The Determinants of Risk Attitudes in Ireland and the United Kingdom

An Analysis of the Determinants of Risk Attitudes in Ireland and the United Kingdom
- by Kieran McQuinn and Nuala O’Donnell
Irish Central Bank Research Paper, May 2010

This paper (linked above) uses a measure of attitude to risk in the financial domain. Attitude to risk is elicited using a six-point Likert scale; the information in this variable is transformed into a binary indicator which is the regressand in a probit model. The results show that people from ethnic backgrounds appear to be more risk averse, while married people and males seem to have a significant preference for risk. It also appears that the greater the degree of population density, the greater the preference for risk. It is suggested that improving educational attainment within the population can increase preferences for risk. It is also suggested that risk preferences are a significant determinant of an individuals ability to accumulate wealth.

Psychology, Financial Decision Making and Financial Crises

Thanks to Michael D., for sending on this fantastic overview from the recent edition of Psychological Science in the Public Interest. Psychology students and graduates, the world needs you!

Psychology, Financial Decision Making, and Financial Crises

Tommy Gärling, Erich Kirchler, Alan Lewis, and Fred van Raaij

How could the current financial crisis have happened? While fingers have been pointing to greedy banks, subprime-loan officers, and sloppy credit card practices, these are not the only contributors to the economic downturn. A new report examines the psychology of financial decisionmaking, including the role of risk in making economic choices, how individuals behave in stock and credit markets, and how financial crisesimpact people’s well-being.

Risk taking is a very important component of financial decision making — If we take out a big loan, will we be able to pay it back? Should we buy shares of a company that is unknown but has potential for great success? When it comes to making decisions under uncertainty, people tend to be more influenced by perceived risk than by objective risk. People who are extraverted and high in sensation seeking are likelier to take more andhigher financial risks than are people high in conscientiousness and anxiety. Stock market investors are prone to cognitive biases (such as overconfidence), which are reinforced by affective and social influences, and these may contribute to several phenomena observed in stock markets (e.g., volatility of stock prices due to excessive trading). Credit use involves many different stages of decision making, including deciding whether or not to purchase a product using credit and determining a strategy for paying back the borrowed money.

Financial crises take a large toll not just on people’s wallets, but also on their behavior. Consumer confidence affects spending and saving. Individuals cope with financial crises in a number of ways, for example by shopping in cheaper stores and eating out less. Making lifestyle changes (e.g., selling the car, making their own clothing) is very difficult for most people and is often a last resort to dealing with economic troubles–these changes clearly signal to themselves and others that they are struggling financially.

Are financial crises inevitable? The authors argue that bringing about change in financial institutions may not be easy, but they offer suggestions for improving economic decision making. For example, educating consumers — by offering economics courses to children in school and teaching consumers how to appropriately handle credit — and by making financial institutions more responsible (e.g., banks offering Web-based programs to assist with budgeting).

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?

Protecting Consumers

Becker and Posner both address the creation of the Consumer Financial Protection in the US. This agency emerges from the Obama administration partly in response to the arguably ill-informed decisions made by financial consumers during the last 10 years, and is heavily grounded in the behavioural ideas of Thaler and Sunstein. Posner argues that the current wave of regulation is excessive and gives the examples of smoking health warnings back in the 1960s and food safety inspections as legitimate forms of consumer protection. The difference between these and the financial decision making case, according to Posner, is that the market failure is clear in the case of both smoking and food safety legislation and the potential remedies are clear and welfare enhancing. He argues that potential market failures from poor financial decision making are harder to demonstrate and to remediate, leading to poorly targeted and expensive government regulation. He argues for obesity as a case where there may be a case for intervention arising from the high health-care cost externality resulting from elevated population chronic illness prevalance.

Becker is even tougher on the bill.

"I believe that a Consumer Financial Protection Agency will hurt rather than help consumers. Despite the claim that ignorance induced many consumers with few resources to buy houses during the boom, consumers who bought a house then with almost no down payment and low interest rates were not displaying ignorance, but good sense." 


He makes the classical argument against behavioural intervention.


"In the vast majority of cases, consumers, even those with little education, know their own interests far better than government officials know them."

Becker is also far tougher on obesity externality arguments than Posner, arguing that they distort consumer decisions. He leans on the side of allowing insurers to price obesity into insurance costs, a debate that would be worth having here.