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ABA Risk Management Forum April 28-30, 2010 Best Practices: Managing Judgment Risk Presented by:   Tyler D. Nunnally Found...
<ul><li>What is Judgment Risk? </li></ul><ul><li>Behavioral Economics 101 </li></ul><ul><li>Judgment Bias </li></ul><ul><l...
<ul><li>‘ 92 Summer Olympic Games (Barcelona, Spain)  </li></ul><ul><li>‘ 93 Nunnally International Trade, Inc. (Prague, C...
    PART I: Judgment Risk Key Risk Factors in the Decision-Making Process
What is Judgment Risk? Risk Probability of  Occurrence Judgment Bias X Severity of  Likely Impact Risk Appetite “ JUDGMENT...
What is Judgment Risk? <ul><li>Alan Greenspan commenting on how human factor risks caused forecasting models to fail in su...
<ul><li>“ This, to me, is the large missing ‘explanatory variable’ in both risk-management and macroeconometric models. Cu...
    PART II: Behavioral Economics 101
<ul><li>Combines scientific disciplines of psychology and economics </li></ul><ul><li>“ Bounded rationality” introduced by...
The Way People Make Decisions SYSTEM 1 (Intuitive) SYSTEM 2 (Reason) Automatic Spontaneous Unconscious Instinctive “ Gut f...
Decision-Making Under Risk and Uncertainty Diagnosis:  person scans, appraises and questions available information Assessm...
Behavioral Economics in the Mainstream NY Times Business Best Sellers in 2009 PREDICTABLY IRRATIONAL , by Dan Ariely FREAK...
“ Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the  real world ” Sourc...
<ul><li>Public Policy </li></ul><ul><li>Consumer Choice </li></ul><ul><li>Upside Risk’s approach: Risk Management </li></u...
“ Risk management is a form of engineering: it uses science, but ultimately depends on judgement… The ultimate protection ...
    PART III: Judgment Bias
Probabilities & Statistics: Sample Size Bias Suppose the mean credit score of all senior citizens is 650. You have selecte...
Miscalculating Probabilities & Statistics <ul><li>Decision traps people fall into when judging risk: </li></ul><ul><li>Ove...
Heuristics: Availability Perception of how “risky” something is often determined by how readily examples come to mind from...
Behavioral Biases: Confirmation Bias <ul><li>Suppose you and a colleague disagree whether it would be a good idea to </li>...
Booms and Busts: Subprime Crisis U.S. House Prices: 1988 - 2008 Key Risk Factors :  - Time discounting - Confirmation bias...
PART IV:   Risk   Appetite
Risk Preferences A person’s level of comfort in taking risk often determines business decisions Risk Preference ↓ Risk App...
Risk-Taking Behavior Risk-taking  behavior  has a significant bearing on business outcomes <ul><li>Risk Aversion Behavior:...
Risk Appetite Metrics: Sunk Costs You have a significant sum invested in a project to develop a new product. If successful...
Excessive Risk Appetite and Catastrophic Risk FDIC Troubled Bank List: 2007 – 2009
Risk Aversion and Falling Profits
Prospect Theory <ul><li>People generally dislike  </li></ul><ul><li>loss twice as much as  </li></ul><ul><li>they like gai...
Risk Domains A persons’ risk propensities are compartmentalized and divided into separate domains RISK DOMAINS Financial H...
  PART V: Best Practices: Managing Judgment Risk
“ The best  behavioral risk management strategy is to try and arrest problem development earlier in the behavioral stage”....
Judgment Risk Indicator: Individual Metrics
Judgment Risk Indicator: Organizational Metrics
Creative Risk Mitigation <ul><li>First line of defense in hiring practices </li></ul><ul><li>Education: Professional Devel...
Banking Peer Group Risk Appetite Benchmark
Tyler D. Nunnally, Founder & CEO Upside Risk Atlanta, Georgia U.S.A. Phone: +1 (404) 320 6047 Email: tnunnally@upside-risk...
