How Treasurers Can Optimise the Human Dimension
Increasing numbers of firms are leveraging insights into human psychology and behaviour to help improve their operations, especially when it comes to risk management. Here, two experts discuss the importance of such insights and the benefits they can deliver for organisations, treasury functions, and employees. They also warn against overreliance on statistics alone when making financial decisions.
Crises can often force the questioning of deeply held assumptions and beliefs. And when it comes to financial upheavals, the global financial crisis (GFC) of 2008 stands out in this respect. At the time, experts in the then burgeoning field of behavioural economics weighed in with novel insights into the fundamental causes of the event, even as key industry and regulatory actors struggled to fully comprehend the devastating turn of events.
The extent to which conventional economic theories proved inadequate in predicting and accounting for such a crisis is reflected accurately by a humbled Alan Greenspan, the then Federal Reserve chairman and architect of the US boom of the 1980s and 1990s. During a US Congressional Committee probe into the GFC, he admitted that the credit crunch had left him in a state of “shocked disbelief” and that he had found a “flaw” in his economic philosophy.
Behavioural economists, by contrast, argued that the crisis could be much better understood, and lessons learnt more effectively, by connecting the study of psychology with the analysis of the economic decision-making process of individuals and institutions. For them, economic decision- making should not be entirely based on precise logic; it should also take into account irrational human behaviour and the causality underlying such decisions. In short, they argue for much greater focus on how people really behave under economic stress rather than how they are supposed to behave.
Corporate treasurers have become increasingly involved in corporate risk management only since the 2008 credit crisis. They therefore stand to benefit from gaining more awareness of behavioural finance and how psychology and social context can affect risk decisions.
The contribution made by behavioural economists to the analysis of the 2008 crisis was widely acknowledged and helped to popularise a field that had, in its modern form, emerged only in the 1970s, giving it a credibility that has seen its growing application across the financial services industry, corporate world, regulation, and policy- making. The Bank of England, for example, is leveraging behavioural economics to make its communications clearer and more effective. Meanwhile, across the corporate and institutional spaces the larger players in particular – such as Apple, Coca-Cola, Microsoft, and Lloyds Banking Group – have been especially keen to exploit insights from the field.
Sander van Tol, Partner at Dutch treasury management consultant Zanders, is convinced that behavioural economics, or more accurately one of its subfields, behavioural finance, has much to offer corporates, not least their treasurers.
“The main theories of behavioural finance can be applied to situations and decisions treasurers encounter every day,” he says. “It is clear that decision-making should ideally involve both quantitative and qualitative evaluations. If we rely only on quantitative data, without qualitative supporting analysis, then our decisions could be faulty.”
For van Tol, this is exactly what happened during the credit crisis, when there were numerous defaults of synthetic collateralised debt obligation (CDO) products. These products consisted of pools of sub-prime mortgage loans, which were divided into investment products based on statistical probabilities that certain kinds of mortgages might default. The over-reliance on statistical models by the rating agencies was one of the primary reasons why, by 2010, billions of dollars’ worth, or more than 70% of these triple-A securities, were downgraded to ‘junk’ status.
The main theories of behavioural finance can be applied to situations and decisions treasurers encounter every day.
He adds: “Corporate treasurers have become increasingly involved in corporate risk management only since the 2008 credit crisis. They therefore stand to benefit from gaining more awareness of behavioural finance and how psychology and social context can affect risk decisions. In corporate risk management, we must be wary of over-reliance on quantitative studies. It is the misuse of statistics that corporate treasury must watch out for in particular.”
Van Tol points to the strong faith treasurers have shown in statistics that underpin increasingly popular ‘at risk’ calculations as a case in point. He explains that the concept of value at risk (VaR) is based on the probability distributions of individual risks, the correlation across these risks, and the effect of such risks on the underlying value.
