Your cheatin’ mind: How biz leaders explain away poor choices

July 19, 2012, 9:00 AM UTC

FORTUNE — You can hardly read the news lately without learning how someone at a big bank seemingly flouted both common sense and morality in the effort to make a buck.

A quick sample: Executives from British bank HSBC testified before the Senate this Tuesday over allegations that in 2007, the bank enabled Mexican drug cartel leaders and terrorists in the Middle East to fund illegal activities. Also on Tuesday, the Federal Reserve and the Commodity Futures Trading Commission testified before Congress about how big global banks potentially manipulated a market rate called Libor between 2005 and 2010 to make their financial situations appear better than they were. Barclays (BCS) was the first target in the investigation, having settled with regulators to the tune of $450 million last month. Citigroup (C) executive Brian Stoker is facing allegations in federal court in Manhattan that he sold collateralized debt obligations to clients despite knowing that Citi was planning to bet against those same assets. Last week, J.P. Morgan (JPM) told regulators that an internal investigation into a $5.8 billion trading loss turned up that the traders might have tried to cover up their mistakes.

Unfortunately, the list goes on. The press is bad. Given the fallout of fines and ugly coverage, why would so many of these people try to game the system? To understand the big-picture motives, you need to get inside the mind of a cheater.

Rationalizing poor choices

First, it’s safe to say that most people who make unethical choices think of themselves as good people, says David Mayer, a management professor at the University of Michigan’s Ross School of Business. “But we humans have found ways to not feel so bad about it when we behave a certain way — we basically disconnect these self sanctions.”

People will perform all kinds of mental backflips to rationalize their choices, especially when it comes to business. “We’re pretty good at segmenting our lives into different areas,” says Mayer. “If you were to go to church or temple, that’s a moral domain. People tend to not think about business as a moral domain.”

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In a big business, there’s often considerable distance between the people who are making questionable choices and the people those choices hurt. HSBC, for example, allegedly ignored signs that people involved in drug cartels were using its system. “It’s not like they were watching someone being shot by a drug cartel,” says Mayer. “It’s totally depersonalized, you’re just looking at numbers,” Mayer says.

Leaders, like most people, generally prioritize the people who are closest to them. That can make it difficult to think about the wider reach of unethical choices. In their minds, “They’re almost performing altruistic behavior, because they’re protecting the jobs around them, and perhaps the survivability of the corporation,” says Barry Staw, a professor of leadership and communication at the University of California, Berkeley.

But these kinds of rationalized decisions can spin out of control. And they tend to do so more dramatically in a dog-eat-dog sector such as the financial industry, says Staw. He and his team have examined the scenarios when people tend to make the worst choices. “The more competitive a particular industry is, and the more lean it is, the more people are willing to manage at the edge.”

‘You are unethical, I’m just caught in a vise’

Then, if we act on the edge of our own morality, we will trick our brains into thinking we are not. One way we do this is with something psychologists call “fundamental attribution error.” According to this concept, we tend to think of our own poor choices as responses to challenging situations, but when others act similarly, we are more inclined to think that those people are unethical. For example, say a woman is driving down the freeway; she’s late to her son’s baseball game after being held up at work, and she realizes that she needs to exit soon or she’ll miss half the game. She cuts across three lanes of traffic to get to the exit. The woman views the choice in the context of her life — she thinks of herself as a good person, her desire to be a good mom perhaps outweighing her interest in being a good driver at that moment. Everyone else on the freeway thinks she is huge jerk.

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We not only rationalize our own jerk-like behavior, but our colleagues’ actions as well, says Mark Frame, a psychology professor at Middle Tennessee State University who specializes in workplace psychology. “The more you surround yourself with the kind of people who are engaged in the same deviant behavior, the more it seems normal,” he says. For example, it appears that groups of traders acted together in both the Barclay’s rate-fixing debacle and at J.P. Morgan, to cover their tracks.

If we rationalize questionable behavior once, we’re likely to repeat it, Frame says. “It’s not, ‘Hey, today I woke up and decided I’m going to fudge the numbers for my corporation.’” Instead, it’s a collection of small rationalizations that build up over time. That’s what happened this past September when UBS trader Kweku Adoboli was arrested for having made a series of bad trades over a three-month period that ended up losing the company billions of dollars.

When the problem goes system-wide

Businesses as well as individuals can normalize unethical behavior. Take Barclays, which, among other banks now, is accused of fixing its Libor rate submissions. In a statement addressing Barclays Chairman Marcus Agius’ departure, former Barclays CEO Bob Diamond’s argued that other banks were fixing Libor submissions as well, and his executives didn’t want Barclays to look bad.

And for a while, it didn’t. But then the problems came to light this year, and he and Agius lost their jobs. There are other casualties: David Bagley, HSBC’s had of group compliance announced yesterday that he was stepping down. Those high-profile resignations could set an example that top executives will be on the chopping block if they don’t keep their people on the straight and narrow. But on the other hand, none of these banks are in danger of collapsing any time soon. Without a major cultural shift, removing key participants is a cheap Band-Aid.

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The rewards for unethical behavior at big banks are large and fast while regulators act slow and penalties are relatively low. In a low-risk, high reward situation, our brains will work extremely hard to get our values on board with being rewarded, even if that means cheating. That’s not even a complex rationalization. Simply put, Frame says, “People will do what you reward them to do.”

If we want our big bank leaders to demonstrate standout ethical behavior, we should start to think about ways to reward them for it.