The psychology of buying collateral management solutions

I have been involved in collateral management for about 15 years.  For most of that time I’ve been selling solutions designed to support and promote the use of collateral.  Throughout my career, I have always been interested in the psychology behind buying what is, in effect, an insurance policy (how well are you protected in the event of a default).  I’m never more fascinated than when a decision maker, faced with a collateral related challenge and a series of possible solutions, decides to opt out of buying anything.  To remain effectively uninsured or, at best, under-insured.  I believe the world of behavioral psychology offers an insight as to why certain individuals find this option of greater risk most appealing.

This insight offered by psychology can be divided into two, risk related, themes: first, the stakes, the relationship between loss and gain.  Let us call this risk appetite.  Second, the perception of risk over extended or open-ended time frames.  Let us call this risk perception.

With regard to risk appetite, a number of studies in recent years have highlighted that human beings are more prepared to gamble to reduce a loss than they are to extend a gain.  A practical (and often used) example of this is the work of psychologists Kahneman and Tversky[1].  Here, they asked hundreds of individuals to make a choice between two bets:

1.     The option to win $300,000 with a 90% probability; or to win $600,000 with a probability of 45%

The results were overwhelmingly in favour of the $300,000 safer bet (86%).  Participants within the study would far rather accept the lower cash value with a far higher, near certain probability, than gain an extra $300,000 on a riskier bet.

The genius of Kahneman and Tversky was to then reverse the question. They asked the same individuals to make a choice between:

2.     The option to LOSE $300,000 with a probability of 90%; or to LOSE $600,000 with a probability of 45%

In this case, the results were overwhelmingly in favour of the riskier option (92%), i.e., in an attempt to possibly eradicate a loss, the individuals questioned were happy to risk losing a far greater value, in this example, $600,000. Where a loss was involved, human nature greatly increased their risk appetite.

I stress, this was part of a far broader study and indeed part of many decades of groundbreaking work by Kahneman and Tversky.  They concluded early on that “…people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty.  This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses.”

Let me address the question of risk perception before we consider how this affects decision making around collateral management solutions.

Amongst other findings, a recent study by Thomas Epper and Helga Fehr-Duda[2] identified that individuals are far more likely to choose riskier options where the length of delay in which an outcome materialises is longer.  In addition, people are again happy to choose riskier options where there is no transparency around the outcome of their decision until the very end point.

They illustrate this with insurance decisions, comparing life insurance policies with a flight insurance policy which covers the same event but expires immediately when your flight lands.  There can be little doubt that large percentages of Western populations (myself included!) have long been and remain grossly underinsured.  However, flight insurance policies were highly popular in the 1950s and ’60s[3].  Individuals were very happy to pay substantial premiums to insure themselves against a highly improbable, near-term outcome.  To quote Epper and Fehr-Duda: “Delay dependence of risk tolerance implies that rare adverse events that tend to be overweighted when perceived to materialise soon may end up being underweighted when expected to materialise in the remote future.”  In lay terms, we worry much more about an event (death!), however unlikely it may be, where we contemplate its occurrence in the immediate future versus the same events occurring some time thereafter.

So, how does this psychology relate to collateral management?  Or more specifically, buying a collateral management solution?  I would say that the nature of the decision is closely related to the dynamics identified by both studies.  The cost of a collateral management solution is perceived by some as a ‘loss’, this in turn prompts those individuals to take the gamble i.e. to do nothing.  Further reinforcing this tendency is the risk perception, when the ‘gamble’, or potential for future disaster, is likely to play out over many months and years rather than in the immediate future, per the observations of Epper and Fehr-Duda.

I realise that there are many other influences at play in these decisions.  However, I actually regularly witness this thought process being played out.  This is in spite of the fact that the frequency and impact of financial crises are increasing, thereby amplifying the long-term risk associated with inaction.

Some might argue that I’m stretching a point.  That the correlation between having a robust solution in place and being uninsured or under-prepared is, at best, tenuous.  To these individuals, I would make the following points: the world of finance is littered with examples where a lack of focus or even negligence has led to calamity, and during the next crisis, without a doubt, a number of institutions will become insolvent due to poor risk and/or collateral management practices.  How can no solution or no decision be your best defense against this?!

I would summarise by adding that due to the entrance of cloud-based systems, the cost of collateral management platforms has declined rapidly in recent years, and so perhaps the impact of the behaviors identified above will become more limited.  Also, understanding the role that human nature plays in these decisions may be the first step in combatting this phenomenon.

[1] Prospect Theory: An Analysis of Decision Making Under Risk, Daniel Kahneman and Amos Tversky, 1979
[2] A Tale of Two Tails: On the coexistence of overweighting and underweighting of rare extreme events, Thomas Epper, Helga Fehr-Duda, April 2017
[3] As recently as 1997, AIG applied for the right to sell flight insurance policies at Japanese airports

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