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American Bankers Association Risk Management Forum April 29, 2010 Tyler D. Nunnally, Upside Risk

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American Bankers Association Risk Management Forum, April 29, 2010. Best Practices: Managing Judgment Risk. Presented by Tyler D. Nunnally, Founder &amp; CEO, Upside Risk

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Transcript of "American Bankers Association Risk Management Forum April 29, 2010 Tyler D. Nunnally, Upside Risk"

  1. 1. ABA Risk Management Forum April 28-30, 2010 Best Practices: Managing Judgment Risk Presented by: Tyler D. Nunnally Founder & CEO Upside Risk
  2. 2. <ul><li>What is Judgment Risk? </li></ul><ul><li>Behavioral Economics 101 </li></ul><ul><li>Judgment Bias </li></ul><ul><li>Risk Appetite </li></ul><ul><li>Best Practices: Managing Judgment Risk </li></ul>Presentation Topics
  3. 3. <ul><li>‘ 92 Summer Olympic Games (Barcelona, Spain) </li></ul><ul><li>‘ 93 Nunnally International Trade, Inc. (Prague, Czech Republic) </li></ul><ul><li>‘ 03 University of St Andrews (St Andrews, Scotland) </li></ul><ul><li>‘ 04 Global Business Consulting (Barcelona, Spain) </li></ul><ul><li>‘ 06 Oxford Risk Research & Analysis Ltd (Oxford, England) </li></ul><ul><li>’ 09 Upside Risk (Atlanta, Georgia, USA) </li></ul>Presenter Background
  4. 4. PART I: Judgment Risk Key Risk Factors in the Decision-Making Process
  5. 5. What is Judgment Risk? Risk Probability of Occurrence Judgment Bias X Severity of Likely Impact Risk Appetite “ JUDGMENT RISK”
  6. 6. What is Judgment Risk? <ul><li>Alan Greenspan commenting on how human factor risks caused forecasting models to fail in subprime crisis </li></ul><ul><li>“ I do not say that the current systems of risk management or econometric forecasting are not in large measure soundly rooted in the real world… But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modeling—the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. </li></ul><ul><li>Source: Alan Greenspan, “We will never have a perfect model of risk”, Financial Times, March 16, 2008. </li></ul>
  7. 7. <ul><li>“ This, to me, is the large missing ‘explanatory variable’ in both risk-management and macroeconometric models. Current practice is to introduce notions of “animal spirits”, as John Maynard Keynes put it, through “add factors”. That is, we arbitrarily change the outcome of our model’s equations. Add-factoring, however, is an implicit recognition that models, as we currently employ them, are structurally deficient; it does not sufficiently address the problem of the missing variable” </li></ul><ul><li>… Forecasters’ concerns should be not whether human response is rational or irrational, only that it is observable and systematic ”. </li></ul><ul><li>Source: Alan Greenspan, “We will never have a perfect model of risk”, Financial Times, March 16, 2008. </li></ul>What is Judgment Risk?
  8. 8. PART II: Behavioral Economics 101
  9. 9. <ul><li>Combines scientific disciplines of psychology and economics </li></ul><ul><li>“ Bounded rationality” introduced by Herbert Simon (’78 Nobel Prize) </li></ul><ul><li>Prominence of study led by Kahneman & Tversky (’02 Nobel Prize) </li></ul><ul><li>Heuristics and biases </li></ul>Behavioral Economics 101
  10. 10. The Way People Make Decisions SYSTEM 1 (Intuitive) SYSTEM 2 (Reason) Automatic Spontaneous Unconscious Instinctive “ Gut feel” Thoughtful Controlled Informed Deductive Analytical
  11. 11. Decision-Making Under Risk and Uncertainty Diagnosis: person scans, appraises and questions available information Assessment: risk versus rewards analysis made of available options Action: commitment to chosen course of action Adjustment: evaluate decision outcomes and adjust accordingly Diagnosis ▼ Assessment ▼ Action ▼ Adjustment
  12. 12. Behavioral Economics in the Mainstream NY Times Business Best Sellers in 2009 PREDICTABLY IRRATIONAL , by Dan Ariely FREAKONOMICS , by Steven D. Levitt and Stephen J. Dubner SWAY , by Ori Brafman and Rom Brafman NUDGE , by Richard H. Thaler and Cass R. Sunstein
  13. 13. “ Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world ” Source: Levitt, Steven and List, John “ Homo Economicus Evolves ,” Science , February 15, pp. 909–10. What the Critics Say…
  14. 14. <ul><li>Public Policy </li></ul><ul><li>Consumer Choice </li></ul><ul><li>Upside Risk’s approach: Risk Management </li></ul>“ Real World” applications
  15. 15. “ Risk management is a form of engineering: it uses science, but ultimately depends on judgement… The ultimate protection against risk is good judgement and alertness: your own and that of your colleagues”. Source: Risk Management, November 2005
  16. 16. PART III: Judgment Bias
  17. 17. Probabilities & Statistics: Sample Size Bias Suppose the mean credit score of all senior citizens is 650. You have selected a random group of 50 senior citizens. The first person that you review has a credit score of 800. What do you think the mean credit score of this group of 50 senior citizens will be? A. 598 B. 650 C. 653 D. 725
