It’s (Not) All About the Money

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday November 23, 2012 at 12:00 pm
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Editor’s Note: The following post comes to us from Nizan Geslevich Packin at the University of Pennsylvania Law School.

In the paper, It’s (Not) All About the Money: Using Behavioral Economics to Improve Regulation of Risk Management in Financial Institutions, forthcoming in the University of Pennsylvania Journal of Business Law, I focus on the Dodd-Frank Act’s risk management provisions, and specifically the requirement that financial institutions create separate risk committees. The goal of this regulation is to mitigate risks to the financial stability of the US, because despite media attention to financial institutions and great regulatory efforts, including the focus on risk management, little has changed in financial institutions’ business cultures. Indeed, excessive risk-taking by such institutions is still rampant. In the article, I argue that risk-related decision makers do not make decisions about risk-taking in a vacuum, but in an environment where multiple factors, noticed and unnoticed, can influence the decisions. Such factors include cognitive-related biases and group-related biases, and there are tools, which have not yet been analyzed in literature that regulators can use to reduce undesired or excessive risk-taking. Indeed, by shaping such environmental factors in which risk-related decisions in financial institutions are made, regulation can help actors make better, less pro-risk-taking, choices. With the goal of reducing excessive risk-taking by financial institutions, this article builds on an emerging focus in behavioral law and economics on prospects for “debiasing” actors through the structure of legal rules. Under this approach, legal policy may reduce biases’ effects and judgment errors by directly addressing them. Doing so will then help the relevant actors either to reduce or to eliminate these effects and errors. Accordingly, the article suggests using behavioral economic-based legal guidelines to supplement the Dodd-Frank Act‘s risk committee’s requirement. Such legal guidelines would help reduce the degree of biased behavior that risk committees exhibit.

The legal guidelines proposed in the article focus on the composition, obligations and work procedures of the financial institutions’ newly mandated risk committees. These guidelines provide behavioral incentives that will not only help reduce excessive risk-taking, but may even raise social responsibility awareness, while not compromising financial institutions’ legal and financial responsibilities. The article uses JPMorgan’s 2012 multi-billion dollar loss and MF Global’s collapse in 2011 as case studies for certain behavioral effects and biases that are relevant in the context of risk-taking. As demonstrated in the article, the proposed guidelines, which address those biases, could have helped avoid — or at least mitigate the damages from — the great JPMorgan losses and the MF Global collapse. In addition, the article also demonstrates that incorporating such behavioral economic-based guidelines into the regulatory framework of financial institution’s risk management addresses at least the following deficiencies in the Dodd-Frank Act: (i) the Act ignores social influences and psychological biases on risk-taking and risk management; (ii) the Act’s solutions, for the most part do not counterbalance the existence of undesired financial incentives; (iii) the Act fails to raise awareness to some of the kinds of concerns the ‘corporate social responsibility,’ movement is concerned with and (iv) the Act provides insufficient clarity regarding the duties and obligations of those responsible for risk management at financial institutions.

The paper commences by presenting management theories, and in particular the way risk is managed in financial institutions. It then describes attempts made to regulate the duties and responsibilities of those responsible for risk management. It continues with an analysis of the existing relevant legal authorities on risk management and monitoring and explains why additional regulation or supplementary guidelines are needed. The article then moves on to introduce the field of behavioral economics and suggests using studies from that discipline to better regulate the composition, obligations and working procedures of risk committees. Such regulation will be aimed at counterbalancing negative biases, which can impact risk taking in financial institutions, and “debiasing” the relevant actors through the structure of legal rules.

The guidelines counterbalance negative biases in the following fashion. First, focusing on the composition of risk committees, the article examines the following biases and behavioral effects and suggests counterbalancing regulation: (a) the power of diversity, including diversity in gender, minorities representation, and opening-up to various professional backgrounds, and the effect this has on group dynamics and performance; (b) the experience factor — the difference in attitudes towards making riskier choices between risk managers with or without prior relevant experience; and (c) the choice shift phenomenon, pursuant to which groups make riskier decisions than individuals in finance-related issues, and the effect of independent directors on group dynamics and decision making.

Second, focusing on the obligations of risk committees, the article examines the following biases and behavioral effects and suggests counterbalancing regulation: (a) the impact of causing individuals to become more aware of their honesty standards, which decreases their tendency for deception, and the value of disclosure; and (b) the illusion of control and dealing with uncontrollable situations.

Third, focusing on the working procedures of risk managers and risk committees, the article examines the following biases and behavioral effects and suggests counterbalancing regulation: (a) the framing effect, which deals with the presentation of information, and specifically with the impact of presenting formulas or graphs versus verbal explanations on those making decisions based on the data presented; (b) the psychological impact that accountability has on performance; (c) the impact that the association of risk with potential disastrous outcomes has on decision makers and risk taking; (d) the theme of familiarity bias and its significance in the context of risk perception; and (e) the hindsight bias, which is the tendency to view events as being more predictable than they really are.

The full paper is available for download here.

 

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