Reflections on Daniel Kahneman’s Contributions to Risk Management: The Power of Human Frailties

Why do some banks take on too much risk? While there is no simple answer to this age-old question, human behavior certainly has had a big effect on risk-taking. Indeed, people are influenced by beliefs and biases, and sometimes act in an economically irrational manner when attempting to frame losses and gains.

We were reminded of these truths by the recent passing of Daniel Kahneman, the Nobel Prize-winning psychologist and Princeton University professor whose groundbreaking Prospect Theory opened our eyes to how behavior impacts decisions and risk-taking. Kahneman’s theory, which scored him the Nobel in economic sciences in 2002, essentially asserts that people tend to be risk-averse when pursuing potential gains and risk-seeking when considering potential losses.

Clifford Rossi

This finding on the seeming asymmetrical nature of risk/reward was reached only after Kahneman performed a series of experiments on human behavior – first in the 1970s and later in the 1990s – with Stanford University psychologist Amos Tversky. (Prospect Theory was born from this research, and if Tversky had not passed away in 1996, he likely would have shared the Nobel Prize with Kahneman.)

The notion that risk-taking is characterized by asymmetry in terms of gains and losses contradicted the previous widespread belief in classical economics that decisions were made by “fully rational actors” who were dedicated to making logical, unbiased choices that would minimize losses. Kahneman and Tversky radically shifted perspective on risk-taking, leaving behind a legacy that the reminds us that the business of banking isn’t simply a dollars and cents enterprise.

The Psychology of Risk Management

Psychology plays a large role in how we think about risk, which has far-reaching implications for risk managers today.

Whether driven by an individual institution or a systemwide panic, banking crises seem to be recurring phenomena – despite the ever-increasing amount of regulation and supervisory oversight imposed on the industry. So, how is it that otherwise well-established institutions – with in many cases storied backgrounds – wind up in trouble?

Ever since I left the financial services industry for academia 15 years ago, this question has haunted me. Undoubtedly, deficiencies in how risks are controlled are an important contributing factor to any major risk event. But that only paints part of the picture.

While the banking model is to some extent a variation on the classic constrained profit-maximizing agent, human behavior tends to turn that framework upside down at times. This is where Kahneman’s work, and the insights of other behavioral finance researchers, comes into play.

Kahneman and Tversky taught risk managers that decisions are influenced by various beliefs and biases that affect the way we all perceive risk. What can we learn from their pathbreaking theory, and what is its applicability to real-life risk management at banks?

Applications to Bank Decision-making

As it turns out, a theoretically sound explanation for bank risk-taking can be found in the concept that people may not act in an economically rational manner when it comes to framing losses and gains.

Risk outcomes that are influenced by cognitive biases and beliefs are amplified when senior executives are involved. The basic model of Prospect Theory – combined with herd mentality, recency, confirmation and anchoring bias – explains much about how banks can get off track by taking on too much risk. This rings particularly true at firms where incentive compensation plans exist.

Assuming that bank management maximizes their expected utility, which is based in large part by their incentive compensation structure, Prospect Theory’s asymmetric risk outcomes play an important role in how risks are taken.

When incentive compensation plans are tilted more toward business than risk outcomes, senior executives become less sensitive to losses than to gains. According to Prospect Theory, management is risk averse when compensation plans are balanced and risk-seeking on upside gains when compensation plans favor short-term performance over long-term risk-adjusted return.

The degree of sensitivity management has to gains versus losses, in other words, ultimately drives the degree of risk-taking at the firm.

Risk Aversion vs. Risky Behavior

What drives the differences in the degree of management risk aversion? Differences arise largely by the extent to which managers are affected by cognitive biases, as well as by the effectiveness of the governance process that a firm has in place.

On a personal level, this model bears out well from my own experiences, as well as those of other CROs, around the time of the 2008 crisis. Some banks at that time were, in short, afraid of losing market share to rivals. Stories exist about board and management risk meetings where senior leaders were insistent that the bank had to match the competition’s product set, even if that meant developing an untested product that was much riskier than anything in the bank’s existing portfolio.

Likewise, decisions were sometime based on dubious “facts” that reflected strange biases. There was one story, for example, about a senior bank executive basing his outlook on housing markets partly on the “wisdom" imparted to him by a Las Vegas taxicab driver, who felt that housing would hold up just fine in his city.

Lamentably, such biases continue today.

Think about it: How is it that a bank opens millions of unauthorized bank accounts, or takes no action to reduce its interest rate risk exposure when interest rates are clearly on the rise?

Parting Thoughts

The combination of Prospect Theory, cognitive bias, incentive compensation and governance provides us with a model for how banks take risk. Banks with strong governance and oversight can hold their risks in check; banks on the opposite end of the spectrum will likely suffer damaging effects from management teams imbued with cognitive biases that reinforce a lesser degree of risk aversion.

Kahneman and Tversky offer an enlightening roadmap for how banks take risk. Risk-taking isn’t some sterile activity driven purely by numbers. Indeed, it is affected more by intrinsic biases held by managers, as well as by their asymmetric views toward gains and losses.

The sooner we recognize these tendencies and biases, the sooner bank boards can take corrective action to limit the degree of risk-taking when it starts to manifest. Boards would be well-served to not only look at their own beliefs and biases but to also put Kahneman and Tversky’s theory to the test by evaluating the extent their management teams are blinded by inherent biases and views.

Clifford Rossi (PhD) is the Director of the Smith Enterprise Risk Consortium at the University of Maryland (UMD) and a Professor-of-the-Practice and Executive-in-Residence at UMD’s Robert H. Smith School of Business. Before joining academia, he spent 25-plus years in the financial sector, as both a C-level risk executive at several top financial institutions and a federal banking regulator. He is the former managing director and CRO of Citigroup’s Consumer Lending Group.