Not So Smart Bankers & The Madness of Crowds

Image: From ABC News

Do you think people are getting smarter? Do you think we know more about the risks inherent in running economies and businesses? Do you think we will look to others to work out what we should do? Do these sound like loaded questions? Of course they are, however there is a point to be made. Knowing more doesn’t stop us being human and making the same errors people have in the past. The context and details may differ however the errors are the same.

History Repeats Itself

In early 18th century France an investment bubble developed around shares in the Mississippi Company. Trading over a period became frantic. Normally sober people found themselves investing and those who recognised what was happening were sometimes mocked and just as often developed significant doubt about their attitudes to the trade. At dinner parties, being the only person who seems not to be making great profits can be a deflating experience. Even the person responsible for the float of the company could not dissuade people from being overzealous. Of course the company went bust. It is all beautifully chronicled in Charles Mackey’s entertaining  “Extraordinarily Popular Delusions And The Madness of Crowds” published in 1841. It’s a great read as an introduction to what would now be referred to as behavioural economics. And more importantly to draw parallels to the boom phase that led up to the crash in 2007/8. There is the possibility it could be applied to the inflated Australian markets as well.

Four Cognitive Errors

The thing that behavioural economics suggests is that even when people know about the characteristics of markets and the real possibility of a bust, they are still at risk of doing four things.

1. Convincing themselves that their situation is different to other examples;

2. The participant believes they will manage the situation better than those before them (after all we’re smarter); and

3. The participant believes they will be better able to judge when to get out or pull back from the situation so as not to lose … an extension of the first two items.

4. The participants will look to others in their situation for ‘social evidence’ that they are doing the ‘right’ thing.

Did Banking Executives Learn Anything From The GFC?

Some examples of the above behaviour emerged in the Australian Financial Services Royal Commission. As we wait for the findings from the Commission we already know that the industry engaged in behaviour that seems crazy on any inspection following the Global Financial Crisis … and it did this without missing a beat. They did this with considerable disregard for the effect on the Australian economy and public, while believing that the Australian context is different, that they could manage the situation (sometimes using only Public Relations) and would know when to pull back (not push the regulator too far). Smart people engaged in and facilitated bad behaviour and made poor, unethical and probably illegal decisions. They did this in the knowledge that others in the industry were engaging in similar behaviours (social evidence) and like athlete drug-cheats they argued that they needed to do the same to be competitive. 

It is easy to question whether the Australian Financial Services executives collectively learned anything from the Global Financial Crisis … though I’m certain they could talk for hours on the topic. The consequences of their behavior for the economy (the misallocation of capital and reduced consumer spending) and consumers (overpriced housing and increased debt) are still to be fully realised. The basic operating principle of the financial sector is to transfer risk (and costs) to the consumer (and the government) and it is likely they are already taking steps to remedy their situation by methods that do exactly that. Following the October 1987 crash (now long forgotten) the Australian financial services industry adopted methods that made it more difficult to hold Fund Managers and others responsible for investment decisions and performance. In part, this involved making customers more involved in the asset allocation process. I would be surprised if the same motivations to disperse responsibility do not surface again.

There is a lot more going on from a social psychology/ perspective however, that can be another discussion.

Survivor Bias

Australian banks mostly survived the Global Financial Crisis quite well. A paper by Stephen King (2013) for the Economics Society of Australia summarised, ” it appears that Australia’s banks did well during the GFC for three reasons: Goldilocks competition – neither too hot nor too cold; strong regulation; and decisive government intervention when needed”. It is unlikely that the bankers in Australia are significantly better than elsewhere, however it is likely that Australian bank executives probably feature in their own explanations of the crisis. These global survivor/heroe bankers get to tell their story of the GFC. Unfortunately, it can also give rise to rationales that can fuel more risky behavior.

Statistically speaking, in any ‘risky’situation, there is some percentage of participants that will do just fine and get out … by good luck or good management. Many will not! The errors of underestimating risk, and overestimating management ability and judgment are not limited to investment and financial behavior. Similar errors will make themselves known in almost any complex project or change management initiative. As stated previously, the paradox is that knowing this will not stop it happening again, though good processes can help. Observers, such as journalists and even academics, will look for wisdom from those who survived and profited. And generally, the survivors/winners will provide it- making us all more confident. This is known as the ‘survivor bias’.

The Challenge and Politics

The challenge for organisations and leaders is to build cultures, processes, and regulations that promote good judgment, and healthy competition, innovation and risk-taking. We may not be able to stop people from making errors however we may be able to mitigate the worst of the impacts. From an organisational behaviour perspective changes will require a good understanding of everything from corporate governance to corporate culture, competitive/market dynamics, decision making and perhaps even the role of Psychopathology (e.g. narcissism and psychopathy/sociopathy) in the business sector. The benefits to society, the economy, organisations, and the individual are potentially dramatic over time.

There is a lot of politics in changing in the Financial Services Sector (not least making worse the competitive advantage of the large four banks over the 70+ smaller customer owned banks in the Australian market). Regardless, long term success will require that the Regulators remain independent, and the same goes for any change practitioners. Capture by the industry participants limits the effectiveness of both.

I hope to explore just some of those topics in future blogs.

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Filed under Change Management, Corporate Culture & Strategy, General Business, Uncategorized

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