With risk, says Haldane, policy should respond to every raindrop; it is fine-tuned. With uncertainty, the response is to every thunderstorm; it is coarse-tuned and simple decision rules are best.
He cites a number of instances where people have sought simple behavioural rules to cope with a complex environment. Doctors diagnosing heart attacks find simple decision trees beat complex models. Detectives tracking down serial criminals find that simple locational rules trump complex psychological profiling. Investors have found simple passive strategies outperform complex active ones.
A big call
Haldane wants to change the way we think about economic science and it’s a pretty big call, says Chris Adam, associate dean and a professor of finance at the Australian School of Business. “It just sweeps away most of what’s in the textbooks.”
Adam notes that behavioural finance “doesn’t provide us with clear predictions of events. At most, it is very good at looking back and working out why we get things wrong and at identifying and analysing outcomes that don’t fit classical finance theory.” It helps to identify that people made the wrong decisions or they focused on particular points when they should have been looking more widely. “Rather than estimating a currency exposure and hedging it with a probabilistic pricing model, behavioural finance can run a range of models and suggest myriad possible actions,” Adam says.
Still, behavioural finance has a novel aspect in moving finance into an experimental area and Adam advises running controlled experiments comparing how people make decisions using both classical finance and behavioural finance to see which gives the most useful answer.
The problem is, behavioural finance can’t predict: it can find solutions to real world problems using genetic algorithms and the process of evolution. Using computer-generated codes, it can create generations of agents with particular behavioural characteristics which interbreed. “You can get unusual outcomes which a standard economic model can’t explain … such as the emergence of altruism,” Adam says.
Due to the inability to predict outcomes, behavioural economics models cannot be used in the same way as the classic models, such as in predicting tomorrow’s exchange rates.
“The danger of taking an experimental approach is that it can sweep away a lot and may not leave much in its place,” cautions Adam. “We’re fishing in very deep water in making these comparisons. A sweeping reassessment of classical finance and economics is neither feasible nor desirable.”
So, how should the new uncertainty be approached? Terblanche suggests there will always be a role for behavioural finance. “However rational we think we are, we disappoint on rationality measures,” he says.
As a result, it’s hard to provide a single, comprehensive model that can encapsulate human complexity and, at the same time, provide certainty in its outcome. “The more you obsess about arriving at a single solution that encompasses human behaviour, the more you run the risk of missing macro-trends and changes which, individually and collectively, can produce new risks,” says Terblanche.
His response is to not throw the baby out with the bathwater – and to retain the development in risk management that we have. Importantly, the limitations of existing models, including the assumptions, need to be understood.
Risk modelling needs to be expanded to incorporate macro shifts in our operating landscape, which may appear insurmountable in light of the sheer volume of information. There are established mechanisms and models to distill the information to key issues that matter, significantly, to businesses. “Companies should therefore focus on macro-economic, socio-political and other large-scale changes, their interconnectedness and their velocity of disruption in order to identify upside and downside,” says Terblanche. Leading organisations are already doing this. Many central banks have also seen the light and have established prudential stability units or departments.
A recently released survey carried out by Natixis Global Asset Management, one of the world’s top 15 asset managers, reveals that managers have completely backed off the accepted financial models and investment theories in the belief that they will fail.
More than two-thirds of Asian institutional investors surveyed are convinced the diversified portfolio approach is no longer the best way to pursue a steady stream of income over time, and are focusing on allocation of risk rather than capital, which is a startlingly different approach.
Changing rules to counter risk
The Bank for International Settlements says none of the problems that contributed to the global financial crisis have been comprehensively resolved. Haldane points out that risk models are now too complex. The Basel regulatory framework, which started at 30 pages in the late 1980s, will run to some 60,000 pages when Basel III is finalised. So why do it?
For Terblanche, the answer is, in essence, straightforward. “When ordinary investors lose money on a large scale, governments feel a sense of duty to respond. The bigger the market adjustment, the bigger the response in the attempt to ensure it does not happen again,” he says.
Justin O’Brien, a professor in law at the University of New South Wales and director of the Centre for Law, Markets and Regulation, approves of the call for more effective supervision rather than a reliance on rules. He says that equating effective risk management with compliance is a fundamental misconception: “It’s important to change the culture of regulations, not rewrite the rule book. We need to rethink whether or not we are creating the right kind of regulatory environment.”
O’Brien suggests that rather than looking at “how we regulate, we all need to step backwards, review the entity we’re supervising, and ask what we’re regulating and for what purpose”.
“[Haldane’s speech] has come at a very interesting time. If you look at the recent Treasury select committee report into LIBOR, it points to a fundamental problem, not just with the culture within Barclays but banking as a whole and with oversight. A complicated system of regulation creates circumstances whereby those rules can be transacted around. And, the more complicated the structure, the more invasive the oversight has to be,” says O’Brien.
