Banking Mess: Blame Our Brains

As the current financial chaos moves toward some kind of resolution, there will no doubt be plenty of Monday morning quarterbacking to explain what went wrong. One group that one wouldn’t expect to have explanations are neuroscientists. As it turns out, neuroscience researchers actually can shed some light on why things went so wrong.

One of the first questions that everyone asks is how so many seemingly intelligent people could make so many errors in judgment. One simple answer, of course, is greed – at least some individuals saw a way to profit personally by making poor business decisions (loaning money to people unlikely to be able to pay it back, insuring such loans, rating securities based on these shaky loans, and so on). While there’s little doubt in my mind that personal interest was the biggest underlying factor, systemic factors and even biology likely played a role. By systemic factors I mean the way many of these markets were structured. Writing a shaky loan sounds like a bad business decision, but if there are buyers for loans of this type perhaps it really isn’t a bad decision for the originator. But, on to the brain science…

Department of the Painfully Obvious. When one business hires another business to rate something, there’s a potential for bias. While the second business is theoretically hired to be impartial, the reality of many of these situations is that they will try to respond to the needs of the business who hired them, who is paying them a lot of money, and who could fire them and hire someone else. We saw it with Arthur Anderson’s audit services fiasco, with periodic stock pumping by the research divisions of investment banking firms, and currently with the raters of mortgage-backed securities. Now, using the Ultimatum Game, Carnegie Mellon behavioral economists show that such behavior is inevitable in the absence of mechanisms to prevent it.

Consider this forthcoming research by Loewenstein, Roberto Weber and John Hamman, all of Carnegie Mellon. They organized volunteers into partners. One partner is given $10 and told to split it however he sees fit. On average, the deciding partner keeps $8 and gives away $2.

Then researchers repeat the game. This time, the decider pays an “analyst” to decide how to split the money fairly. The game continues for multiple rounds and the decider can fire the analyst. With this change, the decider gets everything. Paying somebody else to ensure assets are divided fairly actually makes things less fair. [From Forbes – Market Mess? Blame Your Brain by Mathew Herper.]

The Forbes article get input from other neuroscience researchers on why our brains aren’t hardwired to make the most rational financial decisions:

Dread, the anticipation of a loss that is expected to happen, is another powerful force. Emory’s Berns has shown that people differ in how they respond to expected pain. He gave electric shocks to people in an MRI machine, and then gave them the option of either getting an intense shock immediately or a less intense shock later. People whose brains started lighting up in areas associated with pain beforehand were more likely to decide to get the pain over with. They also would have sold stock.

I’d add that I haven’t heard anyone excusing illegal or unethical behavior based on our hardwired tendencies. Rather, the research is simply showing that humans will tend to behave in potentially undesirable ways when incentivized to do so. In addition, the research clearly shows that when we are presented with a confusing and scary situation (like daily bank failures), we may act more like a lion-spooked herd of antelope than rational investors.

A great read on how our hunter-gatherer brains are poorly optimized for financial decision-making is Your Money & Your Brain by Jason Zweig. Exploring the nascent field of Neuroeconomics, Zweig provides countless examples of our brain’s financial foibles and shows that so-called financial professionals are just as likely to make poor decisions.