Why did the bankers behave so badly?

Anne Sibert, 18 May 2009

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Many people share the blame for the current financial crisis; politicians, supervisors, regulators and even imprudent households and businesses. One group, however, has been judged to be especially guilty; the employees in the financial services sector. In response to their perceived greed and bad judgment, the US House of Representatives passed a bill that would effectively confiscate the 2008 bonuses of employees of financial firms receiving significant bailout assistance. In the UK, vandals smashed the windows and trashed the Mercedes of the former head of the Royal Bank of Scotland, while protestors tried to take over a London branch of the bank. In Iceland, financiers have wisely fled the country.

The populist outrage may be excessive, but it is hard to deny that certain aspects of these employees’ conduct were undesirable. Bankers imprudently counted on a continuation of the US housing boom long after most economists predicted its demise; they were overly sanguine about sustainable leverage ratios; managers of insurance companies and pension funds failed to exercise sufficient caution when they purchased collateralised debt obligations and asset-backed securities that they did not understand or know the value of. Since few would characterise the bankers and other employees of financial firms as an unintelligent group, it is interesting to ask why they behaved in such an egregious fashion; I advance three theories.

Humans are prone to cognitive errors

The first explanation is that humans are prone to cognitive errors involving biases towards their own prior beliefs. A vast empirical psychology literature documents that people fail to put sufficient weight on evidence that contradicts their initial hypotheses, that they are overconfident in their own ideas and have a tendency to avoid searching for evidence that would their disprove their own theories. Psychologists attribute these cognitive errors, collectively known as confirmation bias, to several factors. These include emotional reasons, such as embarrassment, stubbornness and hope, and cultural reasons, such as superstition and tradition. There may also be physiological explanations; the evolutionary development of the human brain may have facilitated the ability to use heuristics which provide good judgements rapidly, but which can also lead to systematic biases. In addition, recent research supports the theory that the human brain arrives at outcomes – such as confirming one’s own beliefs – that promote positive and minimise negative emotional responses.

Sexism and the City

UK Labour cabinet member Hazel Blears suggests a second reason, commenting that, “Maybe if we had some more women in the boardrooms, we [might] not have seen as much risk-taking behaviour” (Sullivan and Jordan 2009). Indeed, the financial services industry – one in which lap dancing is apparently considered appropriate corporate entertainment (UK Equality and Human Rights Commission) – is overwhelmingly male dominated. Women hold only 17% of the corporate directorships and 2.5% of the CEO positions in the finance and insurance industries in the US (Sullivan and Jordan 2009). In Iceland – home to a particularly spectacular collapse – it is said that there was just one senior woman banker, and that she quit in 2006 (Lewis 2009). If men are especially prone to being insufficiently risk averse and overly confident, then this male dominance may have contributed to the financial crisis.

There is a substantial economics literature on the effect of gender on attitudes toward risk and most of it appears to support the idea that men are less risk averse than women in their financial decision making.1 There is also a sizable literature documenting that men tend to be more overconfident than women. Barber and Odean (2001) find that men are substantially more overconfident than women in financial markets. In general, overconfidence is not found to be related to ability (see Lundeberg et al (1994)) and that success is more likely to increase overconfidence in men than in women (see, for example, Beyer (1990)). Thus, if confidence helps produce successful outcomes, there is more likely to be strong feedback loop in confidence in men than in women.

In a fascinating and innovative study, Coates and Herbert (2008) advance the notion that steroid feedback loops may help explain why male bankers behave irrationally when caught up in bubbles. These authors took samples of testosterone levels of 17 male traders on a typical London trading floor (which had 260 traders, only four of whom were female). They found that testosterone was significantly higher on days when traders made more than their daily one-month average profit and that higher levels of testosterone also led to greater profitability – presumably because of greater confidence and risk taking. The authors hypothesise that if raised testosterone were to persist for several weeks the elevated appetite for risk taking might have important behavioural consequences and that there might be cognitive implications as well; testosterone, they say, has receptors throughout the areas of the brain that neuro-economic research has identified as contributing to irrational financial decisions.

