Behavior Finance: The Missing Element in Risk Management

May 13, 2009J. Rizzi, CapGen Financial(jrizzi@capgen.com)

Presentation to:

International Financial Institutions: Creating Value Through Operational Risk Management

Panel

(The ideas expressed herein are those of the author and not CapGen Financial)

Need to overhaul intellectual approach to risk management. Risk managers claim a precession that neither their raw material nor their skill warrant. Their models ignore the human element. Risk is managed by people, not models. Data is not generated by random number machines.

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Executive Summary

• Decision processes influence perception and shape behavior

• Behavioral finance examines how we gather, process and interpret information

• Behavioral finance can supplement not replace traditional risk management to improve decisions

• The current market crisis highlights the need to rethink risk management

• Ignore behavioral finance at your peril

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Table of Contents

• Executive Summary

• The Setting

• Risk Management

• Conclusion

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The Setting

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The Problem

• Guided by selective memories and information

• Fail to consider what we believe to be false

• Influenced by the actions of others

• Confuse preferences with prediction

• Engage in self serving attribution

• Disregard non-conforming views

(Economic Capital is a lighthouse….)

(… for the soon to be shipwrecked)

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Some Behavioral Effects in Risk Management

• Hindsight and Confirmation: I knew it all along and ignore nonconforming evidence

• Anchoring: Unduly influenced by first impressions

• Sunk Costs: Doubling down

• Overconfidence: Infallibility of judgment. Gives raise to illusions of control

• Optimism: It will work out

• Availability: More weight given to events easily recalled

• Threshold: Once frequency drops below threshold it is ignored

• Pattern Seeking: Fooled by randomness. Gamblers fallacy

(Risk Management is the fig leaf …)

(… behind which risk taking takes place)

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A MAP on the Limits of Statistics

(We observe the data….)

Considerations: Distributions and payoffs

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Normal (risk)

Fat tails/unknown(uncertainty)

Distribution

(…not the process)

Quadrant 4: Normal techniques fail. Alternatives to consider: Redundancy not optimization Avoid predication: focus on discipline and resiliency Time is longer Moral Hazard: bonuses tied to hidden risks Metrics: standard metrics no longer work Volatility absence is not equal to risk absence Risk numbers are dangerous: framing

Simple Complex Payoffs

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(Source: N. Taleb)

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Humans and Markets

(In physics you play against God….)

Markets and Hurricanes: they are different (J. Meriwether)

Hurricanes are not more likely because more hurricane insurance is written. This is not true for financial markets.

An increase in financial insurance increases likelihood of disaster.Those who know you sold the insurance (will trade against you) canmake it happen.

In a crisis all that matters is who holds what and at what price.

Markets are more complex than casinos. The numbers on the Roulette wheel never change. Markets make no guarantee that yesterday’s odds will be the same tomorrow.

(… in markets you play against God’s creatures)

Decisions at Risk

Uncertainty Bias

Beyond the data experiencesExperiencesExposures

Black SwansRare Events Large ImpactExplainable

Over confidence

Illusion of control

Hindsight bias

Anchoring

Amplifiers

Incentives

Bureaucracy

Opaqueness

(It is not what we don’t know that gets us in trouble…)

(…it is what we know that ain’t so)

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Risk Management

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The Setting

DimensionsFrequency

ExposureExperience

Severity

Focus: High impact low probability events (HILPEs)HILPEs difficult to understand and frequently ignoredHistory proves HILPEs do happen and can threaten survival of the unprepared

IssuesStatistical: insufficient data

Behavioral: infrequency clouds perceptionRisk estimates anchored Disaster myopia

Social: reduced from regulations collapse once behavior changesGoodhart’s LawRisk Adaptation

(Performance – is it luck…)

(… or skill)

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Risk Management

ToolboxAvoidance IgnoreMitigateTransferEquity

Self insure

(Not just that risk management fails…)

(… but it can produce unintended consequences that amplify damages)

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Operational Risk Amplifiers

Size

Compensation systems

Complexity

Management

(Impossible to make things foolproof…)

(…Fools are too clever)

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Complex Financial Institutions

High Risk Systems: prone to endogenous normal (system) accidents. Manmade catastrophesComplex nonlinear interaction: inevitable but unpredictability uncertain

Branching pathsFeedback loopsJumps

Tight coupling: network effectsGovernance: prevent management

from imposing risks on organization for their own benefit

Policy Implications(A ) Tolerate and improve (B ) Restructure(C ) Abandon

Disaster recovery

Strategic and

management

Processing errors

Model risk

Simple

Complex

Tig

ht

Loose

A

B

CAlternative costs

Catastrophe loss potential

(It is the system…)

(… not the event)

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Conclusion

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Thinking About Risks: the Shift

(Organizati0ns are a social…)

ClassicalIndependentStationaryRationalGaussianFrictionlessConsistent beliefsLinear Risk RewardComplete InformationIndividualsRisk Objective FunctionEquilibriumShocks

NewMemoriesUnstableBiasFat tailsArbitrage limitsInconsistencyNonlinearAsymmetric InformationInstitutionsUncertaintyPrincipal-Agent ConflictsCreative DestructionEndogenous

(…not a physical phenomena)

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Conclusion

• Risk is managed by people not mathematical models

• Accept randomness

• Discipline not predictions

• Expect the unexpected

• Avoid catastrophe risk

• Focus on what you know and insure against extremes

(Ignore behavioral finance…)

(… at your peril)

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