July 19, 2012

Can Behavioral Finance Stop a Financial Crisis?

While the theory can be helpful, the application may still be too unrefined

Can behavioral finance be effective in combatting financial crises? As policymakers around the world continue to deal with the legacy of the 2008 crisis, some are considering incorporating elements of behavioral finance into their proposals as they look to strengthen systems for the future, based on the view that financial crises are at least partly the result of behavioral factors. But while behavioral finance as both a theory and a practice has a lot to offer, it is not yet evolved enough as a science in order to be applied toward the resolution or prevention of financial crises, says Michal Skorepa, author of the 2011 book “Decision Making: A Behavioral Economic Approach,” which surveys human decision making from an economic perspective.

Skorepa, who is an advisor to the Czech National Bank, shared with AdvisorOne his thoughts on how he believes behavioral finance should evolve in order to be effectively applied toward financial crisis prevention and resolution, and in which areas it’s most effective today.

Why is behavioral finance being considered for the prevention and/or resolution of financial crises? How is that central banks/policymakers are interested in behavioral finance?

I think the main reason for this has been the fact that the latest crisis started with the wave of subprime mortgage defaults in 2007. Many American families seem to have succumbed to the pressure of mortgage brokers either on the wrong assumption that if house prices had been rising, they were bound to rise forever, or because many home buyers did not understand how their mortgages would work financially. Later on, it turned out that even many financial professionals probably underestimated risks involved in complex securities that they were buying. Issues like wrong assessment of trends and risks--and also overestimation of one’s own ability to assess these issues--are among the central topics in behavioral economics and behavioral finance, as is clear also from my book.

In what ways are policymakers looking to use behavioral finance to either solve or prevent large-scale financial crises? Do you have any examples of tools that different central banks, for instance, may be considering, or any policies that may include behavioral finance principles?

The general claim that all financial crises, including the latest one, are at least partly caused or amplified by behavioral factors certainly makes sense. To the best of my knowledge, however, this claim has so far been transformed into only few significant specific practical applications. For example, one area where behavioral fallacies may kick in is the determination of credit risk ratings, including banks’ internal risk weights used for the calculation of the various capital adequacy ratios in bank regulation based on the Basel rules. These ratings may be pro-cyclical for behavioral reasons; that is, in boom times the assessor may start to exhibit excessive optimism and assess a given borrower more positively than would be objectively appropriate. All steps taken by regulators to reduce the reliance of bank regulation and supervision on such ratings can therefore be viewed partly as addressing behavioral issues. To take one specific instance, the brand new Basel III regulation emphasizes the leverage ratio; that is, capital relative to total rather than risk-weighted assets.

Do you think it makes sense to incorporate behavioral finance principles to financial crisis resolution?

Such an effort would certainly be sensible. The problem is that behavioral economics and finance findings tend not to be ready for such applications yet. Indeed, while the regulatory measures I mentioned before may be partly motivated by behavioral considerations, I do not think that specific behavioral economic findings played much of a role either in their conception or specification.

You have said that the scope of behavioral finance is as yet too narrow for solving or preventing financial crises. Why is this the case?

The problem is that most findings in the academic literature still refer to grossly simplified situations only. Also, the more we know about human thinking, the more we see how conditional it is: Change the circumstances a bit and people seem to not exhibit a given bias anymore, or they even commit it in the opposite direction.

What aspects of behavioral finance can potentially help in the area of financial crises, if any at all? How does behavioral finance--the theory as well as the practice--need to evolve, in your opinion, in order to be effective in combating financial crises?

The conditionality needs to be mapped first--that is, we need to know more on how different people in different situations assess risk, probabilities, the future, their own knowledge, experience, abilites, reliablity of their recollections of the past and how they incorporate these complex issues in their decision-making. But I am afraid that applications in the prevention of financial crises will remain limited. Right now, they are limited because we do not know enough. Llater they will be limited because of the conditionality. Practical guidelines need to be simple and robust, rather than sensitive to a long list of fine considerations.

Where do you think the application of behavioral finance is proving successful and why?

The above is not to say that behavioral economics and finance are without useful real-life applications. But they are more likely to occur on the micro level. For example, a lot of attention has rightly been devoted to the power of nudging; that is, of one fairly commendable option being set by the authorities as the default which, however, can be changed easily if a given individual wants to. Another area where this research may help is consumer protection--for example, the format of information on various investment or loan products may be regulated such that retail clients notice and understand all the important parameters and implications. Also, applications seem looming in the areas of microfinance and economic development more generally.

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