Five Years After Lehman’s Collapse, Bankers Still Haven’t Confronted Their Biases

In 2005, four dozen senior executives at Lehman Brothers took a decision-making course. They holed up at the Palace Hotel on Madison Avenue and heard from top business school researchers and behavioral psychologists about dangerous cognitive biases. Then they rushed back to their headquarters in Times Square and made some of the worst snap decisions in the history of financial markets.

Five years after Lehman’s collapse, the question endures: can bankers learn the limits of human cognition? Might tomorrow’s bankers redesign a course to help them learn something useful and lasting from Lehman’s legacy? Or are they doomed, like lemmings, to repeat the same mistakes?

Unfortunately, financial leaders still do not recognize that Lehman’s widely-publicized transgressions — accounting shenanigans, massive leverage, undisclosed risks — were the symptoms, not the disease. And the disease is spreading. Regulators who focus on new capital requirements or proprietary trading limits for banks are missing the one problem that those rules do not address: modern financial markets tempt human beings into cognitive error.

Instead of recognizing and confronting this problem, financial market participants are following Oscar Wilde’s advice about how to overcome temptation: they are yielding to it, in droves. Today’s super-fast technology cues traders’ fight-or-flight responses, leading them to make snap decisions that do not account for the probability of disastrous future events. Even the supposedly long-term compensation structure of banks – the annual bonus – leads salespeople and brokers to ignore future harm and focus too much on immediate consequences. Day-to-day, bankers’ lives have come to resemble those of the impatient four-year-old children in the famous “marshmallow experiment”: they cannot wait 15 minutes for a second treat.

In the past, reputation was an effective tool to police bad financial behavior. At banks a hundred years ago, as in hunter-gatherer society a hundred thousand years before that, people worried that bad behavior might ruin their futures. They paused to consider the long-term consequences of what the human beings who mattered in their lives might think about their behavior.

But because today’s bankers succumb to short-term bias, they care less about their longer-term reputations. Moreover, the complexity of modern markets and the detailed (often nonsensical) web of financial regulation have impersonalized finance so that reputation has become virtually irrelevant. When the majority of banks and bankers have bad reputations and there are no real personal consequences for ripping off a client or taking excessive risks, it doesn’t matter what you do.

To some extent, human beings can overcome their cognitive biases. Deliberative speed bumps can slow down snap decisions. A longer-term approach to compensation — the career instead of the year — can lead people to think more about future gains and losses. The prospect of real reputational consequences might make the next rogue banker think twice. Lehman’s bankers didn’t imagine that their actions might destroy their reputations. And, in fact, for most they did not.

Financial leaders who want to avoid becoming the next Lehman should structure their decision processes so that, instead of always lunging ahead, they consider the best arguments against their gut reaction. That doesn’t mean their decisions need to be slow, just that they should be conscious of potential error. Bank officers might require traders to reflect periodically on their positions: how much are they really worth and what risks do they face? Supervisors might stop relying on overly simplified numerical measures of risk, which attempt to predict what will happen most of the time. Human beings tend to anchor thoughts around such numbers, so that they become blind to other factors. Instead of crunching numbers, bankers should tell stories. They should reflect on worst-case scenarios and conduct what the psychologist Gary Klein calls a “pre-mortem” by imagining hypothetically that their bank has failed and then asking what led to the failure. In other words, they should stop, wait, and think.

The main lesson of Lehman is that banking should be a slower profession, as it once was — like medicine or law. Professions require thoughtful training, and courses designed to tap our human spirits, not our animal ones. When Joe Gregory, the former president of Lehman, preached that employees should “go with their gut,” he was leading them in the wrong direction.

Like humans, lemmings have strong biological urges. Yet the urban myth about lemmings is false: in fact, they rarely rush into collective death. When they arrive in groups at a body of water, they usually have the collective wherewithal to stop. Perhaps one day that might be true of bankers as well.

This entry was posted in Leadership. Bookmark the permalink.

Comments are closed.