Behavioral Risk Management

The psychological dimension of managing risk is huge. Those with an understanding of the underlying psychology and the skills to recognize its manifestation in practice, have the opportunity to address its implications in a systematic fashion. Those without the understanding and the skills are destined to be more hit and miss in their approach to managing risk.

Managing risk is about managing psychology. For risk managers, understanding the psychology of risk has become “need to know,” not “nice to know.”

People make decisions about which risks to assume based both on how they feel and how they think. When the Nobel committee announced in 2002 that psychologist Daniel Kahneman would be a Nobel laureate, they singled out work he had done with his late colleague Amos Tversky. Together, Kahneman and Tversky developed a framework they called “prospect theory,” which provides great insight into the cognitive aspects associated with the psychology of risk.1

Identifying and quantifying risk are two of the most important activities in which risk managers engage. Research in psychology over the last four decades has taught us that these activities are extremely vulnerable to judgmental biases. People overestimate some risks and underestimate, if not overlook, others. What are the major biases that risk managers need to understand in order to exhibit expertise? And what can be done to help mitigate these biases?

People with different personalities have different tendencies when it comes to risk taking. Not surprisingly, these tendencies relate to fear, hope, and the pain of loss, factors lying at the heart of Chapters 2 and 3. This chapter describes what managers of all stripes can begin to infer about behavior from their understanding of people’s personalities.

Managing risk is about managing psychology. For risk managers, understanding the psychology of risk has become “need to know,” not “nice to know.”

People make decisions about which risks to assume based both on how they feel and how they think. When the Nobel committee announced in 2002 that psychologist Daniel Kahneman would be a Nobel laureate, they singled out work he had done with his late colleague Amos Tversky. Together, Kahneman and Tversky developed a framework they called “prospect theory,” which provides great insight into the cognitive aspects associated with the psychology of risk.1

Identifying and quantifying risk are two of the most important activities in which risk managers engage. Research in psychology over the last four decades has taught us that these activities are extremely vulnerable to judgmental biases. People overestimate some risks and underestimate, if not overlook, others. What are the major biases that risk managers need to understand in order to exhibit expertise? And what can be done to help mitigate these biases?

People with different personalities have different tendencies when it comes to risk taking. Not surprisingly, these tendencies relate to fear, hope, and the pain of loss, factors lying at the heart of Chapters 2 and 3. This chapter describes what managers of all stripes can begin to infer about behavior from their understanding of people’s personalities.

Risk managers need to understand more than the psychology impacting individual behavior. They also need to understand how these issues play out in organizations, and the important role of organizational culture.

At this point we turn our attention to risk management in the financial sector. The next several chapters apply the concepts developed to analyze the psychological dimension of risk management at major financial institutions that were at the heart of the global financial crisis. This chapter sets the stage by providing a general framework for understanding financial instability from a macroprudential perspective, in which macroprudential is understood as referring to the welfare of the financial system as a whole. To do so, the chapter presents the insights of acclaimed economist Hyman Minsky, who died in 1996. Minsky’s study and analysis of the causes and consequences of financial fragility, financial crises and economic instability are unparalleled.1

When it comes to the global financial crisis, the devil lies in the details. This chapter reviews the histories of two investment banks, UBS and Merrill Lynch, identifying the psychological issues that drove the decisions they made which promoted financial fragility and subsequent economic instability.1 Both banks participated actively in the market for CDOs constructed with mortgage-backed securities. Both banks practiced risk management poorly, and both banks incurred large losses as a result. What happened within these organizations that permitted this magnitude of errors?

In the early 2000s, there were three major rating firms in the United States: S&P, Moody’s, and Fitch. Rating agencies have reputational capital to protect: the opinions they express only have value if people believe those opinions are accurate indicators of creditworthiness. Therefore, in the lead-up to the global financial crisis, how in the world could two of these firms, S&P and Moody’s, have assigned triple-A ratings to many mortgage-related securities that plummeted in value when the housing bubble burst?1

Fannie Mae, Freddie Mac, and AIG specialize in taking tail risk, meaning the risk associated with rare, unfavorable events. During the housing bubble, all three accepted the risks of homeowners en masse defaulting on their mortgages. In the end, all paid dearly for taking bets that threatened their survival. Were they simply unlucky? Were they misled by rating agencies? Or, did they suffer from psychological pitfalls of their own?

