Wednesday, February 4, 2015

The most important behavioral, cognitive psychology, research program ever

Bank system crises never ever result from excessive exposures to what is perceived as risky, these always results from excessive exposures to what was erroneously perceived as safe.

And yet bank regulators imposed on banks credit-risk-weighted equity requirements that are much higher for what is perceived as risky than for what is perceived as safe.

That is very clearly a monstrous mistake. It means that is something really bad happens to banks where that usually happens, regulators have made sure banks will stand there especially naked, with no equity to cover themselves up with. 

And my thesis is that the at-first-sight, Daniel Kahneman's “System 1: Fast, automatic, frequent, emotional, stereotypic, subconscious” standard basic intuition of “risky-is risky and safe-is safe”, is way too strong so as to permit opening a more reflective “System 2: Slow, effortful, infrequent, logical, calculating, conscious” analysis… and this most specially if that means questioning some other members of a mutual-admiration/ mutual-importance-reinforcement club. 

And that is the subject I would like to see researched by experts in behavioral finance and in cognitive psychology.

But why do I call this “the most important research program ever”?

Easy! Those regulations allow banks to leverage the back-stop supports that for instance central banks give more on assets perceived as safe than on assets perceived as risky; and that means banks will obtain higher risk-adjusted returns on their equity on assets perceived as safe than on assets perceived as risky.

That has introduced a regulatory risk aversion that seriously distorts the allocation of bank credit to the real economy.

And since risk-taking is the oxygen of any development, and what helped to bring the Western world to where it is, suspending it, de facto prohibiting banks from taking risks on the “risky”, our economies will first stall and then fall. And I hope you’d agree that’s not entirely unimportant.

Reading Daniel Kahneman's "Thinking Fast and Slow"