“Although the effect of risks on the underlying value in this setting is relatively easy to quantify, the interpretation of the outcome of the VaR measure is still quite a challenge. In a corporate setting, the statistical relationship between a risk, for example FX rate, and the underlying value, such as cash flows or net profit of the company, is not that clear and hence the interpretation of the VaR number is even more challenging.
“VaR was mainly developed for measuring the risk of trading portfolios for financial institutions, so this raises the question of whether statistical risk management tools that were developed for financial institutions can also apply to a corporate environment.”
Addressing errors and biases
Elsewhere, van Tol highlights the harmful impact biases can have. In behavioural economics generally, bias is seen as a human predisposition that can lead to an error, such as excessive confidence or optimism, the illusion of control, or confirmation bias. Biases can be cognitive or emotional – in other words they can be caused by faulty cognitive reasoning or by feelings and emotions. The illusion of control meanwhile refers to people’s belief that in some way they have influence over the outcome of uncontrollable events.
“A familiar instance of the latter in the financial profession is when we hold a long currency position and the currency appreciates in value. We might explain this to ourselves by saying that we had the ‘correct’ market view, reflecting our illusion of control over the market. However, if the same currency depreciates in value, we attribute this to unexpected volatility in the financial markets.”
The combination of different biases such as overconfidence, illusion of control, and excessive optimism are particularly dangerous in relation to the corporate risk management function, says van Tol, adding: “Risk management should be primarily looking at the impact of the most negative outcomes on the company. The combination of the biases may lead to an underestimation of these negative outcomes, as shown by some of the commonalities in different financial market crises, such as excessive exuberance, poor regulatory oversight, herd mentalities and, in many cases, a sense of infallibility.”
Van Tol, who is also chairman of the advisory board of the Dutch Association of Corporate Treasurers (DACT), believes treasurers can benefit significantly from gaining more awareness of behavioural finance and how psychology and social context can affect risk decisions.
He continues: “There are many factors we treasurers need to take into account when assessing opportunities and making choices, and our decisions are not always as rational as we might think. Although we work in a professional environment and participate in mainly efficient financial markets, we have to acknowledge that, as treasurers, we are also human. This means that we are prone to possible errors or biases in our day-to-day decision-making. We would do well to keep this in mind next time we are asked to give our opinion on a hedging strategy or an investment proposal.”
Like van Tol, Christian Hunt, Founder, Human Risk, a consultancy and training firm focused on bringing behavioural science to bear on ethics and compliance, is also clear about the need for organisations to appreciate the impact human behaviour and psychology can have on operational performance.
Hunt, formerly Managing Director and Head of Behavioural Science, UBS Asset Management, and Chief Operating Officer, Prudential Regulation Authority, says: “Human risk is the largest risk facing all organisations. While that sounds like a very bold statement, the reason I claim that is because every single time something goes wrong there is a human component – it’s a common denominator.”
To underline the scope of the field’s ambitions, he says that behavioural economics even finds application in analysing the role of humans in mitigating the impact of natural disasters like earthquakes. He continues: “How can dealing with an earthquake be the responsibility of someone within the organisation? Well, if earthquakes are going to be a significant potential issue in a location where you are operating a business, then somebody within the organisation must have responsibility for thinking about that risk and putting together a plan to mitigate it and manage the response.
“Similarly, in the financial space, rates, markets, FX, and credit ratings all pose risks, but we still need people to make decisions off the back of those risks. If we have an effective behavioural toolkit to examine their decision-making then we can start to recognise whether people are really managing those risks properly. We can address any problem through a behavioural lens.”
Avoiding costly mistakes
To be sure, errors will be made within organisations. But Hunt says that, in his experience, they result more often than not from genuine human error rather than any malicious intent or carelessness. Helping humans to minimise or prevent their unforced errors therefore should be a major priority within organisations, he says, pointing to safety-critical industries such as aviation and power generation as offering some of the best examples of human error being kept largely in check.
