Altruistic risk taking in finance25.07.2017
In my earlier blog post on herding I pointed out that the literature has introduced the notion of altruism as a possible means to cope with the inefficiencies that result from negative information externalities. That means, if a person has private information that contradicts market opinion, herding is individually rational, thus contributing to collective failure. To the contrary, if individuals had social preferences they would include the negative effects of their own herding on the welfare of others. Thus, following private information would be an altruistic act. If people had social preferences anyway, this might even eradicate the cause of herding: For example, the individual with contrary private information might feel the ‘duty’ to reveal it by taking appropriate actions.
In fact, in our modern societies risk taking is partly treated as a public good because we think that taking individual risks is beneficial for society. We highly value entrepreneurship, therefore we have established institutional measures that foster risk-taking via limiting individual liability. However, these institutional devices indeed foster the salience of individual preferences as compared with social preferences, because they explicitly individualize benefits and socialize costs.
In a seminal recent paper, Ashraf and Bandiera have argued that altruism is endogenous to the economic, organizational and institutional context. Their empirical reference is the financial industry. They introduce the notion of ‘altruistic capital’ which accumulates via sequences of altruistic actions which receive positive feedbacks from the social and organizational environment. Their example taken from the financial industry is the problem of compliance, such as making profits from money laundering, as just one instance of excessive risk taking by testing all other kinds of legal limits. Since monitoring of such activities is difficult, there is much scope for individual advantage, thus producing negative externalities for society. On the other hand, altruistic preferences would imply that financial actors act responsibly on their own, thus giving up profit opportunities for the good of society. Ashraf and Bandiera show via a large international survey among employees of a global bank that conditions differ a lot across countries regarding the perceptions of social impact and social worth of such altruistic actions.
I think that this lends support to the idea that financial regulation has its limits. If you talk to bankers, they complain a lot about the suffocating effects of tighter compliance regimes in recent times. But this kind of regulation only creates even stronger incentives to circumvent it, because it increases risks, but also the expected profits of risk taking for those individuals who manage to find the loopholes. In the end, regulation can only follow the course of events, and the public good will be damaged anyway. This is an unholy alliance between public regulation and individual rationality, where the public interest undermines itself.
Therefore, there is another public interest in the accumulation of altruistic capital in the financial industry. In simplest terms, this means to increase the weight of social preferences in individual decision making. This is what I call ‘altruistic risk taking’, which is taking risks in a socially responsible manner. For example, we need an institutional and organizational setting where compliance is not monitored in ever increasing detail, but in which responsible actors adopt ethically sound business strategies autonomously.
How can this be achieved? I think the current approach is doomed to fail, which is just adding a ‘business ethics’ course to programs in finance at business schools. The formation of social preferences is a much more complex phenomenon. It can only be achieved by fundamental cultural changes in the socialization of actors in the financial industry. One step might be to rethink the relation between risk and profit in a fundamental way, such that the notion of risk would include negative externalities already on the theoretical level, like distinguishing between individual and social discount rates. Teaching students the use of financial instruments must include this on the elementary level. That might start the accumulation of altruistic capital in the earliest stages of their careers.
Ashraf, Nava, and Oriana Bandiera. 2017. „Altruistic Capital.“ American Economic Review, 107(5): 70-75. DOI: 10.1257/aer.p20171097