

INTRODUCTION

Operational risk has become an increasingly important risk element for financial institutions

(FIs) throughout the world.

1

The sheer magnitude of operational losses has a severe impact not

EUROPEAN

FINANCIAL MANAGEMENT

For helpful comments, we thank the editor (John Doukas), an anonymous referee, Gunther Capelle Blancard, Shing‐

yang Hu, Terry Pan, Marc Oliver Rieger, Wing Wah Tham, and conference participants at the 2018 FIRN annual

conference, the 2018 Conference on the Theories and Practices of Securities and Financial Markets, the 2018 World

Finance & Banking Symposium, and the 2019 Academy of International Business Conference. Li would like to thank

the National Natural Science Foundation of China for financial support (Grant No. 71873058). Please correspond to Cao

or Li for all enquiries. All authors made equal contributions to this article. All errors remain ours.

1

According to the Basel Committee on Banking Supervision (BCBS, 2001), approximately 15%–25% of banks’capital is provisionally allocated to operational

risk, which highlights the material loss due to operational‐risk events throughout the world.

only on FIs but also on the global financial market. It is essential to understand the

determinants of operational risk in an international context. The previous literature focuses on

FIs from the United States. One notable study by Chernobai, Jorion, and Yu (2011) suggests that

the occurrence of operational‐risk events is related to FIs’internal controls. Wang and Hsu

(2013) argue that FIs with a larger size and a more independent board have lower operational

risk. However, these US studies are not able to explore the cross‐country determinants of

operational risk. National culture, as an informal institutional determinant, plays a significant

role in influencing fundamental economic decision making via people's expectations and

preferences (Guiso, Sapienza, & Zingales, 2006), thereby determining FIs’operational risk.

2

This paper examines how national culture, particularly individualism, impacts FIs’operational

risk in an international context.

Individualistic cultures emphasize individual achievements, self‐orientation, and autonomy

and tend to evaluate and reward managers based on firm performance. Individualism is not

only considered the most influential cultural dimension regarding cross‐country cultural

differences (Heine, 2008; Triandis, 2001) but is also expected to have the most significant

influence on corporate decisions. The previous literature suggests that individualistic cultures

foster people's tendency to be overconfident, thereby driving firms’financial and operating

decisions (Heine, Lehman, Markus, & Kitayama, 1999; Markus & Kitayama, 1991; Van den

Steen, 2004). Chui, Kwok, and Zhou (2016) suggest that low‐embeddedness (i.e., high‐

individualistic) countries are more concerned with agency activity, with managers being more

likely to engage in improper management practices that hurt firm value. Empirical evidence

shows that firms in individualistic countries engage in more risk‐taking (Ferris, Jayaraman, &

Sabherwal, 2013; Kanagaretnam, Lim, & Lobo, 2011; Li, Griffin, Yue, & Zhao, 2013; Shao,

Kwok, & Zhang, 2013) and earnings‐management activities (Han, Kang, Salter, & Yoo, 2010;

Kanagaretnam, Lim, & Lobo, 2014). Along this line of research, we expect managers in

individualistic countries to be less motivated to improve FIs’internal control weaknesses

(ICWs) than to increase earnings, which are directly tied to compensation. In addition,

individualistic managers tend to advisedly hide unfavorable information and overestimate their

ability to control the risk generated through firms’operating procedures. Therefore, FIs in

individualistic countries are prone to taking on higher operational risk.

Employing a sample of 2,957 operational‐risk events across 31 countries from 1990 to 2011,

we find that Hofstede's individualism index is significantly and positively related to FIs’

operational risk. To address endogeneity concerns, we employ two instrumental variables (IVs)

–the genetic distance to the United States (i.e., the most individualistic country) and the

grammatical rule on pronoun drop –in a two‐stage least squares (2SLS) model. The positive

relation between individualism and operational risk remains valid. Furthermore, we conduct

several robustness checks. In particular, the results hold when using alternative individualism

measures, alternative model specifications, alternative samples, and different event types.

Moreover, we find that the positive relation between individualism and operational risk is

achieved through the risk‐taking channel and the earnings‐management channel. In addition,

the magnitude of operational losses is higher in more individualistic countries. In sum, our

results indicate that FIs located in countries with higher individualism tend to have higher

operational risk.

2

In May 2008, PricewaterhouseCoopers and the Economist Intelligence Unit conducted a joint survey on the factors that contributed to the recent banking

crisis. They found that “culture and excessive risk taking”(73%) together with “mispricing of risk”(73%) and “rewards systems”(70%) were regarded as the top

three factors by participants.

AN ET AL.EUROPEAN

FINANCIAL MANAGEMENT

|

809