Hubert Fromlet: Ongoing psychological shortcomings in (many) financial institutions

26 Nov 2009 | Posted By: JIBS Stories

How mobile is talent?

The current financial and economic crisis can partly be explained by deficits in understanding psychology of financial markets (in academic terms: behavioral finance). Reactions by financial leaders during the financial crisis do not give major evidence for a fundamental and very necessary improvement. Financial institutions (banks) get understandable low rankings in customer surveys. Politicians get tired of continued – sometimes very high – bonus announcements. Nobody should be surprised if politicians at some point will react even more restrictive against these provocations.

One of these simplifying defense arguments for bonuses has recently been used in public by the CEO of a British bank, saying that bonuses were necessary because “talent is highly mobile�. In my understanding, there is no scientific evidence whatsoever that high bonus payments per se have an positive impact an employment stability of investment banks or bank divisions with that commercial orientation. According to my analysis and experience, mobility in this special field of the labor market is mainly a function of activity volumes on security markets, M & As, etc. In good times, mobility tends to be high anyway because demand for (somewhat) experienced people in investment banking is high. Changing the employer during good times is regarded as an effective tool to push up wages and bonuses.

By the way, we are very short of neutral and good research on banks in Sweden, since a major part of financial research funds is coming from the financial industry. And which research institute wants to be confronted with hostile reactions from its main funder? For this reason, governments – including the Swedish – should give more money to completely independent financial research.

Combating the government – not a good way to go forward

There is no doubt that the political sphere and regulators in many countries will have an increasing influence on the financial sector – despite the ongoing belief of many financial leaders in perfect financial markets and self regulation. In Sweden, the whole banking lobby is fighting strongly against the possibility that Swedish financial institutions might face somewhat harder regulations in the future than competing banks in most other countries. This argument may be partly motivated – but is certainly characterized by ambiguity, too.

Serious mistakes have been committed by Swedish bank leaders as well. Two banks had an aggressive and destroying lending policy in the three Baltic countries during a longer period of time. Another bank concentrated on an offensive lending strategy in this region much later – but such an unwise shift happened anyway. And a forth Swedish major bank – for them fortunately – missed its entry into the Baltic market to a high extent by its reluctance in the early days of these three newly established countries. Thus, all four major Swedish commercial banks should have reason to be humble and co-operative.

Who can rule out that a new asset bubble will show up in the foreseeable future? Warning signals still can be received from real estate markets in Asia and, for example, from Sweden – but also from valuations on a number of important stock markets, New York and some emerging countries included. Banks looking for conflicts with political leaders act psychologically and strategically unwise. During the Swedish financial crisis in the early 1990s, there was a good spirit of co-operation between the banks and responsible politicians. I am missing this positive attitude during the current crisis which must be interpreted as a serious psychological misunderstanding. It may be worthwhile to have some second thoughts about this issue also when it come more long-term perspectives.

How keen may a government be on supporting suffering banks if/when the next financial crisis occurs? What will the banks during a thinkable future financial crisis answer to the ruling government about the fact that the banking lobby – certain officials included – in 2009/2010 was hindering necessary regulations? Is there really a chance to get to common international regulation standards?

German chancellor Angela Merkel has already directly accused German bank executives of becoming complacent again. Swedish minister of finance Anders Borg seems to dislike some major banks’ behavior as well – without using similar tough words compared to Merkel. Merkel even added that banks should understand that the government does not automatically guarantee a similar active rescue treatment of the banks when the next crisis occurs. Apart from these recent stories, I remember very well when I – in the early 1990s – had the opportunity to visit Congress and listen to the then U.S. House Banking Committee Chairman Henry Gonzalez. In the aftermath of the Savings&Loans crisis, Gonzalez did not have many friendly words to say about financial institutions.

Executive financial public power should not be challenged too much by a banking sector that one year ago was on the verge of a disaster.

Psychologically neglected areas

Consequently, the following five core contact areas of the banks/ other financial institutions are currently neglected or treated in an unwise way- to a high extent related to insufficient psychological considerations: politicians, the general public, customers (as a particularly important subgroup), the press and certain organizations (unions, credit-crunch suffering enterprises and their lobbyists). It is hard to understand why many – or even most – banks’ headquarters do not everything to improve their current poor image. Increasing efforts in this important respect would also be a good way of supporting many good and competent bank employees at the branches who most frequently – and “innocently� – have to meet angry customers.

One may ask why so many bank leaders still have these irritating and many times even arrogant attitudes. Do they still think that they are as powerful as five years ago? Or aren’t they aware of the importance of applying appropriate psychological standards? Or are they still not enough skilled to deal with the changing economic environment and fundamentals of global economics and macrofinancial trends – as, for example, in Sweden some years ago when important bank leaders did not understand the risks of the rapidly accelerating current account deficits in the Baltic countries!

Without directly relating to Swedish banks, it is a matter of fact that wages, bonuses and prestige usually correlate with a bank’s size – which does not make sense. How short can memories be? During the days of the financial crisis in the early 1990s, a number of Swedish banks very clearly communicating to the general public that the main organizational and commercial focus in the future should be put on local branches, meaning a marked decentralization of their activities. This appropriate strategy was maintained for about a decade – and in recent years gradually reversed into more central power and centralized commercial activities. Herd mentality on global financial markets turned plans again in the opposite direction.

Are banks now changing strategy again? Certain indications point at such a direction. But how long time would this last this time? In other words: When will psychological expansion hunger become visible again? By the way, this topic should also be closely watched by central banks (supervision).

Maybe we should in the future rather use the term “too big to succeed� than “too big to fail� – and consequently relate regulations to the size of a financial institution. This may serve two objectives: both avoiding moral hazard and maintaining the extremely important role of a well-working financial sector in the market economy – the system that still is superior to all other economic systems, at least in general terms.

Other shortcomings

Regulations, improved supervision, better early warning signals, a more financial stability oriented monetary policy, better working rating agencies, application of behavioral finance in important analysis, etc., cannot do everything to bring the financial sector on a safer track in the future. Ways should also be found to improve psychological, macroeconomic and macrofinancial skills of financial leaders.

There may exist psychological impediments to take up this issue by responsible or appropriate institutions. However, there is no reason to avoid this sensitive topic in the aftermath of the financial crisis. Sure, it will be difficult to develop methods to increase leaders’ competence in these two particular economic areas. Contributions to improvements could come from the theory of incentives.

Conclusions

Summarizing my conclusions of this article, I would like to suggest five ideas to be considered carefully by the banks:

• First. Co-operation – and no fights – with politicians and authorities.
• Second. Application of psychology in all external relations, the press included (and, of course, in internal matters).
• Third. The creation of some jobs for bank psychologists: on one hand as advisors to the highest decision makers for considering all thinkable external reactions before having launched new products, rules, positions and strategies – and on the other hand a bank psychologist who serves the lower and middle management (where many new ideas are born – but only for advising, not for controlling!). Economic research departments could have psychological expertise, too, in order to improve knowledge on risk considerations on financial markets and, consequently, on many customers’ and groups’ behavior.
• Forth. Better incentives and psychological encouragement should be developed for the banks’ staff.
• Fifth. Too much of the current debate on the financial crisis is addressing improved institutions and regulation in the traditional way. More attention should be paid to psychology behind the banks and all the other institutions.

A final reminder: We can read on a daily basis that financial markets to a high extent are influenced by psychology. For this reason, it cannot be logical that psychology on such a limited scale is part of positioning and decision-making by the players on financial markets – and even research!

Visit professor Fromlet’s blog (mainly in Swedish)

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