Banks and Disaster Myopia
Large economic shocks occur so infrequently that bankers often underestimate shock probabilities.
Here is a good piece, worth meditating.
The ability to estimate the probability of a shock – like a collapse in real estate prices – depends on two key factors. First is the frequency with which the shock occurs relative to the frequency of changes in the underlying causal structure. If the structure changes every time a shock occurs, then events do not generate useful evidence regarding probabilities.
On the other hand, if the shock occurs many times while the structure is stable, probabilities may be estimated with considerable confidence. High-frequency shocks affect many kinds of activities conducted by banks. For example, default rates on credit card receivables and car loans or routine deposit withdrawals can be estimated with considerable confidence. Consequently, high frequency shocks are not a significant source of insolvency exposure for banks. Banks have both the knowledge and the incentive to price high-frequency shocks properly and to make adequate provisions to serve as a buffer against loss.
In contrast, the causal structure underlying low-frequency economic shocks by definition do not remain stable for long enough to permit empirical estimation of shock probabilities with much confidence. How do banks make decisions with regard to low frequency shocks with uncertain probabilities? Specialists in cognitive psychology have found that decision-makers, even trained statisticians, tend to formulate subjective probabilities on the basis of the “availability heuristic,” the ease with which the decisionmaker can imagine that the event will occur. Since the ease with which an event can be imagined is highly correlated with the frequency that the event occurs, this rule of thumb provides a reasonably accurate estimate of high frequency events. But ease of recall is also affected by other factors such as the time elapsed since the last occurrence. Under such circumstances the availability heuristic can give rise to an “availability bias.”
At some point, this tendency to underestimate shock probabilities is exacerbated by the threshold heuristic. This is the rule of thumb by which busy decision-makers allocate their scarcest resource, managerial attention. When the subjective probability falls below some threshold amount, it is disregarded and treated as if it were zero.
Once this threshold has been reached, behavior seldom changes even in the face of evidence that the actual shock probability has increased as, for example, in the cases discussed in succeeding sections where commercial real estate lending continues despite evidence of rising vacancy rates.
The availability and threshold heuristics together cause “disaster myopia,” the tendency over time to underestimate the probability of low-frequency shocks. To the extent that subjective probabilities decline even though actual probabilities remain constant or increase, banks take on greater exposures relative to their capital positions and the banking system becomes more vulnerable to a disaster. This is an insidious process. Disaster myopia can lead banks to become more vulnerable to a disaster without anyone having taken a conscious decision to increase insolvency exposure.
Susceptibility to disaster myopia is often reinforced by several institutional factors. For example, managerial accounting systems may inadvertently favor activities subject to low-frequency shocks. Although standard accounting practices are helpful in monitoring, pricing and provisioning for high-frequency shocks, they are not useful in controlling exposure to a low-frequency hazard because the shock occurs so infrequently that it will not be captured in the usual reporting period. Indeed, the absence of bad outcomes in the accounting data may intensify pressures to reduce default premiums and reserves. Moreover, in the absence of appropriate provisions for potential losses, an activity subject to low-probability shocks will appear misleadingly profitable. This problem is often compounded by the practice of recognizing fees (which may be considerable in some lines of real estate finance) up front, when the loan is booked, rather than amortizing them over the life of the loan.
The illusion of high profitability creates additional problems. To the extent that salaries and bonuses are based on reported short-term profits without adjustment for reserves against shocks, the line officers who are in the best position to assess such dangers will be rewarded for disregarding them.
In addition, competition may interact with disaster myopia in two related ways to increase vulnerability.
First, competitive markets make it impossible for banks that are not disaster myopic to price transactions as if there were a finite probability of a major shock when banks and other competitors who are disaster myopic price them as if that probability were zero.
Second, if banks are apparently earning returns above the competitive level (disregarding the need for reserves against future shocks), equally myopic banks will be encouraged to enter the market, thus eroding those returns.
In response, banks can protect target rates of return on equity for a time by increasing their leverage and rationalizing such actions in terms of the need to maintain target returns in the face of shrinking margins, and in terms of similar actions by other banks. Thus competition, interacting with disaster myopia, may accelerate the process through which banks become increasingly vulnerable to a major shock like a collapse in real estate prices.
Once a shock occurs, disaster myopia turns into disaster magnification. The availability heuristic may exacerbate financial conditions because, just after a shock has occurred, it is all too easy to imagine another sharp decline in real estate prices and the subjective shock probability will rise well above the true shock probability. As Guttentag and Herring (1984) show, this will result in sharply increased tiering of interest rates in financial markets as lenders try to reduce exposures and increase risk premiums in response to sharply higher shock probabilities. The extent of credit rationing is likely to expand for borrowers who cannot offer a credible contractual rate that will compensate for the increase in the perceived risk of default.
The abrupt drop in the flow of credit to the real estate market will put further downward pressure on real estate prices. This is also likely to diminish lending to other sectors of the economy as banks try to rebuild their reserves and capital to cope with the increased risk of default. To the extent that supervisors and regulators are susceptible to disaster myopia, they are also likely to suffer from disaster magnification. In response to the greatly increased subjective probability of a disaster they may seek to protect the banking system by insisting on higher capital ratios and more aggressive provisioning against potential losses.
Bubbles in Real Estate Markets By Richard Herring And Susan Wachter
First posted March 9, 2008