Behavioural Psychology, Finance, and the Question of Social Accountability

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Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes

^1. For a general discussion of biases in judgements under uncertainty, see Tversky and Kahneman, “Judgment under Uncertainty.”

^2. Gennaioli and Shleifer dismiss this theory arguing that banks knew as much as their clients, as allegedly proven by the following facts: that they kept some Mortgage Backed Securities (MBS) on their books; that some of their mid-management staff lost their job and investments; that the data they presented to clients showed optimism. Yet these “facts” have little weight when compared to the amount of evidence that shows how bankers intentionally misrepresented information they had to both clients and regulators, so building on them is disingenuous. By estimating that “households, financial institutions, and policy makers all shared the optimism about the housing market and securitization…[and that] banks shared the optimism and sought to exploit it and, like everyone else, got into trouble,” the authors assume a black-and-white scenario where all these actors were gaining the same from the system that caused the crisis, and all lost the same from that crisis. In this scenario there is no causal link between the astronomical returns on capital and labour in the banking, financial and real-estate industries, and the stagnant or shrinking returns in most other industries and in the real economy in general, throughout the eight years prior to the crisis and during the crisis itself. As per the intentionality in financial fraudulent practices, one only needs to read the minutes of the hearings of the 2008 U.S. Financial Crisis Commission to learn about the level of malicious awareness, misrepresentation, and manipulation in the financial industry in the years before 2008.

^3. The theory posits that financial intermediaries and investors alike neglected risk, and this caused an overexpansion of the financial sector, which was the reason behind its fragility and crisis. The mechanisms through which neglect of risk caused an over-heating of the financial system are three: (1) financial intermediaries (e.g., traditional banks, investment banks) issue to investors demanding safe assets (e.g., hedge funds, pension funds, sovereign funds) an excessive amount of safe debt (AAA-rated Mortgage Backed Securities) for any level of fixed volume of assets they have (e.g., mortgages, with all risky mortgages being perfectly correlated and therefore with no scope for diversification from pooling); (2) financial intermediaries issue an excessive amount of subprime mortgages to sustain the issuance of AAA debt; (3) financial innovations (pooling and tranching) pushes the intermediaries’ propension to issue assets and safe debt under the illusion that they are diversifying both idiosyncratic risk and systemic risk. Moreover, the crisis was potentially worsened by the fact that pooling causes all intermediaries to be equally exposed to revenue shortfalls, while in a no-pooling scenario some of the intermediaries may receive good idiosyncratic draws which allow for a more paced and ordinate liquidation process of those intermediaries who received bad idiosyncratic draws, thus avoiding panic, fire sales and crisis.

^4. In line with behavioural psychology, the theory posits that systematic forecast errors—and therefore deviations from rational expectations—cannot be explained by “bad luck” but have to be related to a certain faulty “methodology” used by our brains. The authors show that financial intermediaries and investors across different industries with different levels of sophistication have what they call extrapolative expectations (e.g., recent-biased expectations), meaning that they expect future stock returns to be in line with the current situation: high when they are currently high, low when they are currently low. However, historical correlations point at the contrary: high market valuations (typically causing high returns) are associated with lower returns going forward, and vice versa. Consequently, when “stock market returns have been high, investors expect high returns to continue, but in reality, the returns are, if anything, on average low” (A Crisis of Beliefs, 117), and vice versa.

^5. See Lipton, The Biology of Belief.

^6. See Malkiel, Random Walk Down Wall Street.

^7. See Soros, Alchemy of Finance; and Popper, Objective Knowledge.

^8. An understanding often represented in popular culture through expressions such as “make-believe,” “self-fulfilling prophecy,” and “fake it till you make it.”.

^9. The authors recognize the existence of this mechanism: “How much were the policies shaped by the neglect of risk, how much by a lack of legal authority to intervene in the financial sector, and how much by the fear of spooking markets and precipitating an earlier crash?” (62). However, after having been mentioned, the second option is not pursued.

^10. For example: “securitization specialists working at investment banks were just like everybody else” (53), which implies symmetry of information; “There is no trickery by intermediaries in this model” (87), which ignores the parliamentary and judiciary evidence that has emerged since 2008, while implying that everyone’s interests were aligned; and both “investment banks and rating agencies relied on incorrect models to value MBS and especially CdOs… underestimating the correlation in the defaults of individual mortgages” (55), which implies that the top managers in the best paid firms of the world were not aware of basic features of basic portfolio asset management models, such as the diversification of idiosyncratic and systematic risk as it is taught in the CAPM model in any MBA course in the world.

^11. For example, in discussing the excessive creation of MBS, “push” factors (intermediaries wanting to maximize returns and engaging in all described practices, including creating excess AAA debt out of a pool of mortgages, expanding the pool of mortgages to subprime in order to create fodder for debt/MBS, retaining all the risky equity on their balance sheet in view of a positive economic outlook) are mostly ignored, while much of the drive is portrayed as coming from the “pull” factor: e.g., investors wanting a safe debt.

^12. For example, by not mentioning that credit agencies were harshly criticized in US congressional reports for failing to adhere to their own credit-rating standards and falling short on their pledge of transparency, accepting to rate AAA assets they knew were much riskier. In particular, the U.S. Senate released documents showing how employees at Moody’s and at S&P were aware of housing market troubles well before the massive downgrades in July 2007 (House Committee Meeting— “Credit Rating Agencies and the Financial Crisis,” October 22, 2008).

^13. While it is commonly recognized that extraordinarily few have been formally charged for their role in the 2008 financial crisis, journalistic sources suggest that the US Securities and Exchange Commission still brought charges against more than 150 people and institutions in the four years after 2008. All in all, the Financial Times found that 47 bankers from 7 countries went to jail worldwide for their role in the financial crisis (https://ig.ft.com/jailed-bankers/). By comparison, following the savings and loan crises of the 1980s and early 1990s, more than 1,000 bankers were convicted by the U.S. Justice Department alone.

^14. In 2011, the U.S. Financial Crisis Inquiry Commission concluded that “many of these [financial] institutions acted recklessly” and that the “financial crisis was avoidable” if only financial institutions would not have engaged in “predatory lending practices, dramatic increases in household mortgage debt, exponential growth in financial firms’ trading activities.” They also pointed at the fact that credit ratings agencies “were key enablers of the financial meltdown.” Crucially, the Commission recognized the role of “widespread failures in financial regulations” due to “more than 30 years of deregulation and reliance on self-regulation.” (“Financial Crisis Was Avoidable, Inquiry Finds,” The New York Times, January 25, 2011).