If – as the research may suggest – men are less risk averse than women, then a work group composed primarily of men (or primarily of women) may be a particularly bad idea. A vast psychology literature documents the phenomenon that group deliberation tends to result in an average opinion that is more extreme than the average original position of group members. If a group is composed of overly cautious individuals, it will be even more cautious than its average member; if it is composed of individuals who are overly tolerant of risk, it will be even less risk averse than its average member (Buchanan and Huczynski 1997).

Bonuses distort behaviour

In a recent paper, Hamid Sabourian and I advance a third reason for the behaviour of bankers; a flawed compensation structure that rewards perceived short-term competency, rather than good long-run results causes bankers to distort their behaviour in an attempt to increase their perceived ability (Sabourian and Sibert 2009). We suppose that a banker’s choices are unobservable. Bankers differ in their ability to make the correct decision and this ability is known only to themselves. In the long run, it can be determined whether the action chosen is the best one or not and the banker would rather make the correct decision than the wrong one. However, in the short run, the banker’s bonus depends upon how competent he is perceived to be.

In the first variant of our model, we suppose that a banker chooses an action and is then confronted with publicly observable conflicting information. He then chooses whether or not to change his course of action. If he is especially competent, then he knows that his original choice is probably still the best and does not change it. If he is less competent, the conflicting information tells him that his choice is probably not the best. We show that, for a range of banker competencies, even if the banker realises that his original choice is not likely to be the best, he does not change it. Instead, in the interest of receiving a higher bonus, he mimics an especially competent banker and continues with his original decision.

In the second variant of the model, the banker chooses an action. There is no publicly observed information in this case. Instead, the banker is asked how likely he thinks it is that his decision is the best. We think of this as a proxy for how strongly the banker sells his views to his employer or customers. In the long run, if the banker’s decision is wrong, he bears a cost that is increasing in his stated confidence. Even though it can be costly to claim to be correct with high probability and there is no intrinsic benefit from being overly optimistic, if bankers who are perceived to be especially competent receive high enough bonuses, then all bankers will imitate the most competent and oversell their decision.

In the third variant of the model, the banker chooses an action and is then given the opportunity to acquire additional information, at a cost, which, if his initial choice is incorrect, might confirm that it is incorrect. The banker could then abandon his original choice. Highly competent bankers are unlikely to devote resources to questioning their decision as they are unlikely to be wrong. Thus, less competent bankers attempt to increase their bonuses by masquerading as more competent ones; they do not search out additional information either.

Footnotes

1 See, for example, Jianakoplas and Bernasek (1998), Bernasek and Shwiff (2001), Holt and Laury (2002) and Eckel and Grossman (2002). Schubert et al (1999) is a rare exception. The differences between men and women may, of course, be due to nurturing rather than nature

References

Barber, Brad M. and Terrance Odean, “Boys will be Boys: Gender, Overconfidence and Common Stock Investment,” Quarterly Journal of Economics 66, 2001, 261-292.

Bernasek, Alexandra and Stephanie Shwiff, “Gender, Risk and Retirement,” Journal of Economic Issues 35, 2001, 345-356.

Beyer, Sylvia, “Gender Differences in the Accuracy of Self-Evaluations of Performance,” Journal of Personality and Social Psychology, 59, 1990, 960-970.

Buchanan, David and Andrzej Huczynski, Organizational Behaviour, London, Prentice-Hall, 1997.

Coates, J. M. and J. Herbert, “Endogenous Steroids and Financial Risk Taking on a London Trading Floor,” Proceedings of the National Academy of Sciences 105, 2008, 6167-6172.

Eckel, Catherine C. and Philip J. Grossman, “Sex Differences and Statistical Stereotyping in Attitudes toward Financial Risk,” Evolution and Human Behaviour 23, 2002, 281-295.

Holt, Charles A. and Susan K. Laury, “Risk Aversion and Incentive Effects,” American Economic Review 92, 2002, 1644-1655.

Jianakoplas, Nancy A. and Alexandra Bernasek, “Are Women more Risk Averse?Economic Inquiry 36, 1998, 620-630.