  18. 18. Miscalculating Probabilities & Statistics <ul><li>Decision traps people fall into when judging risk: </li></ul><ul><li>Overestimate/underestimate real value </li></ul><ul><li>Overestimate/underestimate chances of success </li></ul><ul><li>Overestimate/underestimate chances of failure </li></ul><ul><li>Overweight small probabilities </li></ul><ul><li>Underweight large probabilities </li></ul><ul><li>Failure to adapt to changing business conditions </li></ul><ul><li>Erroneous forecasts, estimates and projections </li></ul>
  19. 19. Heuristics: Availability Perception of how “risky” something is often determined by how readily examples come to mind from memory. Bias occurs when probability assumptions become inflated by recent events. US AIRLINE INDUSTRY PASSENGER REVENUES 1999-2004 Risk Exposure : - Overly cautious - Lost opportunities - Falling profits
  20. 20. Behavioral Biases: Confirmation Bias <ul><li>Suppose you and a colleague disagree whether it would be a good idea to </li></ul><ul><li>launch a new product. You believe that launching the product would be a </li></ul><ul><li>mistake. Your colleague believes that, if introduced, the product would be a </li></ul><ul><li>big success. </li></ul><ul><li>In this situation, what would you do? </li></ul><ul><li>Seek a third opinion from someone who I know would agree with my position </li></ul><ul><li>B. Seek out information that supports my position </li></ul><ul><li>C. Seek out information that contradicts my colleague’s position </li></ul><ul><li>D. Seek out information that could either support or contradict my position </li></ul>
  21. 21. Booms and Busts: Subprime Crisis U.S. House Prices: 1988 - 2008 Key Risk Factors : - Time discounting - Confirmation bias - Herding - Overconfidence
  22. 22. PART IV: Risk Appetite
  23. 23. Risk Preferences A person’s level of comfort in taking risk often determines business decisions Risk Preference ↓ Risk Appetite Risk Averse ↓ Risk Avoiding Risk Neutral Risk Prone ↓ Risk Seeking Conservative Decisions Middle of the Road Decisions Aggressive Decisions
  24. 24. Risk-Taking Behavior Risk-taking behavior has a significant bearing on business outcomes <ul><li>Risk Aversion Behavior: </li></ul><ul><li>Cause decision delays </li></ul><ul><li>Failure to take any action </li></ul><ul><li>Reliance on others to make decisions </li></ul><ul><li>Risk Seeking Behavior: </li></ul><ul><li>Ignore underlying evidence </li></ul><ul><li>Lack of objectivity between options </li></ul><ul><li>Confirmation bias </li></ul>
  25. 25. Risk Appetite Metrics: Sunk Costs You have a significant sum invested in a project to develop a new product. If successfully completed, the project could have a considerable financial impact on your company. However, the project is overdue and over-budget. To complete the project it will now cost double the original projected cost. You must now decide to make the additional investment in order to complete the project, or to terminate it altogether. To complete the project, what probability of success would be required before you would make an additional investment? Please choose one of the following probabilities: 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
  26. 26. Excessive Risk Appetite and Catastrophic Risk FDIC Troubled Bank List: 2007 – 2009
  27. 27. Risk Aversion and Falling Profits
  28. 28. Prospect Theory <ul><li>People generally dislike </li></ul><ul><li>loss twice as much as </li></ul><ul><li>they like gains </li></ul><ul><li>People become risk </li></ul><ul><li>seeking in the face </li></ul><ul><li>of loss and risk averse </li></ul><ul><li>in the face of gains </li></ul>
  29. 29. Risk Domains A persons’ risk propensities are compartmentalized and divided into separate domains RISK DOMAINS Financial Health/ Safety Recreation Ethical Social <ul><li>For instance, a heavy drinker and smoker may take health risks, but he is not necessarily the same guy who makes high risk investments with his 401(k). </li></ul>
  30. 30. PART V: Best Practices: Managing Judgment Risk
  31. 31. “ The best behavioral risk management strategy is to try and arrest problem development earlier in the behavioral stage”. Source: Rudy M. Yandrick, Behavioral Risk Management, 1996
  32. 32. Judgment Risk Indicator: Individual Metrics
  33. 33. Judgment Risk Indicator: Organizational Metrics
  34. 34. Creative Risk Mitigation <ul><li>First line of defense in hiring practices </li></ul><ul><li>Education: Professional Development </li></ul><ul><li>Personnel Evaluation </li></ul><ul><li>Due diligence & compliance </li></ul><ul><li>Benchmarking </li></ul>
  35. 35. Banking Peer Group Risk Appetite Benchmark
  36. 36. Tyler D. Nunnally, Founder & CEO Upside Risk Atlanta, Georgia U.S.A. Phone: +1 (404) 320 6047 Email: tnunnally@upside-risk.com www.Upside-Risk.com
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