The final programme in the documentary series The Love of Money finishes by ascribing the causes of many financial crises, including the most recent, to a “reckless love of money”. Over the series, we have seen how reliance by banks on imprudent investments in property loans with high default risk led to the near total collapse of the world’s financial systems.

Was this the consequence of the actions of a powerful few, driven by extraordinary levels of greed and recklessness, or can the roots of the crisis be found in much more commonplace aspects of human psychology? I am going to argue that there is a great deal in common between the psychology of every day decisions about money and the psychological processes involved in the creation of this global financial crisis.

Consider two examples:

Jenny has recently lost her job, she knows that money is tight and she needs to reduce her costs dramatically, but every time she tries to think about sorting things out she feels bad and ends up by going shopping to cheer herself up.

Jared took on a 100% loan to buy a house with repayment levels he could only just afford. As he thought about this decision from time to time, he felt anxious about the possibility that he would not be able to meet the payments. He was able to avoid this anxiety by focusing on the way in which house prices seemed to keep on rising and by telling himself it was really a ‘one way bet’.

In each case there is a common factor: employing a strategy to avoid bad feelings and maintain good feelings, rather than facing the real problem or risk. We all behave like this from time to time. We all have strategies to regulate our emotions and often do so with the goal of avoiding bad feelings. However, when we feel particularly anxious or are powerfully motivated by an important goal, this tendency can cause us to ignore the important information that negative feelings can carry. Often this can involve fostering illusions about ourselves and the world around us which help us feel better.

Stock market results in a newspaper.
[image © copyright Jupiterimages]

We might imagine that professional financial decision-makers would be better at avoiding such traps. After all they work in a climate which places a great premium on rational decisions. However, in a large-scale study of 118 traders in four City of London investment banks, myself and colleagues found traders to be just as prone to these kinds of illusions as the rest of us. In particular we studied traders’ propensity to suffer from the illusion of control: the tendency to believe we are more in control of events than we really are (especially under stress). We found a significant relationship between a tendency to suffer from illusions of control and poor trader performance (including poor management of risk).

How might this relate to the causes of financial crises? One example back in the early 1990s is worth recalling. Peter Baring has been reported as telling shareholders at an AGM one year before the collapse of Barings’ Bank that, on the basis of the previous year’s performance, he had concluded it is easy to make money in the derivatives market. A year later the bank was valued at £1.

Any banker understands that there is a strong relationship between risk and return. Faced with unusually good financial performance in part of a bank’s operations, an important question to ask is “What hidden risks are we carrying that account for this high return?” However, faced with good returns, it is tempting to foster the illusion that good performance is a result of our unique skills and capabilities, while failures are due to events beyond our control. This tendency is known by psychologists as the self-serving bias.

This unwillingness to seriously question what hidden risks lay behind unusually high returns seems to have been an important factor in the recent demise of Lehman brothers and other major banks. A reckless love of money seems to have fuelled collective illusions about the risks being faced.

We need to understand more about how these kinds of emotion regulation processes work in financial decision-making. Current research is helping us understand these processes and how such blindness to risk can be reduced. The European Commission has funded me and an international group of researchers to conduct a major study looking at ways of improving financial decision-making. This study is looking at traders, investors and private citizens, and is paying close attention to the role played by emotions in their decision making.

Take it further

• Trading on emotion
• Has Robert Peston caused a recession?
• Bankers won, politicians lost

Further reading

Traders: risks, decisions, and management in financial markets, by Mark Fenton-O'Creevy, Nigel Nicholson, Emma Soane and Paul Willman, was published by Oxford University Press.

About the author

Mark Fenton-O'Creevy is Professor of Organisational Behaviour at the OU Business School. His research includes investigations into the performance of traders in financial markets, and the problems that occur when management practices are transferred from one country to another.

He is also a National Teaching Fellow, and Principal of the Centre for Practice-Based Professional Learning.

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In the latest edition of the Open Finance: Lessons From History series, Martin Upton explains what happened on Black Wednesday - and why, in retrospect, it might not have been all bad:

"From quite early on it became clear that the Bank of England was going to have to intervene quite regularly to keep the pound within its permitted range against the deutschmark within the ERM, and at times  - in terms of the foreign currency intervention which was required - this was costly. In addition, at the time, interest rates in Europe and even in Germany, which was dealing with reunification, were high, and that meant that UK interest rates had to be high because otherwise a differential between the interest rates in Germany and the rest of Europe and in the UK would have led to more pressure in terms of the value of the pound. There would have been downward pressure on the pound if the UK had cut interest rates at the time when European interest rates were high."

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One year on from their moment of meltdown, rescued institutions are again riding high, while the politicians who rescued them are paying the electoral price. The scale of the mess suggested, at the time, that banks had got onto their crash course through euphoria, miscalculation and madness. Now, the speed and low private cost with which they escaped that mess raises the equally scary likelihood that they were being rational all along.

The Great Escape

Aside from Lehman, banks have bounced back with their businesses and bonuses intact. Many have already returned to profit, with their investment banking units – whose speculative gambles were at the heart of last year’s problems – now helping to support the commercial side as it writes down its bad mortgage debt.

Lloyds, which looked to have bitten off more than it could chew by acquiring HBOS, is now a legally sanctioned giant that controls around one-third of UK mortgages and current accounts and a quarter of its business banking. Barclays, once viewed as perennially ripe for acquisition by a larger group, has now joined their ranks by cherry-picking Lehman at minimum cost. Fortis, facing bankruptcy a year ago, has announced a major UK expansion in alliance with Tesco. Merrill Lynch and Citibank continue to issue their uncompromising analysis of other firms’ finances, having buried the obituaries that were being written on their own a year ago.

