Decision-Making Biases and the Irish Banking Crisis

An interesting new working paper by Peter Lunn in the ESRI looks at decision-making biases and the Irish banking crisis. The article outlines extrapolation biases, confirmation bias, overconfidence, ambiguity aversion, behavioural convergence, time inconsistency and loss aversion as potential contributors to the banking crisis. There is a lot of interesting material in the article. One issue I have is that many of the biases outlined are general mechanisms and so don’t give a theory as to why Ireland, in particular, had such a dramatic crisis that was so systemic. I think ultimately a behavioural theory of the Irish banking crisis should have some interaction mechanism perhaps with country size or network density. Another area that I think should be developed is the extent and determinants of underdiversification in Irish household wealth portfolios both in terms of country concentration and asset class concentration. I am writing a lengthier comment on this and will link from this post, but put the paper up for now for info.

13 thoughts on “Decision-Making Biases and the Irish Banking Crisis”

  1. @Liam Delaney
    “Another area that I think should be developed is the extent and determinants of underdiversification in Irish household wealth portfolios both in terms of country concentration and asset class concentration.”
    I think you have a key contender here. Housing price booms are permitted to continue precisely because they benefit those in ‘power’. Their houses appreciate by the most (in general they earn more and have bigger/better located houses). Equally, there’s a large font of soft condition loans at stake at some of the institutions and serious party funding, so there’s an element of obligation.

    Finally, politicians in general seem to be suckers for the ‘rich’ particularly the newly rich, lauding them as successful entrepreneurs and shining examples of all that’s best, boosting their image of themselves as essential managers of economic miracles, promoting new alliances industries while denigrating the old ones and old alliances.

    Closer to Boston than Berlin? In bubble terms yes; in governance terms closer to Haiti than Helsinki…

  2. There are seventeen countries in the eurozone and a combined population of 330 million people. We all have one currency,one central bank,one set of interest rates and one set of commercial property lease law. There is one exception to these four variables–Ireland , it has entirely different commercial lease law to all other eurozone countries.

    In all other eurzone countries commercial lease lengths are short,with break clauses,-say three to ten years and rents are adjusted annually by the increases/decreases in the consumer price index. Uniquely in Ireland lease lengths are long say twenty five/thirty five years ,with no break clauses,and rents are reviewed every five years using the upward only rent review commercial lease clause.

    Irish commercial lease law incentivised the overrenting of commercial properties and massively inflated the valuation model for commercial property. Irish banks lent billions against these leases not against the properties. On page 123 of the Fitpatrick Tapes , Fitzpatrick declared “Our exposure is not to the building,it`s to the money that comes from the the leasing of it. If the value of the property goes down ,it dosn`t matter. We still get our loan repaid.“ Fitzpatrick was nothing if not consistent in this ,one of his core philosophies. You could not get these leases in any third world country or certainly not in any other eurozone country.

    These leases also had an unintended consequence of incentivising the oversupply of residential units. Mixed use schemes sprung up everywhere,but it was the commercial component that was seen as the “jewel in the crown“because of these unique commercial leases. The game plan was simple;sell-off the residential units as quickly as possible to cover the costs of the development, but keep the priceless commercial units because banks would lend handsomely on these highly prized financial assets. Why ? because rental growth was assured–upward only–a one way bet. Page 86 Breakfast with Anglo-Simon Kelly writes“ We had lined up a great array of retail tenants, ,including the restaurant chain Milano,AIB and Marks&Spencer ,and we intended to retain these shops as an investment while selling off the apartments. That had become our game plan all over town;hold on to the commercial rental income, and sell off the residential“

    If Ireland had regular eurozone lease law it would have been virtually impossible to have had a monster commercial property bubble. I have a retail outlet on Grafton street ,with a thirty five year lease ,no break clauses and paying one of the highest rents in the world courtesy of our poisonous lease law. In most other eurozone countries there would be a break clause after three years.

    High rents are the symptom, the lease law is the disease. In europe you value commercial property on the quality of the property,in Ireland you value commercial property on the quality of your tenant.

    Irish commercial lease law did not just destroy the tenants –it wiped out the banks.

  3. This observation is not limited to Ireland – so too were events on the global scale. Thus, the implication for the economics community is that we need to be open to alternative methods and models that might improve our intuitions.

    +1

    I would be tempted like to include here, that the structures of representative democracy would benefit from the same openness, to throw over board entrenched ideas and ideological barriers, in the knowledge and from the insight that the problems at hand are of multilevel complexity in deed and not exclusive to economics.

    Thanks for the link Liam.

    Best
    Georg

  4. @hogan….

