HomeFinancial System and RegulationHow human stress increases financial crisis risk

How human stress increases financial crisis risk

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John Coates gives a neuroscience view on how human “stress response” can aggravate financial crises. Rising market volatility causes a bodily response in form of a sustained elevation of the stress hormone cortisol in traders and investors. This raises risk aversion and may contribute to institutional paralysis. Central banks’ policies aimed at keeping markets calm in normal times may weaken traders’ immune system.

“The Biology of Risk”, John Coates
New York Times, Sunday Review, June 7, 2014
http://www.nytimes.com/2014/06/08/opinion/sunday/the-biology-of-risk.html?_r=0

“Cortisol Shifts Financial Risk Preferences”, Narayanan Kandasamya,Ben Hardy,Lionel Page, Markus Schaffner, Johann Graggaber, Andrew S. Powlson, Paul C. Fletcher, Mark Gurnella, and John Coates.
Proceedings of the National Academy of Sciences (Feb 18, 2014):
http://www.pnas.org/content/early/2014/02/13/1317908111.full.pdf

The below are excerpts from the column and the paper. Cursive text and underscores have been added.

Understanding human “stress response”

“One biological mechanism, the stress response, exerts an especially powerful influence on risk taking…Most of us tend to believe that stress is largely a psychological phenomenon, a state of being upset because something nasty has happened. But… the stress response is largely physical: It is your body priming itself for impending movement… In fact, the stress response is such a healthy part of our lives that we should stop calling it stress at all and call it, say, the challenge response.”

“Our challenge [stress] response…is particularly active when we are exposed to novelty and uncertainty. If a person is subjected to something mildly unpleasant, like bursts of white noise, but these are delivered at regular intervals, they may leave cortisol levels unaffected. But if the timing of the noise changes and it is delivered randomly, meaning it cannot be predicted, then [the stress hormone] cortisol levels rise significantly…Uncertainty over the timing of something unpleasant often causes a greater challenge response than the unpleasant thing itself…because the challenge response, like any good defense mechanism, anticipates; it is a metabolic preparation for the unknown.”

How “stress response” affects risk taking

“Most models in economics and finance assume that risk preferences are a stable trait, much like your height. But this assumption… is misleading. Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge.”

“We have… found that traders experience a sustained increase in the stress hormone cortisol when the amount of uncertainty, in the form of market volatility, increases…We then…found that participants became more risk-averse. We also observed that the weighting of probabilities became more distorted among men relative to women. These results suggest that risk preferences are highly dynamic. Specifically, the stress response calibrates risk taking to our circumstances, reducing it in times of prolonged uncertainty, such as a financial crisis. Physiology-induced shifts in risk preferences may thus be an underappreciated cause of market instability.”

“If volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking. In this way our risk taking calibrates to the amount of uncertainty and threat in the environment…Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks.”

How monetary policy affects stress response

“If we understand how a person’s body influences risk taking…can also recognize that mistakes governments have made have contributed to excessive risk taking…Over the past 20 years, the Fed has pioneered a new technique of influencing Wall Street…Ben S. Bernanke…claimed it reduced uncertainty and calmed the markets.”

The process of making monetary policy more transparent was in fact begun by Alan Greenspan back in the early 1990s. Before that time the Fed, especially under Paul A. Volcker, operated in secrecy. Fed chairmen did not announce rate changes, and they felt no need to explain themselves, leaving Wall Street highly uncertain about what was coming next. Furthermore, changes in interest rates were highly volatile: When Mr. Volcker raised rates, he might first raise them, cut them a few weeks later, and then raise again, so the tightening proceeded in a zigzag. Traders were put on edge, vigilant, never complacent about their positions so long as Mr. Volcker lurked in the shadows.”

“Over the past 20 years the Fed may have perfected the art of reassuring the markets, but it has lost the power to scare. And that means stock markets more easily overshoot, and then collapse.”

“The Fed could dampen this cycle. It has, in interest rate policy, not one tool but two: the level of rates and the uncertainty of rates. Given the sensitivity of risk preferences to uncertainty, the Fed could use policy uncertainty and a higher volatility of funds to selectively target risk taking in the financial community…
It may seem counterintuitive to use uncertainty to quell volatility. But a small amount of uncertainty surrounding short-term interest rates may act much like a vaccine immunizing the stock market against bubbles.”

Editor
Editorhttps://research.macrosynergy.com
Ralph Sueppel is managing director for research and trading strategies at Macrosynergy. He has worked in economics and finance since the early 1990s for investment banks, the European Central Bank, and leading hedge funds.