Intellectual hazard: how conceptual biases in complex organizations contributed to the crisis of 2008.

• Author: Miller, Geoffrey P.

INTRODUCTION I. INTELLECTUAL HAZARD A. Complexity Bias B. Incentive Bias C. Asymmetry Bias D. Intellectual Hazards in Financial Markets II. INTELLECTUAL HAZARD AND THE CRISIS OF 2008 A. Banks B. The Fed C. Rating Agencies D. The Basel Committee E. Regulators III. POSSIBLE REFORMS A. Complexity Bias B. Corporate Governance Reforms C. Education D. Government Reforms E. Stress Tests CONCLUSION INTRODUCTION

This Article identifies an important but previously unrecognized systemic risk in financial markets: intellectual hazard. Intellectual hazard, as we define it, is the tendency of behavioral biases to interfere with accurate thought and analysis within complex organizations. Intellectual hazard impairs the acquisition, analysis, communication, and implementation of information within an organization and the communication of such information between an organization and external parties. We argue that intellectual hazard was a cause of the Crisis of 2008 and suggest that this risk may be an important factor in all financial crises. We offer tentative suggestions for reforms that might mitigate intellectual hazard going forward.

NASA's Mars Climate Orbiter, launched from Cape Canaveral with great expectations in December 1998, reached Mars on September 23, 1999. The spacecraft passed behind the planet and out of radio contact at 9:04 UTC (1) and should have reestablished contact twenty-one minutes later. It never reappeared. (2) An investigation revealed that one of the two navigation teams assigned to the mission had been using metric system units and the other had been using the English system. Because of the difference between measurement units, the spacecraft entered orbit at too low an altitude and failed due to atmospheric stress and friction. (3)

On February 20, 1995, Dr. Rolando R. Sanchez, a surgeon in Tampa, Florida, scrubbed and entered the operating room for a routine leg amputation. (4) A blackboard in the operating room specified the leg to be amputated, as did the operating room schedule and the hospital's computer system. (5) When Dr. Sanchez entered the room the patient had already been prepped for surgery, with one of her legs draped and sterilized. The doctor performed the surgery, only to learn that he had cut off the wrong leg. It turned out that other paperwork available in the operating room, including the patient's consent form and medical history, specified the proper leg. Dr. Sanchez had apparently relied on the more commonly used sources of information about the procedure and never consulted the materials that could have prevented the mistake. (6)

Each of these disasters resulted from a common, dangerous, but little-recognized phenomenon. These events took place within complex organizations--a bureaucratic agency with numerous teams and subcontractors working on the same project, and a hospital with its network of physicians, nurses, equipment, and systems for medical and financial record-keeping and control. The mistakes were elementary--so elementary that if a single person had been carrying out the task, rather than a complex team, they never would have happened. Yet the consequences of those mistakes were devastating. The problem in both cases was the failure of the complex organization to properly acquire, communicate, analyze, and implement information pertinent to risk and crucial to the success of the operation.

The catastrophic events in financial markets during the fall of 2008 (7)--events we will refer to hereafter as the "Crisis of 2008"--were more complicated than these disasters, but there are also significant parallels. Financial markets today are among the most sophisticated, well-funded, well-informed, and technologically advanced institutions in the world. They process trillions of dollars in transactions each year. Many highly trained, hardworking, brilliant people work in the industry. Yet these markets and their regulators suffered an astonishing breakdown in 2008. Few people fully appreciated the implications of the housing market bubble or understood the risk that the burgeoning market in subprime mortgage-backed securities posed for the world's financial system. Those who did understand were unable to make their voices heard. When the storm made landfall, in September 2008, financial markets and their regulators were as woefully unprepared as the City of New Orleans in the face of Hurricane Katrina. What went wrong?

