Herding in Bank Panics

Herding in Bank Panics

The work of Devenow and Welch (1996) states that the most basic of human instincts is likely to be that of "…imitation and mimicry" which are the primary characteristics in what is known as 'herding' which often specifically occurs related to such as "fashion and fads…" (Devenow and Welch, 1996, p.603) Devenow and Welch go on to state that among financial economists there is a belief that "investors are influenced by the decisions of other investors and that this influence is a first-order effect." (p.603)

It is reported in the work of Donaldson (1992) entitled "Sources of Panics: Evidence from the Weekly Data" that panic is defined by Jevons (1884) as "a rapid rise in the rate of discount, a sudden flood of bankruptcy and a fall in consols, followed by a rise" (p.8). It is additionally reported that Calomiris and Gorton (1991) "define a panic as an event during which depositors "…at all or many banks in the banking system suddenly demand that banks covert their debt claims into cash (at par) to such an extent that banks suspend convertibility of their debt into cash or…act collectively to avoid suspension (p.112)." (Donaldson, 1992, p.277)

Edward F. Renshaw writes in the work entitled "Stock Market Panics: A Test of the Efficient Market Hypothesis" that the "fashion for person in the academic world has been to assume that changes in stock prices are nearly, if not quite perfectly, random and that the market for equity capital is fairly efficient." (p.48) According to Renshaw, this is quite simply not the case. Short-run changes in prices of stocks are stated by Renshaw to be "very higgledy-piggledy" with evidence of patterns emerging in the longer-run changes in stock prices. (1984)

II. Research Objective

The research project proposed herein would involve spending the next twelve (12) months studying existing work in this field of study and exploring the neurological basis of financial manias and panics under the supervisions of professor Morck and Silverstone.

III. Significance of Research

The significance of this research is the additional information and knowledge that will be added to the already existing knowledge base in this area of study.

IV. Statement of the Problem

There appears to be psychoneurological bases for the 'herding' behavior of individuals on banks in financial and economic crises but this is little understood.

V. Research Methodology

The research methodology chosen for the research proposed herein is of a qualitative nature and will involve an extensive review of literature in this area of study in order to better understand the phenomenon of herding behavior.

VI. Literature Review

Formal explanations based on theory of panics have focused on various elements of the panics. For example, individuals such as Bryant (1980), Diamond and Dybvig (1983) and others focus on examining why 'run the bank' "…is a rational equilibrium outcome for economy populated by sequentially servicing banks who promise to pay depositors more than the liquidation value of bank assets. Bank runs occur in these models when each depositor believes that others will attack an intermediary and force it into costly liquidation. The fear of being last in line at an ultimately insolvent bank causes everyone to run and thus produces a panic. Panics in these models are treated as randomly occurring events in that there is no explicit mechanism by which one can predict whether or not a panic will occur on any given date." (Donaldson, 1992, p.281-282)

It is reported that a second line of research includes individuals such as Jacklin (1983), Smith (1984), Gorton (1987), Chari and Jafannathan (1988) and others who focus primarily on information problems inherent in the bank-depositors relationship." (Donaldson, 1992, p. 282) This vein of research is focused on the fact that an individual depositors "…cannot easily observe the true liquidation value of bank assets and cannot determine whether another depositors who withdraws from the bank is doing so to satisfy a genuine liquidity need or whether the withdrawal is being made because the other depositors has received a private signal regarding the bank's insolvency practices." (Donaldson, 1992, p. 282) In this model, panics are more likely to occur 'when many agents receive a negative signal regarding the value of bank assets or when the general level of economic uncertainty is greatest." (p.282) These models are reported to indicate that the likelihood of a panic is greatest during periods characterized by "general financial distress." (Donaldson, 1992, p.282)

