Chasing the Greased Pig Down Wall Street

Donald Langevoort - Thomas Aquinas Reynolds Professor of Law, Georgetown University Law Center

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             Of all the questions about why the recent financial mess happened, the most troublesome have to do with why large, supposedly sophisticated financial institutions took on so much risk.  There are many possible responses, some of which are about informational asymmetries, others about agency costs and moral hazards, and still others—my particular interest here—suggesting that psychological and cultural biases were at least partly to blame. 

            In response to the crisis, many have called for more responsibility to be placed on corporate “gatekeepers” (outside directors, auditors, lawyers) to help control financial risk-taking.  But there is an especially daunting cognitive challenge faced by anyone who becomes involved in the institutional processes of risk perception and risk management.  If psychological or cultural forces alter or bias risk perception inside firms, then the firm’s managers may well come to believe in good faith—a cognitively-loaded legal construct, to be sure—that there is no risk or problem big enough to worry about, when an outside observer in possession of the same information might well disagree.  As one organizational behaviorist has said, “once you’ve been in water long enough, you no longer perceive you’re in water.”  That is true even when the water starts getting hot, as long as it happens gradually—the familiar reference to boiled frogs.  That is why the gatekeeper’s cognitive independence is so important. 

 Biases in Risk Perception

             Institutional judgment and decision-making take many different forms, making it hard to generalize about risk perception.  Some key decisions are clearly made by individuals (the CEO or CFO, for instance) or small groups (boards of directors).  But even these decisions are made in a highly social setting, based on information gathered, processed, and refined through institutional channels.  Much that is important in risk perception is what is not noticed or taken into account.  Though we can tie failures to notice to individual or small group judgment—that is what plaintiffs do when bringing bad faith claims against officers and directors—this is a domain that seems especially social and cultural. 

            In turn, we can connect this to the crisis.  As in most bubbles, housing prices (and hence the value of the securities and derivatives tied to them) rose over the course of an extended period of time under circumstances that seemed unprecedented historically and could be explained—the “this time it’s different” phenomenon—by reference to shifts in the technology of finance that allowed for a much more efficient diffusion and dispersion of real-estate-related risk.  What appeared to be a continuous trend could, therefore, be extrapolated forward without much pause, especially when authoritative figures like Alan Greenspan at the Federal Reserve were offering justifications for that perception and other major institutions were showing no signs of hesitation (social proof).  The technology of risk modeling used by financial firms institutionalized this and demanded data as inputs to complex mathematical algorithms in which the only available data was from the recent run-up.  And, we can add the obvious: the mind’s tendency to justify that which is profitable—motivated inference—which no doubt caused some people in these firms to ignore facts they did not want to confront.

            All of these biases played a causal role in judgment and decision-making on both the sell and buy sides; they fit readily into an account of cultural perceptions that simplify and motivate.  However, some law-and-economics proponents have pushed back against psychology-based accounts for the crisis.  Their point is that senior executives are presumably selected for their strong cognitive ability and managerial skills and, hence, should not be prone to the estimation biases that ordinary folk might exhibit.  As applied to the financial crisis, this suggests that financial firms simply took calculated risks (admittedly in the face of great informational ambiguity) given the attractive rates of return, and any distortions from the optimal resulted from conventional agency cost and moral hazard problems. 

            This alternative account cannot be ruled out.  But, at the very least, we should try to drill deeper to ground the case for psychology and culture as causal forces in suboptimal decision-making in highly competitive firms.  One insight seems intriguing and has substantial support in the economics literature.  CEOs and other senior executives may be chosen precisely because they exhibit certain traits—overconfidence being the most obvious—that are adaptive in terms of generating cohesion and motivation despite generating certain predictable costs as a result of the bias.  Alternatively, we could say that overconfident CEOs are the natural product of promotion tournaments monitored by people who lack the information, incentive, or both to make more finely textured choices.  Even if we assume a higher level of cognitive skill and prudence on the part of the CEO, a CEO’s information sources are diffused broadly within the organization, making CEOs dependent on institutional risk perception.  Where—as in the case of some securities and derivatives—risk is deeply embedded in a portfolio of unimaginable complexity, that dependency can be both considerable and disabling.  Finally, even if we put aside all these points, a psychological account could join up with the conventional agency cost analysis and emphasize motivated inference—that CEOs had compensation and career incentives to perceive the situation in a near-term time frame and dismiss risks that could be rationalized away. 

 Three Variations on a Theme by Chuck Prince

 A year or so before the crisis hit, the Financial Times quoted Citigroup’s CEO, Chuck Prince, as saying that he knew that “[w]hen the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”  This seeming reference to the children’s game of musical chairs has been repeated in countless books, articles, blogs and the like, not only because it hints at some contemporaneous awareness of looming risk, but because it is so evocative.  Consider three possible readings.

