From hubris to nemesis: Irish banks, behavioural biases, and the crisis

1. From hubris to nemesis: Irish banks, behavioural biases, and the crisis Michael Dowling, Dublin city university Brian Lucey, Trinity college Dublin

2. A behavioural perspective on Irish bank directors and risk management

3. Background on the paper • This paper was written as part of a behavioural finance special issue of the Journal of Risk Management in Financial Institutions, and reflects a recent rise in interest in behavioural finance issues in risk management • Behavioural perspectives on risk management are surprisingly scarce. For example the GARP Financial Risk Manager course publications make no significant mention of how psychological factors might affect risk management strategies • The backdrop of the Irish banking crisis provides a useful case against which to apply a more modern risk management perspective

4. The risk governance role of board of directors Source: Rittenberg and Martens (2012)

5. Bank risk management: Basel • Some basic requirements are Value-at-Risk to measure market risk, supplemented by stress testing: “stressed VaR” • A key issue is that this can lead to an overreliance on purely quantitative approaches to risk management, and perhaps an ignorance of the choices involved in constructing these models • Anecdotally: Alloway, 2013, Financial Times

6. The board of directors and risk management • Given the risk monitoring / risk governance role of the Board of Directors, and given the collapse of the Irish banks: were bank directors and the Boards fit for purpose? • Two issues here: • Is there an optimum Board structure for maximising risk governance? • Are there particular behavioural biases that might affect directors and bank executives in carrying out their duties?

7. Board design • The Board of Directors is considered to be the highest-level of control mechanism in an organization as they possess the ultimate power to sanction and compensate the decisions that are made by top management • A number of studies have suggested that Board composition can have an important impact on effectiveness of this oversight. ‘classic’ findings include: • Board size: small boards are most effective at monitoring, while large boards provide a valuable advisory function to top management (Coles, Daniel, Naveen, 2008) • Independent directors: provide an effective monitoring role and are able to restrain undesirable behaviours, such as excessive acquisitiveness (Kolasinskiand Li, 2013)

8. Modern research on board design • Recent research has expanded in a behavioural direction and is providing new insights into the effectiveness of Boards: • Gender: female directors are more active compared to male directors; attending more board meetings and being more likely to sit on monitoring committees (Adams and Ferreira, 2009; Terjesen, Sealy and Singh, 2009) • Age: reduced risk taking, as measured by acquisitiveness, in firms with an older CEO (Yim, 2013) and with older average age of directors (Dowling and Aribi, 2013) • Prior Experience: increased levels of debt issuance and other risk-taking behaviours when commercial bankers appointed to a Board of US non-financial firms (Burak Guner, Malmendier, and Tate, 2008) • Social Networks: ‘busy directors’ with multiple directorships are less effective at their monitoring role (Field, Lowry, and Mkrtchyan, 2013). The presence of director ‘interlockages’ (where firms share one or more directors on their Boards) is significantly associated with poor corporate governance (Devos, Prevost, and Puthenpurackal, 2009)

9. Application to banks • Most director studies exclude banks and other financial firms as their operating measures are different to other companies. This means there is a paucity of research in the area. • Berger, Kick and Schaeck (2012) utilise a dataset of German banks which have faced considerable pressure to increase number of female directors: while their surface analysis indicates that this was associated with increased volatility of earnings, this was argued to be related to lack of experience • Minton, Taillard, and Williamson (2011): increased levels of directors with financial expertise is associated with higher Tobin’s Q, a standard measure of the riskiness of firms (also found for European banks in Hagendorff and Keasey, 2012)

10. … and the irish case • Board Size: Average Board size for the four main Irish banks (AIB, Bank of Ireland, PermanentTSB, and Anglo Irish Bank) in 2007 was 14 directors compared to FTSE100 average of 10.6, suggesting Irish banks organised Boards for their advisory capacity rather than monitoring role • Female Directors: Three of the four banks had just two female directors in 2007, with Bank of Ireland just having one female director. Given the link between female directors and monitoring this can be construed negatively. • Social Networks: TASC (2010) ‘Mapping the Golden Circle’ analysed the 40 largest public and state companies. Identified a golden circle of 39 directors with multiple linkages across these organisations. • ‘Busy’: 24 (43 percent) of the bank directors in 2007 held a total of 63 directorships in the top 40 institutions in Ireland and also an additional 270 directorships in smaller organisations • ‘Interlocked’: Shared directors between the banks and other companies: Anglo: 10, BoI, PTSB: 8, AIB: 7. E.g. Anglo – McInerney. AIB - INM

11. End result

12. A quick note on behavioural biases…

13. In an irish context • The already-noted degree of social interconnectedness and lack of diversity among the Irish banks is a prime cause of groupthink and herding • Irish bank boards were also dominated by directors with financial expertise, mainly accountants, leading to a weddedness to existing paths and increasing conformity • Lack of alternative advice: • The conformity and lack of criticism amongst financial journalists has been well-noted (Fahy, O’Brien, Poti, 2010): E.g. ‘The Best is Yet to Come’ from the Economics Editor of the Irish Times • Even the now-perceived academic experts: Morgan Kelly (2007) while predicting 40-60 house price falls also said in the same paper ‘the larger banks which dominate lending are well capitalised’

14. The inside perspective • 2007 Annual Reports: • AIB: had ‘strength to meet the challenges’ • BoI: were ‘confident’ of emerging stronger from the financial market turmoil • Anglo: devoted the chairman and CEO statements to their recent successes and hoped to maintain 15% EPS growth • Brennan and Conroy (2013): analyse and (unnamed) Irish bank CEO’s statements to shareholders in the bank’s annual reports over 10 years • CEO displayed more hubris than found in previous studies • Increasing over time, peaking in 2008 just as the crisis intensified • Only 2 percent of sentences used contained any bad news • In general good news was attributed to the CEO’s own actions while bad news was blamed on external conditions

15. What next? • The international evidence suggests a strong link between risk management and behavioural characteristics of directors and executives, and the Irish bank evidence corroborates this story • Risk oversight is improved by greater Board diversity and less distracted and interlocked corporate Boards • Central Bank has focussed on hiring econometric PhDs as a response to the crisis, but should this be our primary preparation for the next crisis? • Professional risk management curriculums do not train risk professionals in behavioural influences on risk management. Does this need to be incorporated as a core part of the curriculum?