The year before the financial crisis erupted, RBS led a consortium to acquire the Dutch bank ABN AMRO. The end result proved to be a disaster for RBS, ABN AMRO, and at least one other party. Sir Philip Hampton, who became CEO of RBS in the aftermath of the acquisition, described the initiative as “the wrong price, the wrong way to pay, at the wrong time and the wrong deal.”1 In other words, the outcome was not just a matter of bad luck but, as we shall see, a series of flawed decisions that were psychologically driven. Given that the acquisition set a record for bank takeover, the case is especially interesting.

Systemic risk and sentiment are core concepts of the FIH. A financial firm is systemically risky when it is too big to fail in a financial crisis, and as a result contingency socialism comes into play as it is rescued by government action. According to the FIH, the route to contingency socialism features the occurrence of euphoria during an economic expansion. Euphoria is the leading edge of sentiment. This chapter discusses empirical aspects of analyzing the coevolution of systemic risk and sentiment over time.

Regulation of the financial system will never be perfect, and so a key question facing regulators is how to mitigate the imperfections. Finance is complex, and complex systems fail in complex ways. This chapter analyzes key psychological phenomena impacting the process of regulating the financial system.

By its nature, the act of investing exposes investors to fraudulent activity by counterparties.1 Ponzi schemes represent one type of fraud. This chapter discusses risk management issues associated with the Ponzi scheme run by Bernard Madoff, which ranks as one of the largest in history. Initial accounts placed the losses to be between $50 and $65 billion, an amount that included fabricated gains. A court-appointed trustee estimated the losses in principal to be between $17.5 and $20 billion.2

When it comes to individual stocks, defining risk is tricky business. Investors can use return standard deviation for this purpose, but that definition is incomplete because it fails to take the benefits from diversification into account. They can use “beta” based on the capital asset-pricing model (CAPM), which does reflect a particular understanding about diversification, but many academic studies conclude that the CAPM does not work. They can use a multifactor model; however, there is no theory to identify exactly what the appropriate factors should be.

Risk managers need to understand more than the psychology impacting individual behavior. They also need to understand how these issues play out in organizations. Therefore, risk managers need to have an understanding of how insights from social psychology inform us about group behavior. In particular, risk managers need to understand the degree to which psychological pitfalls are mitigated or amplified by committees.

The distress experienced by one bank after another during the financial crisis revealed weak risk management practices. However, some banks appeared to have instituted sound risk management and were able to weather the storm without a bailout or a significant restructure. JPMorgan Chase was a bank that was viewed as a role model for best practice risk management, and its CEO, Jamie Dimon, was highly regarded.

Consolidated Edison (Con Ed) is a utility, and BP IS an energy company. Both are large firms that face large risks. This chapter uses the risk frameworks presented previously in the book to analyze and contrast the experiences of these firms in dealing with outliers, meaning rare and extreme events. For Con Ed, the rare event was Hurricane Sandy, which in 2012 struck the Eastern seaboard, including New York. For BP, the rare event was the explosion of the drilling rig Deepwater Horizon, which took place in the Gulf of Mexico in 2010.

The transportation industry touches almost everyone, as most people fly and drive. Therefore, risk management in the industry affects most of our lives directly As with everywhere else, psychology impacts decisions made within the industry about risk and safety.

If risk management were a game of tennis, then a forehand would correspond to the quantitative side and a backhand would correspond to the psychological side. The cumulative message from all the applications discussed in this book is that, although risk managers tend to run around their backhands, they can develop a more balanced game.

Risk managers need to understand more than the psychology impacting individual behavior. They also need to understand how these issues play out in organizations, and the important role of organizational culture.

At this point we turn our attention to risk management in the financial sector. The next several chapters apply the concepts developed to analyze the psychological dimension of risk management at major financial institutions that were at the heart of the global financial crisis. This chapter sets the stage by providing a general framework for understanding financial instability from a macroprudential perspective, in which macroprudential is understood as referring to the welfare of the financial system as a whole. To do so, the chapter presents the insights of acclaimed economist Hyman Minsky, who died in 1996. Minsky’s study and analysis of the causes and consequences of financial fragility, financial crises and economic instability are unparalleled.1

When it comes to the global financial crisis, the devil lies in the details. This chapter reviews the histories of two investment banks, UBS and Merrill Lynch, identifying the psychological issues that drove the decisions they made which promoted financial fragility and subsequent economic instability.1 Both banks participated actively in the market for CDOs constructed with mortgage-backed securities. Both banks practiced risk management poorly, and both banks incurred large losses as a result. What happened within these organizations that permitted this magnitude of errors?

