Scratch the surface of the global financial crisis, and the one thing you’ll find at the heart of many of its contributing factors is people behaving badly.

That extends from the subprime mortgage borrowers who lied on their mortgage applications, often at the behest of unscrupulous mortgage brokers, to the lenders who didn’t ask too many questions about creditworthiness, knowing that the loans wouldn’t have to stay on their books.

And it includes the bankers who then contrived ways to package sketchy loans to create securities that were rated as “first-class” and sold to investors, who in turn didn’t bother to do proper due diligence.

All the way up and down the chain of borrowing, lending, securitization and investment, people sought to cheat the system in their own ways. In hindsight, many probably realize that they behaved badly; but at the time, most probably didn’t see anything wrong with their actions. Humans have a remarkable ability to justify and rationalize their behaviour, if only to convince themselves that they aren’t bad people — a phenomenon known as “moral disengagement.”

However, a new working paper published by the Harvard Business School, Dishonest Deed, Clear Conscience: Self-Preservation through moral disengagement and motivated forgetting, by Lisa Shu, Francesca Gino and Max Bazerman, highlights one possible path to making people act more ethically: simply reminding them that honesty is expected.

“Morality, to a certain extent, is derived from the situation one finds oneself in,” the paper states. “Our studies show that people respond to the permissiveness of their environments and seize the opportunity to behave unethically.”

The unappealing result of the authors’ research is that it adds more evidence to the theory that dishonesty is pervasive in the population. But what’s more encouraging is that the research also found that this dishonesty could be curtailed fairly easily through the use of something as simple as a code of conduct demanding honesty.

The paper notes that previous research into morality and its psychology has refuted the idea that only criminals break the law, and has instead discovered that ordinary people are routinely dishonest but justify or distance themselves from their transgressions to preserve their moral self-image. Previous papers have focused on this moral disengagement as a predictor of unethical behaviour, but the HBS paper suggests that the justification may also come as a result of the immoral behaviour.

“[We] suggest that moral disengagement is not always a necessary condition leading to dishonesty, but that it may in fact result from unethical behavior,” the HBS paper states. In other words, people cheat first and make up an excuse later, rather than cheating as a result of becoming disillusioned.

In a series of experiments involving academic honesty, the researchers found that “the decision to behave dishonestly changes levels of moral disengagement and that awareness of ethical standards affects the decision to engage in unethical behaviour.”

This led the researchers to conclude: “On the one hand, we find that once people behave dishonestly, they are able to morally disengage, setting off a downward spiral of future bad behaviour and ever more lenient moral codes.

“Yet,” the paper continues, “we also provide evidence that this slippery slope can be forestalled with simple measures, such as honour codes, that increase people’s awareness of ethical standards. As a result, making morality salient not only reduces unethical behaviour, but also makes individuals’ judgments more scrupulous.”

Indeed, the researchers found that tools such as codes of conduct that remind people of their moral obligations may actually produce more virtuous behaviour. And seemingly minor measures, such as requiring participants to sign a code of conduct, rather than just reading it, had meaningful effects. “When we strengthened participants’ awareness of ethical standards by having them sign an honour code, cheating was in effect eliminated,” they found in one experiment.

That’s not to say that the financial crisis could have been averted with a few codes of conduct. But ethics do matter, particularly in an industry that’s entirely based on trust, at a time when that trust has been shattered.

So far, efforts to repair that trust are taking the form of regulatory reform from the top. Policy-makers and regulators are examining the systemic failures and trying to craft structures that may have prevented the current crisis. Those efforts are leading to plans for reforms, such as tougher capital requirements, tighter regulation of derivatives and closer monitoring for market stability.

@page_break@Yet, among all of the complex, interconnected causes of the financial crisis, the reality of human nature is one of the fundamental factors that will almost certainly undermine some of the efforts to avert similar failures in the future.

Indeed, lawmakers are well aware of the impossibility of legislating morality, and financial regulators have now realized that their initiatives can easily be undone by basic human failings.

As Hector Sants, CEO of Britain’s Financial Services Authority, recently observed in a speech: “I continue to believe the majority of market participants are decent people; however, a principles-based approach does not work with individuals who have no principles.”

Moral disengagement surely becomes that much easier when people are faced with powerful incentives, too. And, in the current financial crisis, these incentives didn’t just disrupt moral compasses; they also impaired many people’s common sense.

In a speech to the Asian Banker Summit in Beijing in mid-May, Canada’s banking superintendent, Julie Dickson, reflected on the role of human nature in defeating policy-makers’ efforts to ensure permanent financial stability. She said that memory failure is one factor, but that strong incentives are also at play.

These incentives that lead us into questionable behaviour go beyond hefty pay packages for bankers, Dickson pointed out: “Looking at incentives requires us to go down some paths that might be quite sensitive. Many of them involve the depth to which the financial sector has pervaded our culture.”

As the economic significance of the financial services sector has grown, so too has its cultural and political influence, she noted: “So, while every downturn produces lessons to be learned, the question remains: how to, or whether it is even possible to, alter human nature and the strong influence of incentives.”

Her point is that we will never be able to regulate away financial crises. Nevertheless, policy-makers in other countries, where the damage is more acute, are expected to try. The fear is that the result will be an overreaction leading to a massive re-regulation of the sector that doesn’t just reduce risks and close gaps but destroys profitability and ultimately stifles economic growth.

Yet the industry — or, at least, individual firms — could be doing more to avert future calamities by ensuring that employees are inclined to act more ethically in the first place, even in the face of incentives to do otherwise. Now that firms understand that reputational risk is real, and possibly deadly (Lehman Brothers Holdings Inc. and Bear Stearns Cos. Inc.), there’s a compelling reason for firms to encourage ethical decision-making within their ranks.

Regulators may be powerless to alter human nature, but firms can certainly influence their own employees’ behaviour. The lesson for the financial services industry is that “tone from the top” can go a long way in signalling to people whether they are working in a shady shop or an honest one; and that environment can, in turn, affect individual behaviour. Ethical corporate cultures can be built, and seemingly quaint concepts, such as codes of conduct, can have a meaningful effect on something as fundamental as human morality.

For a business based on trust, that’s priceless. IE