The Psychology of Risk

>Posted by Kirsten Hansen
Risk. This four-letter word was prominent in the major headlines last week, as legislators met with the CEO of JP Morgan to discuss the company’s 2 billion dollar losses. Why had JP Morgan taken such enormous risk? Why had JP Morgan’s risk management strategies failed to prevent the risky trades?
In times of financial crisis, risk is an easy scapegoat. The financial institution took on too much credit risk. Interest rates on the company’s liabilities rose unexpectedly. If risk were fundamentally bad, the obviously solution would be eliminating all risks. But, as outlined in a recent Harvard Business Review article, for every financial institution there are always risks that a company actually chooses to take on in order to generate returns, and which are well encapsulated in the idiom, “Nothing ventured, nothing gained.” Since such strategic risks can’t be eliminated but are an essential part of the pursuit of returns, such risks must be carefully managed to maximize potential gains and minimize potential losses.
Effective strategic risk management is far easier said than done however, and experts are trying to figure out why. Last week’s New York Times article, “The Biology of Bubble and Crash,” by John Coates argues that risk assessment traditionally, and wrongly, has been viewed as a “purely intellectual affair, involving the calculation of asset returns, probabilities and the allocation of capital.” In contrast, the Harvard Business Review stresses the role of psychology in our perceptions of risk, citing the human tendencies to be “overconfident,” to “anchor our estimates to available evidence”, and fall victim to “groupthink.” Effective risk management, it follows, must take into account subconscious human folly. Similarly, as Nassim Nicholas Taleb argued in his bestseller The Black Swan, the greatest risks are those we do not even conceive of until they occur, and therefore risk management must prepare for the unknown and unthinkable.
Whether the origins of misguided strategic risk-taking are intellectual, psychological, biological or some combination is unlikely to be resolved in the near future. But the implications of this question suggest that truly effective risk management strategies for financial institutions, including microfinance institutions (MFIs), must be similarly multifaceted. MFI’s, being credit providers, are explicitly in the risk business. Hence, credit risk, the risk associated with lending money and not getting it back, is inherent for MFIs. Thus an MFI deciding whether and what type of loan to make must be conscious of “optimism bias”, and properly evaluate the creditor. A loan officer may be overconfident about the probability or the size of returns and decide to make a loan without full consideration of the creditor’s credit history and circumstances. If the loan was subsequently not repaid, the loan officer might then exhibit “confirmation bias” and suppress information that would suggest the loan was a bad idea in the first place. Similarly, board members of MFI’s should be aware of their psychological tendencies when making business judgments on behalf of the financial institution. As explained in David Lascelle’s recent publication “Microfinance—A Risky Business”, a board, faced with increasing competition from other MFIs or banks, may choose to lower credit standards in order to increase the volume of loans. An individual board member uncomfortable with this new higher level of risk, may then succumb to “groupthink” and accept the decision of the rest of the board, rather than voice concerns about the new standards. That people have a tendency to inaccurately assess risk is nothing new, but recent insights into human psychology  reinforce the challenge of successful strategic risk management. Only when strategic risk is successfully managed on all fronts will MFIs experience the greatest returns and avoid crisis.
Image credit: andyellwood.com

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