    Closer to Boston than Berlin? In bubble terms yes; in governance terms closer to Haiti than Helsinki

    I really liked that! 🙂 excellent!

  5. Perhaps it’s the academic style, but 30 pages seems a bit excessive to do not much more than list a few decision biases, to tick the box that says “Yep, this happened in Ireland” and to give a few examples.

    Sorry if I’m too negative, but that was a lot of text for not a lot of information.

  6. Hoganmahew wrote,

    Finally, politicians in general seem to be suckers for the ‘rich’ particularly the newly rich, lauding them as successful entrepreneurs and shining examples of all that’s best, boosting their image of themselves as essential managers of economic miracles, promoting new alliances industries while denigrating the old ones and old alliances.

    Well spoken. I agree. There was a huge element of that. During the economic miracle phase of Ireland’s short history as a nation, there was a lot of credit taken on board by politicians. Furthermore, the public in general were happy to place that credit upon the politicians. It wasn’t purely that politicians grabbed the praise and thanks of a grateful population, but citizens themselves were happy to play along for the most part. It is funny, how the same citizens who were euphoric about Irish politics and how much good it was doing for the country, are the citizens today, who preach to the younger people in Ireland having to leave etc, that politics makes no difference – it is irrelevant. It is startling to me, to watch this U-turn on a sixpence, done by a significant portion of those people in Ireland, who were young people themselves during the 1960s and 70s. BOH.

  7. John Corcoran wrote,

    There are seventeen countries in the eurozone and a combined population of 330 million people. We all have one currency,one central bank,one set of interest rates and one set of commercial property lease law. There is one exception to these four variables–Ireland , it has entirely different commercial lease law to all other eurozone countries.

    Agreed.

    I happen to be of the school of thought, that our corporate taxation, policies, are responsible for bringing many distortions into the economy in Ireland, which have cost the country enormously in terms of competitiveness, and many other metrics.

    I believe, what happened, was that instead of corporations paying through the nose for taxation on their regular business in Ireland – instead, all of that revenue passed on, in some way or another to private landlord institutions – which in turn, imbalanced all of the banking system in Ireland.

    In other words, instead of banks helping to extend credit to business – Irish banks tried to extend credit to businesses, to get out of business and get into being property owners and landlords instead.

    There hasn’t been an honest, thorough, impartial study of the impact of that banking policy in Ireland, over an extended period of time, and the damage it wrought on the jobs-making engine that the country needs. BOH.

  8. The expression of humility (with an echo of Socrates) in the last paragraph is worth reflecting upon:

    “..it is incontestable that the severe events that unfolded in Ireland after the turn of the millennium were partly, perhaps largely, beyond the methods, models and intuitions of the [economics] profession.”

    But it is much less a failure of the economics profession than it is a failure of democratic governance. It is not the dogs that did not bark, nor the fact that they didn’t fully recognise the dangers and threats that should have caused them to bark, that should be the focus. It is the fact that the dogs were locked, and cheerfully allowed themselves to be locked, in sound-proof sheds where any barking they did indulge in wouldn’t be heard – or the muffled yelps could be ignored.

    The Dail and its Cttees are underempowered, under-resourced, unwilling and have no incentives to provide the forum where adversarial disputation of public policy and regulation may take place with a view to forming reasoned judgements on these matters – in public and in the public interest. And, indeed, they are prevented by governments from doing so.

    This is the only way the demand for the kind of analysis presented in this paper – and much more economic analysis of this nature – could be generated. And the analysis and evidence would be presented and contested in adversarial disputation before these public cttees. It wouldn’t guarantee that stupid policy decisions wouldn’t be made, but it should minimise their incidence and severity.

    We just don’t do adversarial – except in the courts (where it’s poncily dressed up), mock faction fights in the Dail and, unfortunately and increasingly, between the public and the private sectors. In all other areas the emphasis is on being polite, ever so polite. And this suits those who exercise power and influence. They can conceal their ‘groupthink’, woolly thinking and the special pleading and concessions to vested interests under a blanket of consensus-seeking ‘consultations’ with ‘stakeholders’ (all conducted and informed by ‘international best practice’). The adversarial advancing of evidence-based contentions is frowned upon, dismissed or suppressed. But adversarial collective action is the only thing they really understand, are vulnerable to and therefore fear. So it must be suppressed and headed off at all costs.

    And one must concede that those who exercise power and influence in this country have been remarkably successful…so far.

  9. In late 2006 I happened to tune into an interview on RTE News at One in which a young hairdresser, who appeared to know her business quiet well, had been to see her Bank Manager to try and arrange financing to increase her staff numbers in order to accomodate demand she felt was there in the market. The Bank Manager, however, refused her the facility but offered her financing if she wished to purchase the building from which she conducted her business. The young lady in question politely refused the offer as she stated to the interviewer “I am a hairdresser and not a property manager”.

