I am a senior risk practitioner with extensive experience covering risk transformation, regulatory development and capital requirements. There is a lot happening at the crossroads between risk management, economics, financial regulation that I cover in this blog.
It is no
exaggeration to say that behavioural economics has become mainstream. With hindsight, this is not really surprising
because the assumptions underpinning economic theory have always been regarded
as just that: assumptions.
innovation of behavioural economics are the identification of specific
circumstances where there are systematic departures from rational decision
making and the development of context-specific predictions of behaviour. Broadly speaking, departures from rational
decision making are referred to as ‘biases’ because outcomes are poorer than
the optimal outcomes under rational conditions.
These biases may affect preferences, beliefs or decision making. Box 1 below shows some common types of
Box 1: Sample of Common Types of Biases Affecting
Example of bias in consumer decision making
Assessments are influenced by the reference point for the assessment ―
typically the status quo ― or by a fear of losses. Depending on the context, this can
encourage either too much or too little risk taking.
Purchase decisions are driven by alternatives or product features
which are irrelevant to the consumer.
Predictions are made on the basis of few observations believed to be
representative from which a real pattern or trend is inferred and, as a
result, uncertainty is over- or under-estimated.
The quality of financial advice is assessed on the basis of few
successful investments even if these could reflect pure luck.
Rules of thumbs
Decision making is simplified by adopting specific rules of thumb such
as choosing the most familiar and avoiding the most ambiguous.
Products at the top of a list or offered by large companies are
innovation of behavioural economics is the notion that it is sometimes possible
to address those biases, and thereby enhance outcomes, by making small changes
to the environment ― hence the number of books about behavioural economics with
the word ‘nudging’ in the title. I have
come across nudging considerations in terms of sales (e.g. how the default
option affects customers’ choices) and in terms of public policy (e.g. the
introduction of cooling-off periods in financial services).
One of the key
motivating aspects of enterprise risk management is its effectiveness. This is not just a challenge concerning an
outcome at a particular point in time.
The main aspect of the challenge is putting in place a process that
drives enhanced effectiveness. This is
an aspect that has not escaped EU supervisors framing risk and capital
requirements for banks and insurers in the EU, which require assessments of
risk management effectiveness.
So how could
these two meet? An assessment of risk management
effectiveness could seek to identify behavioural biases that affect the
management of risk across the business: for example, in terms of underwriting
and investments. Consider again the
biases set out in Box 1: which ones could be relevant to risk management? If we identify the biases that shape risk management, we can also assess their materiality and consider whether
there are ways of addressing them through changes in the operating environment. If you have any thoughts about how these
biases, or others, could affect risk management, I would be very interested to
This post is part of the series "Aspects of Risk Management". Other articles are available here. If you found this post useful, you may want to subscribe and receive further posts by email – see box on the right hand side of the screen or click here. My target is to post on a regular basis (no more than weekly) and I will not be flooding your inbox.