Donaldson (1992) reports that a third vein of research focuses on the "importance of market liquidity in determining the nature of panics." (p. 282) For example, Bhattacharya and Gale (1987) and Smith (1991) emphasize the fact that "…run banks have traditionally acquired the funds their depositors demand by obtaining cash loans from a central 'reserve agent' such as the Fed. In both models, the fact that several banks use the same reserve agent as a source for emergency cash causes a run on one bank to spread to other banks as the initially run bank drains funds from the common reserve agent and thus reduces the amount of cash available to other banks who also use the reserve agent as a source of liquidity." (Donaldson, 1992, p. 282)

The work of Prechter and Parker (nd) entitled "The Financial/Economic Dichotomy in Social Behavioral Dynamics: The Socioeconomic Perspective" proposes that when individuals are not certain "about the relative values of available options, they typically default to a herding impulse. In utilitarian economic settings, where certainty is the norm, people reason; in financial settings, where uncertainty is pervasive, they herd." (p.11) Herding is held by MacLean (1990) to be a behavior that is both "unconscious [and] impulsive" and is of the nature that develops "through evolution" and evolution is that which also maintains herding behavior. The purpose of herding is "to increase the chance of survival" because when human beings are unsure of what they should do "they are impelled to act as if others know. Because sometimes others actually do know, herding increases the overall probability of survival." (Prechter and Parker, nd, p.12) It is unfortunate, according to Prechter and Parker that investors in the modern financial setting "look to the herd for guidance" not realizing that other individuals in the herd "are just as uninformed, ignorant and uncertain as they are." (nd, p.12)

It was stated in the work of Cosmides and Tooby [1994, p. 327] that research findings from evolutionary psychology "suggest that explicit theories of the structure of the human mind can be made endogenous to economic models in a way that preserves and expands their elegance, parsimony and explanatory power." (Prechter and Parker, nd, p.12) Prechter and Parker (nd) state "In concordance with this inspiration, socioeconomics proposes that the neural origin of human behavior in economic settings is different from that in financial settings." (nd, p.12) It is reported that Montgomery (1983, 1985) was the first to explain the 'triune brain of MacLean (1990) in relation to the concept of herding in finance. Montgomery is stated to have proposed that "reason and herding are components of aggregate financial valuation." (Prechter and Parker, nd, p.13) Prechter and Parker (nd) state that they propose that economic behavior is "mediated primarily by the neocortex, which processes conscious ideas. Financial behavior, on the other hand, is mediated primarily by the limbic system and basal ganglia which generate unconscious thoughts and emotions among others." (nd, p.13)

Research that is more recent is stated to have revealed "that both normal and pathological mood regulation involve complex interactions among the limbic system, reticular activating system, prefrontal cortex, sympathetic nervous system and possibly other neural structures, most researchers still credit the limbic system with the central role in coordinating mood regulation. We are also aware of the theoretical and empirical problems with the "limbic-cortical" distinction as a way of describing emotional vs. cognitive aspects of mental activity and its neural correlates." (Prechter and Parker, nd, p.13)

It is reported in recent studies that "…unconscious portions of the brain can motivate herding behavior even while conscious portions are unaware it is happening." (Prechter and Parker, nd, p.13) Camerer, Loewenstein and Prelec (2004) are reported to have made provision of "a picture of the brain that has more modularity and independence among its neural systems than previously thought." (Prechter and Parker, nd, p.13) It is reported that Bischoff-Grethe et al. (2001) "provided neurophysiological evidence that the brain processes information differently in contexts of uncertainty vs. certainty, a finding that fits our contextual case for a neurological basis for the financial economic dichotomy." (Prechter and Parker, nd, p.14)

Another recent study conducted and reported by Shiv et al. (2005) provides support to the view of Bischoff-Grethe, et al. stating that they found that "patients with chronic and stable focal lesions in specific components of a neural circuitry that has been shown to be critical for the processing of emotions" made investment decisions that "were closer to a profit-maximizing viewpoint" than control subjects. The brain-damaged patients responded less emotionally to other subjects' behavior and were thus better able to execute a logical investing strategy. The researchers noted that "decisions under uncertainty . . . draw upon different neural processes." (Prechter and Parker, nd, p.14) Conclusions stated are reported as follows: "Depending on the circumstances, moods and emotions can play useful as well as disruptive roles in decision-making" (p. 428)." (Prechter and Parker, nd, p.14)

