Monday, January 23, 2017

Has history known a worse and more dangerous case of confirmation bias than that of current bank regulators?

Confirmation bias, also called confirmatory bias or myside bias,[is the tendency to search for, interpret, favor, and recall information in a way that confirms one's preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities. It is a type of cognitive bias and a systematic error of inductive reasoning. People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. The effect is stronger for emotionally charged issues and for deeply entrenched beliefs. People also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and memory have been invoked to explain attitude polarization (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be false), the irrational primacy effect (a greater reliance on information encountered early in a series) and illusory correlation (when people falsely perceive an association between two events or situations).

A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work reinterpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way.

Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts:

The Basel Committee for Banking Supervision's and other bank regulator's confirmation bias. 

Regulators think, as they should, as it is, that what is rated below BB- is much more riskier than what is rated AAA. 

But when deciding on the risk weights to be used for the capital requirements of banks in Basel II of 2004, the regulators directly extrapolated from these beliefs and assigned 20% to the AAA rated and 150% to the below BB-. That is probably one of the most dangerous cases of confirmation bias in history.  Regulator should not have looked at the risk of the assets but at the risk of the assets to the banks, which is not the same thing.

The truth is that precisely because the below BB- is perceived as very risky, that makes it much less risky for the banks; while the AAA rated which is perceived as very safe, precisely because of such perceptions, is what could lead to those dangerously high bank exposures that can cause a huge bank crisis if the ex-post reality turns out to be different.

We are in 2017 and the regulators, because of "belief perseverance", have still not discovered their own confirmation bias… and that even after the mother of all evidences, represented by the AAA rated securities backed with mortgages to the subprime sector turning out to be so very risky.

That this was the fault of credit rating agencies is hugely irrelevant. The better the ratings are, the more confidence is deposited in these, and so the worse do the doomsday scenarios become.

Does anyone know a worse case of confirmation bias?

The dangers? First of course that banks will get caught with their pants down, little capital, precisely when one big exposure might get hit. But second, it introduced a senseless risk aversion that have banks no longer financing the riskier future but only refinancing the “safer” past and present… so our economies are stalling and falling.

PS. Are you still unsure of this? Then try to get the regulators to answer you these questions

PS. In this case it is not only regulators who suffer from “belief perseverance”. Prestigious and influential economists like Martin Wolf, even when being told that the safer is riskier and the riskier is safer, can’t get a grip on the issue.