Lewis, Michael, “Wall Street on Tundra,” Vanity Fair, Apr. 2009.

Lundeberg, Mary A., Paul W. Fox and Judith Punccohar, “Highly Confident but Wrong: Gender Differences and Similarities in Confidence Judgements,” Journal of Educational Psychology 86, 1994, 114-121.

Sabourian, Hamid and Anne Sibert, “Banker Compensation and Confirmation Bias,” CEPR Working Paper no. 7263, Apr. 2008.

Schubert, Renate, Martin Brown, Matthias Gyster and Hans Wolfgang Brachinger, “Financial Decision Making: Are Women Really more Risk Averse?” American Economic Review 89, 1999, 381-385.

Sullivan, Kevin and Mary Jordan, “In Banking Crisis, Guys get the Blame: More Women Needed in Top Jobs, Critics Say,” Washington Post Foreign Service, 11 Feb. 2009.

Topics: Financial markets, Frontiers of economic research
Tags: bankers, Behavioural economics, Financial Crisis 2009, risk aversion

Comments

bankers behaved so badly because they are bad people

Bankers behaved badly because they are very bad people: the selection process in the financial industry ensures that people who make it are smarter and more greedy than the average person (and sadly that applies to women as well). Unless they are restrained by regulators or owners bankers will do bad things. Before the crisis there was no such restraint because bankers are smarter and richer than regulators so the bankers bought the regulators. As for the owners they did not bother to check on the bankers as long as their share prices were rising. Right now both regulators and owners are papering over bank losses and praying that the next crisis happens under someone else's watch: the regulator because they don't want to tell tax payers how much this mess is going to cost and the owners because they cannot accept that all their equity is gone. If you want to discipline the bankers you need either another crisis or a revolution.

Cognitive biases are not really cognitive

Nice piece. The last point has to be the big one, summarised by Hugh Hendry as "these people were paid to be greedy".

I believe there is some literature that says that mixed sex groups are even more risk-taking t han either single sex group.

We need to move people on from 'cognitive biases' that are driven by greed and fear. Damasio and others have blown the Cartesian ideal. The ever-growing list of biases is starting to look like very bad science.

Your hypothesis about testesterone has just been disproven

Read my post There is no difference between men and women in risk taking, altruism, fairness concern or trust

Follow the link to the the study done by Stockholm School of Economics and a leading the research hospital Karolinska. Sex hormones do not affect economic behavior

4/7/2009
A new study published in the April 6 advanced online issue of the Proceedings of the National Academy of Sciences (PNAS), shows that neither testosterone nor estrogen had any effect on financial risk taking.

Neither had it no effect on other “economic behavior” (altruism, fairness concerns or trust).

It is well established that women are more reluctant to take financial risks than men are; women for instance are less prone to invest their retirement savings in the stock market. It has been argued that these differences are due to sex hormones. Particularly, testosterone has been thought to increase risk taking and estrogen has been thought to decrease risk taking.

To test the hypothesis that sex hormones affect economic behavior a team of researchers at the Stockholm School of Economics and Karolinska Institutet conducted a double-blind randomised clinical trial. In the study women in the ages 50-65 years were randomly allocated to treatment with, testosterone, estrogen, or placebo. After 4 weeks of treatment, the women participated in a series of economic experiments to measure financial risk taking, altruism, fairness concerns, and trust. But no difference in behavior between the groups was discovered.

Bad Behavior

Interesting that power over managers' behavior nominally rests with the Boards of banks (and other corporates, as well), but no mention was made of these highly-paid dogs that did not bark.

Supposedly, board members are of an age, or experience, where none of the three reasons need apply: individuals have been selected for excellence of thinking in relevant areas of expertise, the over-testosterone individuals have been weeded out and bonuses are a small enough part of their future income, which includes reputational risk, that their heads were not turned by ill-tuned stock grants.

We're kind of left with the conclusion that ordinary boards have abdicated their responsibilities, are incompetent, or, due to human nature, cannot be expected to prevent occasional collapses of capitalism's function.

Professor of Economics at Birkbeck, University of London and CEPR Research Fellow