“Planes don’t fall out of the sky on a daily basis, and nuclear power accidents are very rare these days. The reason for that is that such industries now have a real handle on safety processes and protocols based on a deep understanding of how humans interact with them.
“Yes, we are dealing with largely physical environments with these sectors so risks are arguably more predictable. But the key factor to note is how proactive regulators for these industries and the companies themselves have been – they fully appreciate the potentially very high cost of getting things wrong.”
Hunt believes valuable lessons can be learnt from such industries, and combined with knowledge about human behaviour from other contexts, to identify forms of risk and mitigate them in other sectors and settings. At Human Risk, Hunt works with clients across regions and a wide range of industries ranging from chemical weapons inspectors to regulators, banks to pharmaceuticals, manufacturers to utility providers, and tech startups to engineering companies.
Human Risk clients have included financial services firms that have had a significant fine imposed on them by the regulator. Hunt says that such a firm typically might recognise that one of the problems that led to it being fined was that its compliance programme was inadequate. “Perhaps the training was insufficient, or the controls weren’t operating in the way expected. The company will therefore bring me in to help them to think behaviourally about solving those problems.”
Hunt cites the example of one client that called him in after it experienced a control failure. “It led to a major regulatory fine. What I did there was to help them think about where their compliance programme and their monitoring lacked behavioural considerations. That resulted in changes to the training programme, including the removal of some controls.
“Very often we think, the more controls, the better. But from a behavioural perspective it can result in employees thinking, ‘Well, what I’m doing is going to be checked by someone else anyway so I may just rely on that check and take on more risk.’ Meanwhile, the second person checking it may assume things have already been checked so he or she needn’t pay attention. So, we end up with the worst-case scenario where neither are really looking at it.
“There are obviously a lot of elements regulators will not negotiate on but, especially with the more forward-thinking regulators who do appreciate the behavioural lens, there is the potential for some negotiation if you can make a solid case. These more enlightened regulators around the world, of which there are increasing numbers, are recognising that treating firms like small children means they will behave like small children and try to hide things from them.”
Technological challenge
In mulling over the outlook for behavioural economics and its application, Hunt argues that organisations that want to be successful in the 21st century will need to use all the tools available to them, not least technology, which he expects over the coming years will have a profound impact on all aspects of an organisation’s operations.
But while technology will help businesses become smarter and more efficient, Hunt believes it will also lead to them becoming in some ways “more human”, changing what human beings do and how they are perceived in the workplace. And that, he says, will present a whole host of new questions, such as how best to structure career paths, incentives and processes to ensure firms get the best out of human capital.
It needs to be a base-level skill set that helps everyone communicate much more effectively and enables organisations develop better strategies and schemes for incentivising and motivating.
He continues: “Increasingly, humans will be doing tasks that cannot be given to machines, tasks that machines cannot ever perform or cannot yet perform, such as decision-making that involves creativity, judgment, nuance, and emotional intelligence. That implies we’re going be employing people to perform tasks that humans can do better than machines. That’s when you will get the best out of them but it’s also when they will be at their riskiest. So, if we want to get the best out of them and at the same time mitigate the risks they will pose, organisations will need to understand human behaviour much better than they’ve ever done before.”
And the way to do that, says Hunt, is by organisations understanding behavioural drivers. For that to transpire, however, organisations will need to have people who really understand behavioural science and behavioural economics and can normalise their use: “It needs to be a base-level skill set that helps everyone communicate much more effectively and enables organisations develop better strategies and schemes for incentivising and motivating.”
Hunt concludes: “The vast majority of people want to turn up at work to do the right thing and we need to help them to do that. They need to know what it is they need to do differently and precisely why. The job of training and communications is to translate something that is important for the organisation into language, tasks, and parameters that make sense to the individual on the ground.
“So, if we’re looking to change behaviours, why are we not trying to better understand what drives those behaviours? After all, you wouldn’t go to a medical professional who didn’t understand how the body worked.”