First, dancing evokes a form of emotional expression, not (usually) a logical one.  One of the problems with arid reference to heuristics and biases in much of the legal literature is that it fails to capture the emotional aspect of judgment and decision-making as it relates to risk.  In fact, in a growing body of work on cognitive neuroscience, researchers have come to better understand the strong role of emotions in financial risk-taking. Among many things, this body of work suggests that different portions of the brain are activated when emotions such as fear and greed are prompted, moving the locus of decision away from the rational processing of information that is centered in the prefrontal cortex. 

            The positive feedback that generates increasing levels of excitement and diminished risk perception can be personal success or the observed success of others.  This suggests a connection to adaptive corporate cultures, particularly their motivational function.  A contagion of enthusiasm energizes those segments of the organization responsible for the creation and marketing (or purchase) of complex financial products, enabling the extraordinarily hard work that goes into the high-velocity deal flow.  This is high-grade corporate grease.  It is likely to energize, if not enthuse, even the support staff in the back office—far from the trading desks and sales calls—because of the feeling of purpose and a profitable future.  Moreover, the corporate promotion tournament will favor those central to the excitement, who easily achieve the “high.”  They quickly take on more seniority and power, in turn silencing expressions of risk that do not share in the euphoria from people who might want to turn down the music.  Maybe that is why the dancing Prince described was so frenzied for so long.

            If Chuck Prince’s reference was to the children’s game of musical chairs, then it evokes a second possible reading—that the dancing was impossible to slow down because Citigroup was in competition with others, each with their eyes on a diminishing number of chairs.  This raises the issue of how the nature of organizational or individual judgment and decision-making shifts as a result of competition, beyond the self-evident effects on the pay-off structure of the game.  Given my focus on firms in hyper-competitive industries, this inquiry is particularly important.  As sports coaches stress, competition demands especially high levels of focus and intensity; distractions are dangerous.  It seems intuitive that the more intense the competition, the more essential the grease.

            We have interesting evidence from recent research on the psychological effects of competition.  A common laboratory finding regarding auctions is that they can trigger a desire to win that carries over even if success is more costly than not winning—the tendency to overpay, which is one explanation for why mergers and acquisitions are so often value destroying.  The “competitive arousal” model of decision-making suggests that situational factors such as rivalry, heavy time pressures, and the presence of an audience prepared to judge the competition stimulates a physiological arousal that pushes motivation away from simple goal attainment to an obsession with winning that crowds out more thoughtful consideration of risks and costs.  Note how deeply all three of those situational conditions affect the financial services industry, especially if there is shift to a new financial technology that firms are anxious to dominate.  Connected to the physiology of competitive arousal are studies indicating hormonal effects.  Testosterone, for example, is linked to a variety of competitive behaviors including power-seeking, social dominance, reduction in fear response, as well as financial risk-taking.  Anecdotal evidence that hyper-competitive firms select for high testosterone individuals (as evidenced by prior status achievement) suggests that this effect will replicate and intensify once such people are thrown into their probationary crucibles.  Here, of course, we are connecting back to the psychophysiology of emotional arousal in risk-taking, discussed earlier.

            In turn, hyper-competition generates other organizational consequences.  To meet high expectations, “stretch” goals are commonly established, which may lead to a higher incidence of aggressive (including unethical) behavior as the risk of loss becomes more palpable, a form of loss aversion.  Even without explicit goals and quotas, agents sensing competition will likely set their own aspiration levels.  A curious duality exists here.  The robust psychological phenomenon of loss aversion triggers greater risk-taking when, perhaps pessimistically, individual agents frame their decision in terms of the risk of falling short of expectations.  On the other hand, to the extent that organizational or individual overconfidence blunts the fear of failure, the resulting overconfidence implies excessive risk-taking apart from any framing effects.  It is hard to calibrate the corporate thermostat to reduce the heat of competitive excess without cooling things down so much that the firm loses its intensity and focus. 

            Finally, Chuck Prince said that “you’ve got to get up and dance,” but why?  Perhaps the competitive imperative described above can explain it.  But dancing can also be a performance art, meant for any number of audiences.  Maybe Citigroup and others were dancing so fast simply because the crowd—investors in the stock market—was demanding it.  The market as a scoreboard has an undeniable emotional pull.  When the stock price rises abnormally for a firm or industry, it is hard not to construe it as an endorsement of its strategy and direction, part of a feedback loop that combines with internal cultural optimism and self-interest to reinforce the belief that this is the right course of action.  The market’s wild applause and the deep fear that all performers have of disappointing the crowd surely fed Prince’s dance.      