Prechter and Parker additionally report that over the past 3 1/2 decades "social psychologists have found that unconscious dynamics affect memory, perceptual skills, self-concept and self-evaluation, and biases and stereotypes related to race, gender and political partisanship. Socioeconomics adds financial decision-making to this list." (nd, p.14) Herding is reported to account for "human behavior in the financial realm that is anomalous to the neoclassical economic theory. The motivation of both types of behavior (financial and economic) is surely the same as that for all evolved behaviors: to survive and thrive. In finance, however, the mind is operating differently. Buyers in a rising market appear unconsciously to think, "The herd must know where the food is. Run with the herd and you will prosper." Sellers in a falling market appear to think, "The herd must know that there is a lion racing toward us. Run with the herd or you will die." (Prechter and Parker, nd, p.15)

The work of Avgouleas (2008) entitled "Reforming Investor Protection Regulation: The Impact of Cognitive Biases" states that Behavioral Decision Theory describes the "interdisciplinary intellectual movement that incorporates theories of decision-making that have their roots in: (1) the branch of cognitive psychology that is called psychology of judgment and choice, pioneered by two leading psychologists Daniel Kahneman and Amos Tversky and (2) experimental economics, a term that is mostly used to describe the laboratory tests of economic theory doctrines and the findings of those tests." (p.2) It is reported that studies that are empirical in nature and which have been "undertaken by psychology of judgment and choice scholars have documented the strong impact of cognitive processes (heuristics) and cognitive biases on individuals' decision-making." (Avgouleas, 2008, p.1) It is reported in the work of Kahneman and Tversky (1974) which provided a description of the heuristics of (1) representativeness, (2) availability; and (3) anchoring that people:

"…rely on a limited number of heuristic principles, which reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations. In general, these heuristics are quite useful, but sometimes they lead to severe and systematic errors. Cognitive biases are the results of the use of heuristics, when they lead to: (a) 'systematic errors in estimates of known quantities and statistical facts' and (b) systematic departures of intuitive judgments from the principles of probability theory." (Avgouleas, 2008, p. 2)

Avgouleas (2008) states that some of the cognitive biases which are most important are those as follows: (1) mental accounting; (2) overconfidence; (3) loss-aversion; (4) anchoring; and (5) the framing effect. (p.3) Behavioral finance theory holds that markets "move only on the basis of rational expectations. Namely, asset prices are set by rational investors." (p.4-5)

EMH is stated to be "the brainchild of rational choice theory" and to make the assumption that "…market reflect-equal fundamental value and change because of new information. Thus, in an efficient market no investment strategy can yield average returns higher than the risk assumed ('there is no free lunch') and no trader can consistently outperform the market or accurately predict future price levels, as new information is instantly absorbed by market prices." (Avgouleas, 2008, p. 5)

EMH further makes the assumption that "…markets are efficient and transaction costs relatively low giving 'professionally-informed traders' the opportunity to quickly observe and exploit through arbitrage trading any price deviations from fundamental value, as this would create an opportunity to profit from such discrepancy. The result of arbitrage trading is that prices reach a new equilibrium, which reflects more accurately the traded asset's value and corrects any mis-pricings."(Avgouleas, 2008, p. 5-6)

The primary assumptions of EMH are challenges by behavioral finance which has as its primary tenets that: (1) certain market phenomenon called anomalies or puzzles may not be explained by the EMH, whereas the use of psychology can provide convincing explanations and (2) the corrective influence of arbitrage trading is limited due to a number of restrictions." (Avgouleas, 2008, p.6)