Houses of Parliament at dusk.

Most of the management teams that presided over near-bankruptcy are still in place, enjoying undiminished performance and retention bonuses. Many of those dramatically turfed out of their Canary Wharf offices in September 2008 already have their feet under a comparable desk on someone else’s trading floor. And of the bosses who bet their banks and lost, there is none whose golden parachute failed to open. Even Lehman ex-CEO Dick Fuld is on hire as a consultant, just round the corner from Wall Street. Sir Fred Goodwin’s RBS pension, big enough to be a one-man stimulus package, attracts powerless resentment but continues to flow.

Meanwhile, the governments whose quick thinking made this possible are condemned, for the budgetary cost and for the scale on which their bailouts and loan guarantees seem to have feathered high-financial nests. Ironically, the more successful their rescue plans and the faster the financial world returns to normal, the worse is the electoral fallout. Gordon Brown, architect of last September’s global rescue, enjoyed a ‘bounce’ when turmoil and recession were at their worst and now sees his ratings fall with every sign of economic recovery.

Incumbents are being punished without regard to political stripe, so the by-election reversals are as bad for Angela Merkel’s Christian Democrats as for Brown’s New Labour. Bankers have become, like Ronald Biggs and Abdelbaset al-Megrahi, once unspeakable prisoners who walked out of jail, leaving condemnation raining down on those who let them out.

Sowing the Sense of False Security

Were bankers just lucky? Sadly, past crises showed a similar pattern. The biggest banks basked in the knowledge that they were ‘too big to fail’, even before the recent deepening and widening of their global interconnections. Many were emboldened in their retrospectively reckless gambles – on mortgages, securitisations and derivatives – by assurance that the state and its regulators would step in if their luck ran out.

emboldened in their retrospectively reckless gambles

With their deposits insured, their liquidity underpinned by a central bank, and their riskier loans apparently underwritten by credit default swaps, banks would have been foolish if they hadn’t taken increasing risks in pursuit of higher returns. Indeed, the management of HSBC – the only ‘Big Four’ bank to ride serenely through last year’s storms – had endured years of onslaught from activist shareholders aghast at its refusal to run down its capital, raise its leverage and gamble like the rest.

Bicycle helmets can prevent head injuries in many common accident situations. Yet their increased use is not associated with a reduction in such injuries – because helmet wearers take more risks, and are treated less carefully by other road users. Similarly, traditional banking safeguards encourage borrowers and lenders to take more risks. We’re usually grateful that they do. There were few more reckless gambles than building the first horseless carriage, microcomputer or oil-well, but lives were transformed for the better by those who did.

In most sectors, however, competition puts limits on risk-taking. Customers will go elsewhere if the firm’s product becomes too dangerous, and shareholders will desert it if the way it makes profit becomes too dangerous. Tragically, competition in financial services seems to have the opposite effect, driving companies to take more punts and fewer precautions. Customers flocked to Ice-Save because of its improbably high interest rates, shareholders to Lehman because of its impressive rates of return.

Counterproductive Competition

Alerted in 2000 (by the Cruickshank Report) to banks’ unusually high and consistent profitability, the UK government made a fundamental and possibly fatal choice. It didn’t want to regulate banks’ rates of return, as it traditionally did with highly concentrated, highly profitable utilities like electricity, gas and telecommunication. So it decided to make banking more competitive; and to encourage the combination of commercial banking, investment banking, brokerage and insurance so that big financial groups could compete along more dimensions.

In retail banking, competition meant narrowing the gap between savers’ and borrowers’ interest rates, and making up for the consequent loss of profit by offering more commission- and fee-based services. From this came banks’ substantially increased use of wholesale financial markets to raise funds, using collateralised debt as security, and the high-pressure selling tactics that led to serial mis-selling episodes. In investment banking, competition meant an erosion of low-risk trading profits, based on identifying and amending asset price misalignments. It led banks to preserve those profits by borrowing (‘leveraging’) more heavily to multiply the diminishing margin, and to supplement them with more investment in purely speculative asset-price movements.

no government can afford to jeopardise the financial sector’s profit recoveryno government can afford to jeopardise the financial sector’s profit recovery

Competition in insurance, and derivative markets, meant that bankers could often buy cover for adverse price movements. They didn’t realise (or didn’t like to mention) that the cover was ultimately underwritten by another part of the same group, or that it couldn’t possibly pay out if a general asset-price downturn caused the risks to become systemic.

Competition for the apparent expertise required to design and trade these exotic new instruments led to a steep inflation of banking and insurance salaries, topped by an even greater explosion in performance bonuses and executive share options. So banks’ profits underwent the desired moderation – but due less to competition than to the diversion of cashflow from shareholders to bonuses, and the large sums that had to be set aside for potentially non-performing investments and debts.

With banks still in delicate health until their mortgagees recover, and businesses under strain until banks can resume normal lending, no government can afford to jeopardise the financial sector’s profit recovery. So the grand regulatory schemes of a year ago, to change the rules and rebuild firewalls between financial activities, have been quietly put aside.

Banks that once, as a cosy cartel, enjoyed big private profits and got the state to subsidise their losses, have now shown that they can pull off the trick even more successfully as a competitive, deregulated industry. No wonder the politicians who pulled the world back from the brink, a year ago, are now being pilloried for letting those who pushed it there off-the-hook.

Take it further

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Courses

• You and Your Money
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About the author

Alan Shipman is lecturer in economics at the Open University, and a former financial journalist. His books include The Globalization Myth, The Market Revolution, and Transcending Transaction. He is involved in OU's new courses on personal finance, and research on insurance pools, 'chaos pricing' and Eastern Europe.

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