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  • 4th Apr 2023

Responding to financial turbulence

Rising interest rates have adversely affected bond yields around the world. Financial Institutions with sizable holdings, accumulated as part of what used to be prudent risk-management strategies in pre-inflation times, saw their portfolio valuations plummet. 

Silicon Valley Bank (SVB), the venture capital banker of tech innovators life-science companies, was no exception. Spurred by larger than expected withdrawals initially by clients with primarily non-insured deposits (ie deposits over $250’000), the bank rushed to meet depositor demands for cash, in turn realising further losses. Within a matter of days, the run on the bank was in full swing and despite the unprecedented move by the Fed to protect all deposits, SVB failed and it has since been bought by First Citizens Bank.

Arguably a textbook case of financial contagion, other financial institutions with links to SVB or pre-existing weak performance, soon found themselves in similar difficulties, thanks in part to the the belief that a wider domino effect had been unleashed. This included Signature Bank, a crypto lender (resulting in a takeover by New York Community Bank) and First Republic Bank, a lender to the ‘wealthy’ (since then provided a $30bn lifeline by a consortium of US banks). On the other side of the Atlantic, Credit Suisse, marred by a long series of scandals, was unable to stay afloat even with a CHF 54bn lifeline from the Swiss Central Bank, resulting in a subsequent takeover by UBS

History has shown that it ain’t over till it’s over. A lot depends on market ‘sentiment’, i.e. economic actors’ beliefs or attitudes towards specific financial instruments, institutions or entire market segments, in turn influencing their behaviour. A critical element shaping confidence is the expectation of how others will act. Professor Robert Shiller has argued that confidence can be shaped by popular narratives that propagate through the economy– stories that people use to make sense of the world around them, and which they share with others. This is related, but separate from the evidence-based assessment of the strength of fundamentals, as shown in the Diamond-Dybvig model. ‘Fundamentals’ refer to the core economic components of a bank’s balance sheets; their assets and liabilities, their ability to borrow or lend. If everyone merely responded to fundamentals, we would not have a situation where otherwise solvent banks were subject to bank runs – in normal times their (enhanced) capitalisation ratios are more than sufficient to cover short-term depositor calls on their funds. As such, market confidence is an inherently social concept, calling for a social approach.

What can Behavioural Insights offer to policy makers and central bankers faced with the Mammothian task of convincing economic actors to “stay calm” in times of crisis? Drawing on our extensive experience, we offer 3 suggestions that are easy, cheap and fast to implement: 1) pre-testing communications to ensure that they achieve their intended impact; 2) correct misperceptions around risk; and 3) invest in ex-ante preparedness through de-biasing forecasting and decision making processes. 

1. Turn communications from an art into a science

Communications are critical in a crisis. For example, the president of the European Central Bank, Mario Draghi, promised to “ do whatever it takes” in the midst of the Euro crisis in 2012. He did not announce a single policy measure, but risk premiums on 10-year bonds of distressed countries like Italy and Spain dropped sharply in response. His speech was credited with drastically reducing spreads on 10-year Eurozone government bonds.

Draghi’s speech was targeted at financial markets. But the same is true of communications targeted at the general public, particularly when delivered by a highly credible and powerful messenger. In Shiller’s Narrative Economics he describes how in 1933 President Roosevelt directly addressed the American public on the radio in the midst of a bank run, asserting “You people must have faith. You must not be stampeded by rumours or guesses. Let us unite in banishing fear.” Roosevelt’s personal and direct request was effective: when banks were reopened, money flew into the financial system, as opposed to out. 

Great communication can seem like an art: hard to get right, but you know what good looks like when you see it. However it can also be treated like a science. Speeches, announcements, and press releases can be rapidly tested and iterated to get them right before they are released.  For instance, at BIT we have worked with governments to test messages to reduce panic buying, and with the Bank of England to test inflation report releases. This can be done rapidly, and at scale with large samples to identify the optimum messaging fast. As the COVID pandemic unfolded, the key messages for the public evolved from hand-washing to compliance with lockdown restrictions to take-up of testing and vaccinations. Throughout, we conducted rapid testing with tens of thousands of participants, often within the space of days, to optimise government communications. The same approach could be deployed by financial regulators in the face of financial instability and wavering market confidence. 

2. Correcting misperceptions around risk

People often understand risk through the lens of emotion rather than probability; this is why we overreact to visceral, ‘dread’ risks like plane crashes and, unwittingly, are less aware of the impact of risks whose impact accumulates over a longer timeframe, such as smoking cigarettes or even environmental harm. However, as Spigelhalter’s excellent work in the domain of risk has shown, if we give people salient, relevant information on risks, they can update their priors and their behaviour. In this case, the information may be about deposit insurance: the fact that for many citizens, the government already has a scheme in place that protects their deposits. For instance, in the UK, awareness that the FSCS deposit insurance schemes covers ISAs – popular tax-free savings accounts- is relatively low, potentially leading them to overestimate the risk to their personal finances. Relatedly, individuals are particularly sensitive to perceived scarcity effects and are mostly loss averse. If there is even an inkling of doubt that unless they act now to withdraw their deposits, the bank may run out of money leading to potential losses for them, they will feel compelled to act to protect themselves, thus fulfilling the prophecy. 

Boosting awareness of and confidence in deposit protection schemes could have the effect of lowering perceived ‘threat appraisal’ – to borrow a term from protection motivation theory. Ambiguity on what is covered and what isn’t can create more volatility, as demonstrated recently in the US policy debate over whether deposits above $250,000 should be covered. 

3. Focus on anticipation rather than response

Finance Ministers and Central Bankers, as well as their staff are, like all of us, prone to errors in their forecasting and decision-making. A particularly costly one is recency bias, the human tendency to recall influential events that happened most recently, as opposed to those that are further remote (perhaps even before we were born), or indeed conceive of other possibilities that are yet to pass. This effectively means that collectively our policy makers tend to routinely “fight the last war” rather than the next one.

Add to that the fact that most policy-makers often surround themselves with people who are quite similar to them in terms of education and background (see eg the stats on educational diversity of the IMF and gender and ethnic diversity at the BoE). Although by no means the only factor, some have argued that this lack of diversity and inclusion has weakened those institutions’ abilities to conduct comprehensive risk horizon scanning exercises (see eg. IEO 2023 and IEO 2011)  

In our Behavioural Government report, we propose a range of strategies to tackle common biases in how risks and problems are noticed, processed and managed. They include the need to assemble teams that are cognitively diverse, introducing mechanisms for challenging underlying assumptions and building flexibility into policy action to allow for more agile, proportionate and appropriate responses. Such conscious de-biasing of forecasting processes alongside an agreement on response triggers when specific events come to pass can go a long way towards better calibrated policy making during crisis, therefore saving lives and money.

To conclude, we cannot avoid shocks and crises from occurring, whether of a financial, humanitarian or climate-related nature. But we can anticipate and handle these instances better. Behavioural insights focussed on effective communication, correcting risk misperceptions, and de-biasing forecasting and decision-making processes have a key role to play in enabling policy makers and regulators to carry out their policy objectives.