July 20, 2011
Lessons from the Financial Crisis: What's Good for One Organization Can Topple an Entire Industry
Innovation drives markets. But when innovation is left unharnessed and spreads too fast, regulation can’t keep up and innovation implodes. Jo-Ellen Pozner studies organizational legitimacy and corporate governance and analyzed how the diffusion of innovative practices contributed to the 2008 financial crisis causing “terminal isomorphism” and the mortgage market meltdown.
“Isomorphism is a phenomenon where organizations tend to look more and more alike over time. They start out as diverse, different types of organizations, and over time, they start to imitate each other,” Pozner explains, "We call the mortgage meltdown ‘ terminal isomorphism’ because instead of organizations tending to look more and more like each other in a positive way, they raced to the bottom in a negative way,” says Pozner.
Pozner is an assistant professor at the University of California, Berkeley’s Haas School of Business.
“Organizations seeking profits from making bad mortgages and then securitizing them seems like a good idea for those making commissions, but when you aggregate that behavior to the institutional or industry level, you get a very dysfunctional industry.”
Pozner’s research, Terminal Isomorphism and the Self-Destructive Potential of Success: Lessons from the Sub-Prime Mortgage Origination and Securitization¸ published in Research in the Sociology of Organizations, found loose regulations at the institutional level combined with lenders’ “innovative” restructuring at the organizational level led to the de-stabilization of the mortgage market and its practices.
The paper is co-authored by Mary Katherine Stimmler, Berkeley-Haas PhD candidate and Paul Hirsch, professor, Northwestern University’s Kellogg School of Management.
The paper argues that financial organizations restructured their own environment from “Main Street logic” to “Wall Street logic.” Instead of focusing on helping people buy homes and gain security, financial companies made decisions based on profit. Lending relationships evolved into lending transactions. This evolution proved harmful when aggregated to the institutional level, says Pozner, because when organizations mimic each other without an appropriate guiding culture or ethic at the institutional level, dysfunction is unavoidable.
By reviewing assumptions in institutional theory, Pozner and her colleagues identified a gap in the literature of how institutional logics can be affected by a phenomenon such as the financial crisis. They argue that a “diffusion of innovations” - a variety of lending practices and bankers being able to shop around for loose regulators – causes institutional erosion. Furthermore, the problem is exacerbated because regulators often don’t keep up with banking innovations and are therefore ill-equipped to regulate them.
“Another thing we saw was a quickly revolving door between Wall Street and Washington. A banker is regulated by people who may have previously headed the bank,” says Pozner. “This is the kind of research that explains more than predicts, but we hope to increase people’s awareness and give them the tools to be more vigilant and identity potential problems earlier on.”