 Goldman Sachs and God’s Work

             In a newspaper interview with the Times of London in 2009, Goldman Sachs’ CEO, Lloyd Blankfein, said that he was just a banker doing “God’s work.”  Perhaps this was meant facetiously—if so, it was a good example of Wall Street’s public relations learning disability—but, in any event, Blankfein’s statement was as evocative and infamous as Prince’s dancing reference, especially when the SEC brought its high-profile fraud case against the firm.

            Recall the claim that the bankers’ culture is of-the-moment, bowing to the innate legitimacy of the market mechanism and so seeking an unquestioning synchronicity with it.  This probably cannot be construed as a belief in the unerring accuracy of the market at any given moment so much as a Hayekian view of the necessary freedom of persons and firms to be tested in the crucible of the marketplace.  The market evolves toward accuracy and innovative efficiency but only through trial and error, in which rewards and punishments are apportioned rigorously for good and bad choices. 

            While I have difficulty calling this God’s work, I suspect that the culture within Goldman did embrace this myth, and maybe still does.  When Goldman defended itself in the press, it did so by saying that it was being a “market maker,” playing a central inventive role that assumed no moral or ethical obligations to either side of the transaction.  Goldman was a manufacturer of market crucibles in which willing participants could test their skills, knowledge, and mettle, with economic resources moving to the winners.  The willingness of the marketplace to compensate Goldman handsomely for playing this role was a recognition of Goldman’s intrinsic value and, hence, the legitimacy of its work.  So construed, there is no obligation (beyond legal ones) owed to anyone else that might be distracting in generating deal flow.  One should simply be smarter, faster, and stronger and take the rightful spoils. 

            Once again, we have found a thick coating of grease.  Doing God’s work, even in reduced dosage, is a classic form of moral rationalization that facilitates corner-cutting and rule-bending: excessive anxiety about whether the means are right burdens the pace of economic innovation, which is the legitimate end society should want.  So long as market players are acting by free will, insiders believe, they should understand the rules by which the game is played.  And those rules are not the least bit paternalistic. 

            The problem is that this is an ideology, not a truth.  Our society tends to acquiesce in it (and a great deal of lobbying by Wall Street seeks to assure the continued acquiescence) during good times, which can support the internal cultural belief in its legitimacy for a sustained period of time.  However, downturns and crises predictably happen, and investors and taxpayers facing losses of various sorts—and who do not feel personal responsibility for the poor investment decisions that led to those losses—are not enchanted by the social Darwinism in Wall Street’s “just making markets” defense for actions that seem exploitative.  In fact, it is striking how many financial frauds have taken place within industries undergoing a technological “revolution,” where inflated self-confidence caused by early marketplace success joined with a destiny myth to override the constraints otherwise imposed by reputation and law.

 The Gatekeeper’s Challenge

             Psychology and culture can play important cognitive roles by offering insiders scripts and schemas that simplify, coordinate, and motivate—essential elements of any business in a highly competitive marketplace.  These scripts and schemas need not correlate with a high degree of perceptual accuracy, especially in risk assessment; instead, some degree of inflated confidence and diminished risk perception can be adaptive in terms of promoting intensity and focus rather than disabling fear and uncertainty.  Firms that have this capacity are more likely to survive competitive pressures; in turn, once they have survived and flourished, they are likely to over-attribute their success to internal skills and competencies, thus bolstering the prevailing belief system.  Good fortune over time—even if just a matter of being in the right place at the right time—can bias perceptions considerably in this direction, leading to the promotion of leaders who are both products of this culture and mindset and evangelists for it.

            This is what gatekeepers should look for but not necessarily what they will find.  It’s a heuristic, designed to help those whose job it is—often as a matter of law—to help the firm make accurate risk assessments.  No doubt, a close, careful exploration of the human inner workings of any business will expose ambiguity and banality that confounds the predictions of any mental model; all firms are different, with unique path dependencies, routines, myths, and ever-changing situational pressures.  But looking for and worrying about ways in which overconfidence, emotions, competitive pressures, and ethical rationalizations might bias the assessment of financial, legal, and reputational risk is necessary to the task of managing those risks.  At the very least, the model instructs the gatekeeper not to fall prey to the illusion that, because the company’s leadership displays evidence of loyalty and commitment, its perceptions and inferences can safely be trusted.  Intensity and passion can instead be a sign that the greased pig is running loose.                


Donald C. Langevoort is the Thomas Aquinas Reynolds Professor of Law at Georgetown University Law Center.

This editorial is based on the article, Donald C. Langevoort, Chasing the Greased Pig Down Wall Street, 96 CORNELL L. REV. __ (forthcoming 2011).

Copyright © 2011 Cornell Law Review

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