The thesis of this Article is that the Crisis of 2008 was partially caused by a problem with the processing of risk-related information in complex organizations. (8) In the Crisis of 2008, as in the Mars mission and the leg amputation, actors in complex organizations failed to properly acquire, process, transmit, and implement key information pertinent to risk. We call this problem "intellectual hazard." Intellectual hazard, as we define it, is the tendency of behavioral biases to interfere with accurate thought and analysis within complex organizations, thus interfering with the acquisition, analysis, communication, and implementation of information both within an organization and between an organization and external parties. Our conception of intellectual hazard, to the best of our knowledge, has not been previously identified as a systemic problem in financial markets, although astute commentators have pointed to many specific examples without recognizing that all are part of the same general phenomenon. We suggest that efforts to reform financial markets should address the problem of intellectual hazard in order to mitigate the risk of future disasters.

Part I of this Article discusses the concept of intellectual hazard. Drawing on research in psychology, behavioral finance, and behavioral economics, we identify three general types of intellectual hazard: complexity bias, incentive bias, and asymmetry bias. Part II illustrates how intellectual hazard manifested itself in some of the key institutions of financial markets before and during the Crisis of 2008. Part III offers possible reforms that take account of the risk of intellectual hazard.

The analysis in this Article is preliminary. Any comprehensive analysis of the problem of intellectual hazard in financial markets would require a much more extensive treatment than is possible here. We hope that these ideas may contribute to the debate on financial market reform and stimulate greater concentration on the problems of information processing in complex organizations of the financial market.

1. INTELLECTUAL HAZARD

   One should understand the concept of intellectual hazard in reference to the better-known problem of moral hazard, a term drawn from historical practices in the insurance industry. Actuaries who set premiums would assign values to known hazards. So, for example, an ocean voyage by a merchant might carry the risk that the ship will go down in a storm, that the cargo will be eaten by rats, that the vessel will be captured by pirates, and so on. The actuary will give each of these risks a value for purposes of calculating the insurance premium. But in addition, actuaries recognized a special kind of hazard--the risk created by the insurance contract itself. An insured policyholder loses much of the incentive he would otherwise have to avoid risk. Even worse, if the value of the property falls below that of the policy, the policyholder gets an affirmative incentive to cause the very harm against which he has obtained insurance. People may thus bum down their houses with the intention of collecting the insurance benefit. In the insurance industry, the risk from the insurance policy itself is the "moral hazard." (9)

   The term "moral hazard" later became associated with financial markets. The problem arises when governments provide implicit or explicit insurance against the failure of financial firms. Deposit insurance is the obvious example. When depositors are insured against losses from the failure of their bank, they lose the incentive to monitor their banks to prevent failure. Freed from this form of market discipline, bankers have less incentive to avoid risks, and instead gain an incentive to undertake socially undesirable levels of risk. (10) Deposit insurance is an obvious example of moral hazard, but it is not unique. As the events of 2008 illustrate, governments are often unwilling to allow any financial firm to fail, whether or not it has insured deposits, if that firm is either so large or so interconnected to others that its failure would jeopardize the stability of financial markets as a whole. Moral hazard is a well-known phenomenon, and a great deal of work has gone into identifying its incidence and designing strategies to reduce its effects. (11)

   Intellectual hazard is similar to moral hazard in the following respects. Moral hazard is a problem that results from a structural feature of markets that is in other respects highly beneficial: the shifting of risk to more efficient risk-bearers. Similarly, intellectual hazard results from the otherwise beneficial division of responsibility among specialized instrumentalities. Like moral hazard, intellectual hazard is pervasive. Just as moral hazard exists whenever risk is shifted away from an actor whose actions may cause harm, intellectual hazard exists whenever production becomes segmented into complex organizational forms. And like moral hazard, intellectual hazard can present systemic risks: Because it affects organizations that are large, interconnected, or linked to many other similarly situated organizations, intellectual hazard can pose a threat to the stability of an entire system of markets or institutions. (12) In particular, intellectual hazard poses a threat to the smooth, orderly, and efficient functioning of the world's financial markets.

   Scholars and astute market participants have already identified aspects of intellectual hazard in financial markets. (13) Useful examples fall into three broad...