The psychology of our bankers

The extensive analysis of the banking and economic crisis has been dominated by economic and finance experts. But on the surface anyway much of the explanation lies in psychology. So it is timely that the Irish Times carries a piece today by Vicky Menzies and Ken McKenzie providing a psychological analysis of bankers behaviour in the run up to the crisis.

Looking Forward to a Speedy Recovery..

I went to Dr. Alan Ahearn's talk last night about "Economic Firefighting". Dr. Ahearn is the special advisor to the Minister of Finance and is probably the main architect of the government response to the crisis, NAMA, and the on-going recovery efforts of the State. A serious job, to say the least.

The talk was interesting and largely positive about Ireland's prospects as we emerge from recession. Dr. Ahearn concurred with growth and employment forecasts and indeed with the views expressed by Mr Lenihan late last year - that the "worst is now over". He also attempted to dispel misconceptions about the "bank bailout" -- debunking the idea that the government are bailing out bankers and developers and arguing that the government are in fact bailing out the country and in doing so securing it's future viability and prosperity. The issue of NAMA for the "small-guy" was also convincingly dispelled as an illogical move. (aside: I think a temporary extension of the current '12-month foreclosure rule' for domestic homes is an area worth considering).

In general, I was in agreement with the arguments presented. There is, however, one thing that I want to pick-up and throw out there -- and it relates to the banks.

To me there are three distinct issues muddled up in our thinking about the banks here. The first issues is that the banking system needed to be salvaged to save the country from ruin. The second is that the banking system needs to be recapitalized in order to function. And the third is that the banking system needs to lend and take risks in the future to secure the country's future stability and prosperity. To date the main analysis and discussions have been about the first two issues. However you like it, NAMA is now a shut case; the deal is done and further energies debating its merits or otherwise are a waste. I think the issue that now needs to come into focus is HOW the banks will operate once they are recapitalized and what role the State can play in regulating and directing their operations.

At present we seem to be content with the notion that "if the banks have funds they will lend and all will be well!" This assumption is the height of our sophistication on this issue to date. I would argue that we're being foolish here, at best, and certainly missing an opportunity. I don't think anyone want banking as it was, or anything close to that and we're assuming that the banks will have learned their lesson -- they probably have to some degree but they will also have learned that they are invincible which isn't fortunate for the state. We know that need prudential banking, and we now know that we need banking to operate with some awareness of the macro environment and their role with in it. They certainly need to be willing and able to take risks again but they also need to remain civically responsible.

So what's happening on this issue? Well it appears that the Financial Regulator/Central Bank has been seriously reinvigorated and they are taking clear steps like increasing capital reserve requirements and sharpening their monitoring and intervention functions. This is all sensible, expected, and welcome. But is there room for some innovation here? One suggestion I would make is that we discuss this.

In particular, I think we should discuss whether the government could issue directives (or similar) to the banks, based on the macro-realities of the day, that would guide the types of lending and risks they take. In the current short/medium, such an ability would ensure that banks aren't taking misguided risks from their new knowledge of invincibility (moral hazard!) and, moreover, that they can actually facilitate real prosperity by lending to productive-enterprises rather than speculative-enterprises for example.

Here are two specific ideas that I think should be discussed further:

One, Ireland needs export-led growth yet Irish enterprises struggle to get credit lines open... Can the government do anything new to ensure that our re-capitalised banks will actually lend to Irish companies and enterprises that are seen as being of particular importance to the recovery and real and sustainable growth in the future?

Two, levels of personal debt in Ireland are some 220% of disposable income! This ratio is amongst the highest in the world. Do we want the re-capitalised banks to extend credit along these lines further and just do retail business as usual? Is there any sense, or legitimacy, in capping this level of debt? what is a sustainable and reasonable level for the country?

Geary Working Paper: Morgan Kelly on Credit Bubble

Morgan Kelly has been among the most forceful critics of government banking policy in Ireland in the last few years. His latest work on this is available as a working paper.

link here

Bankers compensation

The issue of the appropriate compensation/incentives for bankers is a hot topic given the financial crisis in Ireland and elsewhere. Many people, I suspect, just to want to string 'em up. On a more constructive note it is worth asking what behavioural economics & psychology can tell us about how bankers respond to incentives. This paper is a contribution to addressing that question.

Banker compensation and confirmation bias.
Sabourian, H. Sibert, A.C.
Confirmation bias refers to cognitive errors that bias one towards one's own prior beliefs. A vast empirical literature documents its existence and psychologists identify it as one of the most problematic aspects of human reasoning. In this paper, we present three related scenarios where rational behaviour leads to outcomes that are observationally equivalent to different types of conformation bias. As an application, the model provides an explanation for how the reward structure in the financial services industry led to the seemingly irrational behaviour of bankers and other employees of financial institutions prior to the credit crisis of that erupted in the summer of 2007.
http://d.repec.org/n?u=RePEc:cam:camdae:0940&r=cbe

Negative idea?

In a recent article in the New York Times Havard Professor Gregory Mankiw proposes the US Federal Reserve cut interest rates below zero. In essence a -3% interest rate means that one could take out a loan of $100 and only have to pay back $97 dollars in a years time. I have some bad news to those rubbing their hands with glee at the prospect of getting "free" money - Prof. Mankiw also outlines a mechanism that ensures this won't happen. Take every dollar bill - in a years time the Fed pick a random number from 0-9 and if that number appears first on the note it would be made redundant.

The idea is purely tongue in cheek (and the kind of extraordinary outside the box thinking that we need in these extraordinary times), but it does raise the issue of why 0% is considered the lower bound for interest rates.

Personally speaking I'm quite concerned about the drive towards low (even negative interest rates). Do we (developed countries) really need to be stimulating short term spending in this way to get back to our former level of long-term growth rates? Under-capitalised banks have been a symptom of our the current global economic malaise. Long story short - people borrowed too much and didn't save enough. Banking simply doesn't work unless the lender has the capital (savings) to finance their lending practices. In summary, people need to borrow money from other people's savings. This has to happen in the long-term regardless, so why are policy makers trying to squeeze every last consumption drop out of their respective populations? Surely if there wasn't some kind of paradox of thrift effect then the banks would become fully capitalised and start lending again, enabling us to move away from bank guarantee schemes, government re-capitalisation and nationalisation.

Surely we've learned that encouraging people to spend money for instant gratification is not a good thing. I'm not sure the need for balance is being addressed properly.