1. Behavior Finance: The Missing Element in Risk Management May 13, 2009 J. Rizzi, CapGen Financial (jrizzi@capgen.com) Presentation to: International Financial Institutions: Creating Value Through Operational Risk Management Panel (The ideas expressed herein are those of the author and not CapGen Financial)

2. Need to overhaul intellectual approach to risk management. Risk managers claim a precession that neither their raw material nor their skill warrant. Their models ignore the human element. Risk is managed by people, not models. Data is not generated by random number machines. 2

3. Executive Summary Decision processes influence perception and shape behavior Behavioral finance examines how we gather, process and interpret information Behavioral finance can supplement not replace traditional risk management to improve decisions The current market crisis highlights the need to rethink risk management Ignore behavioral finance at your peril 3

4. Table of Contents Executive Summary The Setting Risk Management Conclusion 4

5. The Setting 5

6. The Problem Guided by selective memories and information Fail to consider what we believe to be false Influenced by the actions of others Confuse preferences with prediction Engage in self serving attribution Disregard non-conforming views (Economic Capital is a lighthouse….) (… for the soon to be shipwrecked) 6

7. Some Behavioral Effects in Risk Management Hindsight and Confirmation: I knew it all along and ignore nonconforming evidence Anchoring: Unduly influenced by first impressions Sunk Costs: Doubling down Overconfidence: Infallibility of judgment. Gives raise to illusions of control Optimism: It will work out Availability: More weight given to events easily recalled Threshold: Once frequency drops below threshold it is ignored Pattern Seeking: Fooled by randomness. Gamblers fallacy (Risk Management is the fig leaf …) (… behind which risk taking takes place) 7

8. A MAP on the Limits of Statistics (We observe the data….) Considerations: Distributions and payoffs 8 3 4 Normal (risk) Fat tails/unknown (uncertainty) Distribution (…not the process) Quadrant 4: Normal techniques fail. Alternatives to consider: Redundancy not optimization Avoid predication: focus on discipline and resiliency Time is longer Moral Hazard: bonuses tied to hidden risks Metrics: standard metrics no longer work Volatility absence is not equal to risk absence Risk numbers are dangerous: framing Simple Complex Payoffs 1 2 (Source: N. Taleb)

9. 9 Humans and Markets (In physics you play against God….) Markets and Hurricanes: they are different (J. Meriwether) Hurricanes are not more likely because more hurricane insurance is written. This is not true for financial markets. An increase in financial insurance increases likelihood of disaster. Those who know you sold the insurance (will trade against you) can make it happen. In a crisis all that matters is who holds what and at what price. Markets are more complex than casinos. The numbers on the Roulette wheel never change. Markets make no guarantee that yesterdays odds will be the same tomorrow. (… in markets you play against Gods creatures)

10. Decisions at Risk Uncertainty Bias Beyond the data experiences Experiences Exposures Black Swans Rare Events Large Impact Explainable Over confidence Illusion of control Hindsight bias Anchoring Amplifiers Incentives Bureaucracy Opaqueness (It is not what we dont know that gets us in trouble…) (…it is what we know that aint so) 10

11. Risk Management 11

12. The Setting Dimensions Frequency Exposure Experience Severity Focus: High impact low probability events (HILPEs) HILPEs difficult to understand and frequently ignored History proves HILPEs do happen and can threaten survival of the unprepared Issues Statistical: insufficient data Behavioral: infrequency clouds perception Risk estimates anchored Disaster myopia Social: reduced from regulations collapse once behavior changes Goodharts Law Risk Adaptation ( Performance – is it luck…) (… or skill) 12

13. Risk Management Toolbox Avoidance Ignore Mitigate Transfer Equity Self insure (Not just that risk management fails…) (… but it can produce unintended consequences that amplify damages) 13

14. Operational Risk Amplifiers Size Compensation systems Complexity Management (Impossible to make things foolproof…) (…Fools are too clever) 14

15. Complex Financial Institutions High Risk Systems: prone to endogenous normal (system) accidents. Manmade catastrophes Complex nonlinear interaction: inevitable but unpredictability uncertain Branching paths Feedback loops Jumps Tight coupling: network effects Governance: prevent management from imposing risks on organization for their own benefit Policy Implications (A ) Tolerate and improve (B ) Restructure (C ) Abandon Disaster recovery Strategic and management Processing errors Model risk Simple Complex Tight Loose A B C Alternative costs Catastrophe loss potential (It is the system…) (… not the event) 15

16. Conclusion 16

17. Thinking About Risks: the Shift (Organizati0ns are a social…) Classical Independent Stationary Rational Gaussian Frictionless Consistent beliefs Linear Risk Reward Complete Information Individuals Risk Objective Function Equilibrium Shocks New Memories Unstable Bias Fat tails Arbitrage limits Inconsistency Nonlinear Asymmetric Information Institutions Uncertainty Principal-Agent Conflicts Creative Destruction Endogenous (…not a physical phenomena) 17

18. Conclusion Risk is managed by people not mathematical models Accept randomness Discipline not predictions Expect the unexpected Avoid catastrophe risk Focus on what you know and insure against extremes (Ignore behavioral finance…) (… at your peril) 18