The root causes of the financial crisis are generally attributed to a combination of fundamental flaws in the financial system and human failure. It is therefore obvious that supervisors have tightened administrative controls and technical measures. At the same time it is far less understandable that human behaviour hardly gets any additional attention by supervisors. Consider, for example, the stress tests that are given a prominent position in the prevention of new financial blunders by banks and insurance companies. Wrapped up in challenging scenarios they particularly test financial resistance for severe external shocks. Human stress that arises in such crisis situations, however, only plays a marginal role. Wrongfully, as decades of catastrophes and research prove that people so often make disastrous decisions when they have their backs up against the wall.
In his book Predictably Irrational Dan Ariely, professor in behavioural economics at Duke University, describes a series of experiments that show how easily people are fooled by illusions. Caught up in emotions or overtaken by accidental circumstances we take irrational decisions, which sometimes directly conflict with our own ‘common sense’. To assess the influence of both low and extremely high rewards, Ariely travelled to the Indian countryside. By winning games some participants in his experiment could win prices of just a few roepies while for others months or salaries lay ahead. His findings are remarkable: groups that were offered lower rewards performed considerably better and gained three times as often the highest score as those that could earn truly major rewards.
Caught up by stress even the sharpest minds often take too hasty, irrational decisions. It is smart to develop your executives
personal stress in crisis situations.
‘Choking under pressure’
Ariely looks for an explanation in a phenomenon that is well known as ‘choking under pressure’. It happens frequently to investors that hold extensive positions or sportsmen that suddenly clam up completely when it comes to the crunch and the whole world watches their performance. When people’s motivation strongly increases, people become very conscious of their actions and disable their automatic behaviour. ‘On the training pitch everything he does succeeds, during the game it doesn’t add up’, the coach sighs. Once beyond a critical point, performance rapidly declines when competition, financial incentives and pressure on one’s ego increases. The stress that occurs proves to be especially disastrous for problems that require a combination of insight and creativity. Such circumstances exactly include the challenging crisis situations that can make or break companies.
Automatisms can, however, also overshoot in stressful situations. This happens particularly when suddenly unexpected threats arise that evoke feelings of high time pressure. Because people often exaggerate both in extreme situations, they prematurely and impulsively take rash decisions. They find themselves in a paradoxical state of high alertness in which their thinking and acting contracts to a few or just one option. Instead of weighing up the pros and cons of various alternatives in a structured way, people use little information they, moreover, often accidentally hit upon. When the effects they hoped for fail to occur, panic gets the upper hand and leads to a string of bad decisions. The acting of Lehman Brothers or BP in the Gulf of Mexico are just a few of many examples of this phenomenon. Afterwards everybody is astonished ‘how they could have done so’.
Towards personal stress tests
‘Everything becomes malleable under pressure’. People tend to speak it out with great relief in the hope that everything will turn out just fine by itself when the going gets tough. Unfortunately, in sudden crisis situations exactly the opposite happens. Caught up by stress people are led by accidental circumstances and take, often too hasty, irrational decisions. By only testing financial stress supervisors implicitly deny the role of human stress, which, as a subjective sensation, can work out differently for executives and their teams. Publishing stress scenarios beforehand gives financial institutions ample time to prepare in peace and quiet obviously does not produce any such personal stress. As long as supervisory bodies do not demand personal stress tests, companies are well advised to take up the challenge to simulate situations that do lead to severe and acute personal stress for their top-executives.
First published as a column in CFO Magazine.