Written by: Annanya Venkat
Bank collapse is a phenomenon that occurs due to a coalition of issues with a bank’s assets, liabilities, speculative investments, and more. However, most don't recognize that Psychology is heavily involved with Bank collapse. Bank collapses and financial crises are complex events that have far-reaching consequences on the economy, society, and individuals alike. Understanding the psychology behind these collapses is crucial for formulating preventive measures and managing the aftermath effectively.
Throughout the course of today’s blog, we will delve deep into the intricate psychological factors that contribute to bank collapses. We will learn more about psychological concepts involved with our economy and banking, cognitive and behavioral economics, behavioral panic, and regulatory failures that are involved with bank collapse.
The theory of behavioral economics illuminates the decision-making processes individuals employ in market dynamics, what drives public choice, and the factors influencing business behavior. The 3 psychological concepts that most widely influence banking are: heuristics, framing, and market inefficiencies.
Heuristics: Heuristics play a significant role in the context of banking and bank failures. These cognitive shortcuts are often employed by individuals and institutions to simplify decision-making processes, but they can also lead to biases and errors in judgment. In the banking sector, heuristics can deploy in various ways that impact risk assessment, investment decisions, and overall financial stability, contributing to potential bank failures.
Framing: Framing refers to how information is presented or "framed," influencing decision-making and our perception of risks and gains. In the banking sector, framing can shape the way stakeholders perceive the financial landscape, affecting their actions and attitudes toward banks and their stability.
Market Inefficiencies: Market inefficiencies stem from various cognitive biases and behavioral patterns that affect decision-making within financial markets, including those related to banking. Market inefficiencies often arise from herd mentality, where individuals tend to follow the actions of a larger group without critically evaluating available information. This behavior can be observed in banking, where depositors might withdraw funds based on what others may be telling them.
Cognitive and behavioral economics play a significant role in banking and can contribute to the occurrence of bank collapses. These fields study how psychological and cognitive biases influence economic decisions, impacting the behavior of investors, regulators, and other stakeholders within the banking industry.
Their roles in the context of banking and bank collapse can be shown through the following:
Loss Aversion and Risk Assessment: Loss aversion, a principle in behavioral economics, suggests that people tend to strongly prefer avoiding losses over acquiring equivalent gains. In banking, this can lead to overly cautious behavior, causing banks to avoid certain investments or activities that may carry inherent risks but also potential rewards. This aversion to risk can limit growth opportunities and affect the overall stability of the bank. Conversely, it can also lead to excessive risk aversion, preventing the adoption of necessary risk management strategies.
Overconfidence: Overconfidence, a cognitive bias, can cause individuals within the banking industry to overestimate their abilities to predict market trends and make sound financial decisions. This overestimation can lead to excessive risk-taking, where bankers might engage in risky lending practices or invest in volatile financial products, believing they can accurately predict and manage the associated risks. If these risks materialize differently than anticipated, it can result in significant losses and, potentially, the collapse of the bank.
The psychological concept of behavioral panic significantly influences banking and can be a key factor contributing to bank collapses. Behavioral panic, rooted in cognitive and emotional responses, refers to a sudden, often irrational, collective reaction to perceived threats or uncertainties. In the context of banking, behavioral panic is demonstrated in scenarios where depositors and investors, driven by fear and uncertainty, rush to withdraw funds or sell their investments quickly and in bulk.
How behavioral panic influences banking and its potential role in bank collapse can be explained by the following:
Depositor Withdrawals and Bank Runs: Behavioral panic can trigger bank runs, where a large number of depositors, alarmed by negative news or rumors about a bank's stability, rush to withdraw their funds simultaneously. This mass withdrawal stems from a fear of losing their deposits if the bank were to collapse. The sheer volume of withdrawals during a bank run can deplete a bank's reserves, exacerbating its liquidity problems and potentially pushing it toward insolvency.
Market Volatility and Investor Sell-offs: In the broader financial markets, behavioral panic can lead to a sudden and widespread selling of bank stocks or financial instruments linked to banking. Negative news or events can trigger a domino effect, causing investors to fear losses and start selling their bank-related assets, further driving down prices and eroding market confidence. This market volatility can weaken the financial position of banks, affecting their ability to raise capital and maintain stability.
Amplification of Crises: Behavioral panic can amplify the impact of a crisis by creating a contagion effect. Even if a crisis initially affects a specific bank, the panic and fear generated can spill over to other banks and financial institutions. Depositors and investors may start to question the stability of multiple banks, leading to a broader crisis of confidence within the banking sector. This loss of trust can escalate into a systemic issue, ultimately causing multiple bank collapses.
Bank collapses are not only the result of financial mismanagement, but a complex interplay of cognitive biases, psychological concepts, and collective behaviors. By recognizing and understanding these psychological factors, we can better anticipate and mitigate the risks that contribute to the downfall of banks.
To navigate and prevent bank collapses, it is imperative for stakeholders, regulators, and policymakers to integrate psychological insights into financial practices. Implementing measures that address cognitive biases, enhance transparency, and foster effective decision-making is crucial for a more resilient and stable banking sector, which ultimately safeguard economies and societies from the repercussions of bank failures.
Sources
What is a Bank Failure? ~ Investopedia: What Is a Bank Failure? Definition, Causes, Results, and Examples.
Why Bank Runs Happen: ‘It’s like a mass delusion that becomes a reality’—causing crises like the SVB collapse ~ CNBC: Why bank runs happen: 'It's like a mass delusion that becomes a reality'—causing crises like the SVB collapse.
How the Psychology of Silicon Valley Contributed to a Bank Collapse ~ Scientific American: How the Psychology of Silicon Valley Contributed to a Bank Collapse - Scientific American
Most U.S. bank failures have come in a few big waves ~ Pew Research: https://www.pewresearch.org/short-reads/2023/04/11/most-u-s-bank-failures-have-come-in-a-few-big-waves/
Bay Area Behavioral Economist Says Psychology Has a Lot to Do With Silicon Valley Bank Collapse ~ KQED: Bay Area Behavioral Economist Says Psychology Has a Lot to Do With Silicon Valley Bank Collapse | KQED
Banking on Humans~ Infosys: Banking On Humans
Why our brains are hard-wired for bank runs like those that toppled SVB, Signature ~ CNBC: https://www.cnbc.com/2023/03/17/why-investor-brains-were-hard-wired-for-bank-runs-at-svb-signature.html
How Behavioral Economics is Helping Banks Drive Better Money Management Experiences ~ Personetics: https://personetics.com/how-behavioral-economics-is-helping-banks-drive-better-money-management-experiences/
Financial Crisis Illustrates Influence of Emotions, Behavior on Markets ~ PBS NewsHour: https://www.pbs.org/newshour/science/science-july-dec08-marketpsych_10-08
‘Is My Money Safe?’ Financial Failures Spark Worry ~ Investors Business Daily: https://www.investors.com/etfs-and-funds/sectors/fdic-silicon-valley-bank-failure-sparks-panic-are-you-fdic-insured/
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