Financial regulators still aren’t paying nearly enough attention to the cognitive biases that lead people to take excessive risks, according to a research paper by attorney Nizan Geslevich Packin.Some of her insights:
1) A more diverse group can lead to better decisions
Research has shown that even when they have similar training, experience, and information, people with different cultural backgrounds make different decisions.
Gender plays a role too. Women have been to emphasise risk factors more than male colleagues, be less risk seeking, and less ‘ruthless.’ Groups that are too similar will come up with similar ideas, and have actually been found to take bigger risks than individuals. Having people that will challenge the group and have different risk preferences is essential.
2) People are more honest when they’re reminded of their own standards
No matter what they’re doing, people try to maintain a positive self-image, they like to think of themselves as having integrity.
Requiring frequent statements from risk officers to both executives and the board that the company is in compliance would continually remind them of the need for honesty, and give them a possible outlet beyond their immediate superiors when there are issues.
3) The ‘illusion of control’ makes people underrate risks.
People want to believe that they’re in control of a situation. Even when that’s fundamentally not the case, they continue to believe their experience and skills can influence a situation. That’s particularly dangerous in finance where huge market forces are at play and large losses are possible.
To fight that bias, people who manage risk need to be reminded that some situations can’t be managed, no matter how skilled and prepared people are, and that they should expect the worst.
4) When presented with numbers alone, people make less moral judgements
When it comes to risk management at banks, it’s no longer just about maximizing profits and controlling losses. The crisis and recession have showed the massive social consequences of risky behaviour.
Studies show that when presented with numbers alone, people reduce problems to their mathematical consequences, forgetting the moral impact.
Framing is also incredibly important. If social consequences are presented along with financial ones, people are more likely to take those factors into consideration in their decisions. Risk committees should be presented with more than just numbers and formulas.
5) Accountability has a psychological effect that can overcome a risk bias
When people feel more accountable, they’re more careful in their individual decisions. The idea that others are watching improves their judgement.
Packin suggests that financial institutions publish the names of the members of their risk committees, so, in addition to their accountability to the firm, members feel more accountable to the public.
6) People are very scared of ruinous losses
When made aware of worst possible scenarios, people are significantly more risk averse.
“…all the options from which committee members must choose should be carefully outlined to them, and emphasis, as well as explanations in great detail, should be given regarding the more uncertain options, especially if they have possible disastrous consequences.” Packin writes, “After all, based on studies done, if the risk committee members will understand the full scale of potential ruinous losses, they will show more risk-averse tendencies in their decision-making.”
7) Familiar risks get discounted
According to Packin, “…people feel more comfortable with risk-taking when they are familiar with the specific relevant risks.”
Known risks are still dangerous, and the appearance of safety can make people minimize it. To fight this ‘familiarity bias,’ Packin suggests analyses reflect the unknown factors of risks and that potentially excessive risks are still exactly that even in what may be a safer environment.
8) Hindsight bias makes people overemphasize the past
People tend to assume that future events will follow the past. That was a key factor in the last financial crisis.
Stress tests are one tool to fight this, making sure institutions are strong enough to withstand pessimistic scenarios. Packin recommends that they be extended to more types of risk and try to account for the human factor with simulation:
“…use of scenario planning tools, such as simulation games, can help risk committees better deal with the hindsight bias and its effect on the financial institutions risk managers’ performance. Moreover, using simulation games as part of scenario planning will also enable risk committees to use the services of other professionals, such as psychologists to assist them to create more scenarios to analyse, prepare for,264 and refrain from being negatively affected by the hindsight bias.”
The research paper will be published in the University of Pennsylvania Journal of Business Law, Volume 2, Issue 15, 2013.
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