The Financial Crisis and Managerial Behavioral Biases

RISK MANAGEMENT DECISIONS

Module Convenor: Dr Ahmed Barakat

Topic A: "Managerial behavioural biases in financial institutions have been one of the main causes of the global financial crisis (2007 – 2009).” Using the concepts of risk aversion, loss aversion, information asymmetry and heuristics, critically discuss this statement while giving practical examples and utilising real life case studies.

The financial crisis is one of the major global problems which causes many severe consequences, especially in economics activities. Economists have pointed out several causes of financial crisis, amongst which, managerial behavior biases in financial institutions have been considered one of the most important factors that lead to this major issue. This essay will first discuss the impact of these biases on the financial crisis based on the concept of risk aversion, loss aversion, information asymmetry and heuristics, then focus on the case of HBOS’s collapse in 2008.

To begin with, the financial crisis can be set in several ways. It can begin with a pricing bubble, people then have over expectation on the continued rise of these asset’s price so that they bulk buy them. When the bubble bursts and prices fall, the fall of the corporate network and the deleveraging of financial institutions after that cause market collapse. These behaviors may be caused and even made worst by behavior biases, especially managerial ones in financial institutions, as they interfere the valuation and decision about risk.

The behavioral approach to the financial crisis can be first discovered by the concept of risk aversion and loss aversion. Risk aversion concept influence risk decision in the financial crisis after people experienced gain in holding assets. Since they had already gained, the situation can be framed as a gain, they are then less risk averse and bought asset even more enthusiastically. The same thought occurred in the banking system, and together they pushed the price up even higher. On the other hand, after having suffered a loss in risky asset holdings, loss aversion, together with ambiguity aversion, would fall, led to the quick selling out of all risky asset holdings (Thaler and Johnson 1990). As a result, asset prices went down even lower. In particular, during the time of the house price problem (before the financial crisis actually happened), financial innovation in mortgage market made people who less likely to be able to pay back their mortgages are the ones offered more purchases. Banks were afraid of keeping too much subprime – linked securities, since they were risk averse, so they offered them to even riskier borrowers to get rid of them, even after being aware of the low probability of these borrowers to pay back.

Secondly, information asymmetry is another cause of financial crisis. Information asymmetry, the different amount of information, between banks (lenders) and borrowers, leads to averse selection and agency problem. Due to the information advantage of borrowers over banks, it is difficult for banks to distinguish the low risk from the high-risk borrowers. This issue is called the adverse selection, which threaten banks to the larger probability that the high-risk borrowers do not pay back the loans. Since banks have trouble in determining the quality of investment projects of the borrowers, the borrowers have incentives to involve in personally beneficial projects but with a high chance of default. Take the housing market as an example, from 2000 to 2005, the housing boom and lending standard allowed borrowers to borrow up to the value of the house. Therefore, too many risky borrowers were allowed to buy houses to sell them at the higher price. So when house price fell in 2007, those risky borrowers cannot afford to pay back the loan, made some banks faced with the high amount of debt.

On the other hand, banks are not only the victim of the information asymmetry. They, however, knowingly bundle toxic loans, then sell them to investors who have no doubt about it. (Harry Bruinius 2013) Banks may know some bad information about loans, but they do not reveal to investors, make them unsuspectedly buy these loans which may turn bad after that. Investors then become losing faith in the banking system. In the case of the housing bubble, this behavior of banks made the situation even worst and turned a housing crisis into a financial crisis.  JP Morgan is a well – known example for this. This bank has been alleged by the government to have reported facts to investors that turned out to be untrue.

According to economics theory, lots of financial crises occurred when an asset class became overvalued. Why might these overvalued asset problems happen? There are some heuristics and biases that can explain this issue. The first explanation might come from the representativeness heuristic and availability bias, when managers of institution and investors over – extrapolate of past return and the information that availability to memory, while in fact, prices are determined from trade and real people, not from randomness. For instance, as housing price had risen for a long time, people extrapolated that grown too far in the future, so they believe that the price would keep increase more and more. Quite similar to this, overconfidence and illusion of control discuss how people overestimate the precision of future forecast. Hence, if favorable information about one asset is uncovered, the overconfidence of how reliable information is may push the price of that asset up too high. But in fact, Shefrin (2008) has claimed that, Wall Street strategists, for example, can poorly forecast. In addition, managers in some institutions may hold the belief of the ability to control over risk because they can predict and understand market relatively well. In the pre –  crisis period, financial institutions’ managers hold an illusion that interest rate will stay at a low rate for a prolonged period, thus there will be enough liquidity available. This illusion was what caused the asset bubble later on. Overconfidence and illusion of control inside managerial behavior will lead to the thought of underestimating risk of cost while overestimating gain.  

One of the most important heuristics that influence managerial behavior leads to financial crisis might be herding. According to J.V.Rizzi, people usually follow the social pressure in order to conform and feel safer when hiding in the crown. Even after recognizing the risk, following the crown is usually the choice of most managers. They learn to manage risk by sticking to an index. By doing so, they can blame all the failure on the collective action while keeping their reputation and avoid being punished or fired. Bankers, therefore, continued risk practices even after recognizing the unsustainable market that may lead to financial crisis. This is also the reason why banking expert’s forecasting abilities are relatively poor. And because of herding, they invested too much in the same area at the same time, credit cycle effect amplifies which makes the situation (before the crisis) even worst. Herding effects might even larger when it comes with group think (Irving Janis, 1972), with which, bias can be amplified within organizations.  HBOS’s example in the next part will illustrate more this issue.