    Explaining the actions of the banking sector over the period 2002 to 2007 in behavioural finance terms possibly does a disservice to the discipline. I am afraid the problem was more fundamental as basic common sense was not too common in the centres of power within the sector over the period in question.

  10. Michael Garrahan,

    Interesting story.

    Not the half of it though. When the folk who really had acquired the skills to do business in the marketplace in property development and management in Ireland, witnessed what was going on, they decided there was far too much frothy and got out completely. Hence, the situation arose in Ireland, where an overwhelming majority of businesses operating (or pretending to operate), in property in Ireland deserved no more than the label of chancer. Of course, being a chancer didn’t come against anyone, as long as the asset inflation continued.

    Irish banks didn’t seem to care about this however. The crucial knowledge that should have been available in the property area, was leaking out of that sector as the boom continued. That was responsible for establishing a new set of unknowns surrounding the figures on the balance sheets of the banks.

    The wonderful thing about credit, is that it becomes available to worthwhile endeavours, of which there were some during the boom years. However, the credit seemed to become available to a far wider variety of folk, than was absolutely necessary. I heard the president of Stanford University remark not too long ago, that many undergraduates students had left without degrees during the dot.com boom in the 1990s. The funny thing is, many of them returned again in the later 2000s, having watched the dream collapse. BOH.

  11. @ Brian O“Hanlon

    Chancer may be a little severe. I think a more appropriate description might be “wheeler dealer“

  12. @ John Corcoran,

    The analogy I would use is that of a Twister, like those you see in the wide spaces of the north American heartlands. A natural phenomenon which rages its way through a countryside sucking up things as it goes. I have listened to anecdotal evidence which pieces together a picture which is very like this. And I tend to find, that the Irish Property Twister, worked by explusion of talent as it went, leaving it behind and taking up all kinds of random stuff here and there.

    Early in the process, a layer of construction and development talent which had been there before the 1990s exited the stage. It was followed by a new breed from Anglo. As the Anglo club got full, the new arrivals went down the street and were consumed by other banks such as BOI and AIB. That is, those rejected in one place, became the fuel for the next. This is what anecdotal evidence suggests at least. That the smart money got out, or attempted to get out and lesser and lesser ‘smart money’ came in.

    If I was to look at any decision making bias, in relation to banking policy and lending, I would model it somehow on the Twister idea. Simon Kelly talks about the fact, the banks were only annoyed when you paid them back. Which led to a trend, where those who were capable of paying back fell out of the system as time went on, and you were only left with a gigantic black swirling funnel of borrowers who go around and around, and are part of the thing for good. BOH.

  13. @liamdelaney
    “I think ultimately a behavioural theory of the Irish banking crisis should have some interaction mechanism perhaps with country size or network density.”

    The working paper is of some interest in that it provides examples of the various biases and heuristics in an Irish context. However, it does not address the causes of our recent economic problems because the biases are universal and ubiquitous in humans. Social networking factors, also, such as the presence of ‘interlocking directorates’ that TASK highlighted are also to be found elsewhere as recent research on ‘small world networks’ in Germany, US, Australia and UK has shown.

    What might be worth considering is the effect of major population changes on Irish personality characteristics following recent research published on regional variations in personality in the US (American Psychologist, Sept. 2010). Ireland suffered from 2 major population disruptions. The first occurred at the time of the Cromwellian settlement when the native population was reduced from 750000 to 350000. It is unlikely that the aggregate personality characteristics of those who survived and those who perished were isomorphic. At the time of the Great Famine and its sequalae the population on the island reduced by over 2 million. It is also unlikely that the 3 groups – those who perished, those who emigrated, and those who survived and stayed in Ireland – were isomorphic from a personality perspective.

    A hypothesis that might worth exploring is that these events increased the odds of ‘gombeen men’ and ‘cute hoors’ being found in the population of the island, just as there are regional personality variations to be found at the aggregate level of personality characteristics in the US. (The descriptors I have used are in the vernacular for the purposes of illustration). The descriptors are well known in an Irish context and the lexical approach used in personality research would suggests that such personality ‘types’ as the gombeen man and cute hoor could be of some social significance in an Irish context. It may be that these types are to be found among our business and political classes with greater frequency than elsewhere in the world. There is evidence that certain personality characteristics at the level of the individual decision maker can be detrimental to sound long term strategic decision making, and there may well be a link between aggregate and individual personality characteristics in business and political circles in Ireland. This would be more likely if Ireland is less of a meritocracy based society than other developed world countries.

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