In the early 2000s, there were three major rating firms in the United States: S&P, Moody’s, and Fitch. Rating agencies have reputational capital to protect: the opinions they express only have value if people believe those opinions are accurate indicators of creditworthiness. Therefore, in the lead-up to the global financial crisis, how in the world could two of these firms, S&P and Moody’s, have assigned triple-A ratings to many mortgage-related securities that plummeted in value when the housing bubble burst?1

Fannie Mae, Freddie Mac, and AIG specialize in taking tail risk, meaning the risk associated with rare, unfavorable events. During the housing bubble, all three accepted the risks of homeowners en masse defaulting on their mortgages. In the end, all paid dearly for taking bets that threatened their survival. Were they simply unlucky? Were they misled by rating agencies? Or, did they suffer from psychological pitfalls of their own?

The year before the financial crisis erupted, RBS led a consortium to acquire the Dutch bank ABN AMRO. The end result proved to be a disaster for RBS, ABN AMRO, and at least one other party. Sir Philip Hampton, who became CEO of RBS in the aftermath of the acquisition, described the initiative as “the wrong price, the wrong way to pay, at the wrong time and the wrong deal.”1 In other words, the outcome was not just a matter of bad luck but, as we shall see, a series of flawed decisions that were psychologically driven. Given that the acquisition set a record for bank takeover, the case is especially interesting.

Systemic risk and sentiment are core concepts of the FIH. A financial firm is systemically risky when it is too big to fail in a financial crisis, and as a result contingency socialism comes into play as it is rescued by government action. According to the FIH, the route to contingency socialism features the occurrence of euphoria during an economic expansion. Euphoria is the leading edge of sentiment. This chapter discusses empirical aspects of analyzing the coevolution of systemic risk and sentiment over time.

Regulation of the financial system will never be perfect, and so a key question facing regulators is how to mitigate the imperfections. Finance is complex, and complex systems fail in complex ways. This chapter analyzes key psychological phenomena impacting the process of regulating the financial system.

By its nature, the act of investing exposes investors to fraudulent activity by counterparties.1 Ponzi schemes represent one type of fraud. This chapter discusses risk management issues associated with the Ponzi scheme run by Bernard Madoff, which ranks as one of the largest in history. Initial accounts placed the losses to be between $50 and $65 billion, an amount that included fabricated gains. A court-appointed trustee estimated the losses in principal to be between $17.5 and $20 billion.2

When it comes to individual stocks, defining risk is tricky business. Investors can use return standard deviation for this purpose, but that definition is incomplete because it fails to take the benefits from diversification into account. They can use “beta” based on the capital asset-pricing model (CAPM), which does reflect a particular understanding about diversification, but many academic studies conclude that the CAPM does not work. They can use a multifactor model; however, there is no theory to identify exactly what the appropriate factors should be.

Risk managers need to understand more than the psychology impacting individual behavior. They also need to understand how these issues play out in organizations. Therefore, risk managers need to have an understanding of how insights from social psychology inform us about group behavior. In particular, risk managers need to understand the degree to which psychological pitfalls are mitigated or amplified by committees.

The distress experienced by one bank after another during the financial crisis revealed weak risk management practices. However, some banks appeared to have instituted sound risk management and were able to weather the storm without a bailout or a significant restructure. JPMorgan Chase was a bank that was viewed as a role model for best practice risk management, and its CEO, Jamie Dimon, was highly regarded.

Consolidated Edison (Con Ed) is a utility, and BP IS an energy company. Both are large firms that face large risks. This chapter uses the risk frameworks presented previously in the book to analyze and contrast the experiences of these firms in dealing with outliers, meaning rare and extreme events. For Con Ed, the rare event was Hurricane Sandy, which in 2012 struck the Eastern seaboard, including New York. For BP, the rare event was the explosion of the drilling rig Deepwater Horizon, which took place in the Gulf of Mexico in 2010.

The transportation industry touches almost everyone, as most people fly and drive. Therefore, risk management in the industry affects most of our lives directly As with everywhere else, psychology impacts decisions made within the industry about risk and safety.

If risk management were a game of tennis, then a forehand would correspond to the quantitative side and a backhand would correspond to the psychological side. The cumulative message from all the applications discussed in this book is that, although risk managers tend to run around their backhands, they can develop a more balanced game.