An ECB working paper explains formally why senior decision makers are unprepared for crises: they can only process limited quantities of information and rationally pay attention to rare events only if losses from unpreparedness seem more than inversely proportionate to their rarity. The less probable a negative event, the higher the condoned loss. Inattention gets worse when managers bear only limited liability.

Maćkowiak, Bartosz and Mirko Wiederholt (2015). “Inattention to rare events”, ECB Working Paper Series, No 1841 / August 2015
http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1841.en.pdf

The below are excerpts from the paper. Headings and cursive text have been added.

On information inattentiveness of financial markets view post here.

The (disastrous) consequences of inattention

“The observation that agents take good actions in normal times does not imply that agents will take good actions in unusual times.”

“The world recently experienced several rare events with disastrous consequences: the global financial crisis, the European sovereign debt crisis, and the Fukushima nuclear accident. These events have in common that key decision-makers were unprepared for them, which aggravated these events….The model helps us understand what we think was a critical feature of the recent events: In each case an adverse shock occurred, key decision-makers were unprepared to take action in response to that shock, and catastrophic consequences followed.”

“In Fukushima, the adverse shock was the earthquake and tsunami that cut the power supply and disabled the cooling system of a nuclear power plant. In order to prevent an explosion, the staff on duty had to vent a nuclear reactor. They opened the emergency manual and discovered that it contained no instructions on how to vent the reactor in the absence of electricity. The staff had to improvise the venting and failed to prevent an explosion. The model suggests why the staff were unprepared: The adverse shock they had to respond to was a low probability event and the management of the company owning the plant faced limited liability.”

Why decision makers do not think much about rare events

“Learning is the mental process of absorbing available information. All information required for the agent to take the optimal actions in both regimes is in principle available. The agent, due to limited cognitive ability, cannot attend to all this information and therefore cannot prepare a perfect action plan for each contingency. Furthermore, once the agent has formed a conditional expectation of the optimal action, there is no physical cost of implementing the action. We think that this setup captures the critical feature of the recent events: people had failed to think through what action to take in certain contingencies, while information about what action to take was available and the physical cost of implementing good action was negligible.”

“Agents…cannot prepare perfectly for all contingencies. The expected benefit of thinking about the optimal action in a contingency is higher when the contingency is more likely. Thus, the extent to which agents think about a contingency is increasing in the probability of the contingency….Agents allocate attention so as to equate the probability-weighted expected loss due to suboptimal actions across contingencies. As a result, the expected loss due to suboptimal action in a contingency is inversely related to the probability of the contingency. For example, if the probability of one contingency is one thousand times smaller than the probability of another contingency…the expected loss due to suboptimal action is one thousand times larger in the first contingency than in the second contingency. “

“Limited liability is a feature of many real world situations and…kicks in more frequently in unusual times than in normal times…Limited liability makes agents prepare even less for rare events. The intuition is the following. Since agents think less about the optimal actions in unusual times than about the optimal actions in normal times, agents take on average worse actions in unusual times than in normal times. Limited liability therefore is more relevant in unusual times than in normal times.”

Annex: Case studies

Case study 1: Fukushima nuclear accident

“The 9.0-magnitude earthquake that struck off the coast of Japan on March 11, 2011 cut all off-site power supply to the Fukushima Dai-ichi nuclear power plant, owned and operated by Tokyo Electric Power Company (Tepco). The ensuing tsunami waves knocked out all of the plant’s emergency diesel generators apart from one. After the earthquake and tsunami had cut power supply and thereby disabled the cooling system, workers at the plant tried to avoid a catastrophe. The most severe problem was that the fuel rods inside the reactors were overheating, causing a buildup of steam and hydrogen inside the reactor buildings, which meant a possible explosion. After communicating with Tepco officials in Tokyo and the prime minister of Japan, the workers on site decided to vent reactor Unit 1 to reduce pressure. The workers opened the emergency manual and discovered that it did not contain any instructions on how to vent the reactor in the absence of electricity. Throughout the night, the workers tried to figure out ad hoc ways to vent the reactor in the absence of electricity. At about 2:30pm on March 12, the operators confirmed a decrease in pressure inside the reactor, providing some indication that the improvised venting was starting to work. Unfortunately, this good news came too late. Shortly thereafter, a hydrogen explosion destroyed the Unit 1 reactor building.”

“What happened was not that the Tepco staff had thought carefully what action to take if the cooling system were disabled and then judged that action to be too costly to implement. Instead, the Tepco staff had not thought [beforehand] about what to do if the cooling system were disabled.”

Case study 2: Global financial crisis

“The defining moment of the global financial crisis…came when Lehman Brothers filed for bankruptcy on September 15, 2008…We consider the actions of U.S. policy-makers…The possible actions in normal times were ‘don’t intervene’ and ‘orchestrate’ a sale of Lehman to another financial institution, possibly with a small amount of public support. “

“To take the optimal action in normal times the policy-makers needed to process information about a few potential buyers of Lehman, the price at which a sale would occur, and the details of any public support. On the other hand, the possible actions in unusual times were ‘don’t intervene’ and ‘offer a large amount of public support of some form.’ Crucially, assessing the consequences of the ‘don’t intervene’ action is a very different thought process in unusual times than in normal times. In normal times the shutdown of Lehman will not trigger bankruptcies of other financial institutions.”

“reading of the events is that the policy-makers thought carefully about what to do in normal times. In particular, the policy-makers prepared to orchestrate a sale of Lehman Brothers to another financial institution (like Bank of America or Barclays) with a small amount of public support. Importantly, almost the entire meeting of the policy-makers and bankers at the Federal Reserve Bank of New York on the weekend of September 13-14, 2008, was devoted to planning a sale of Lehman Brothers. By contrast, little time during the meeting was spent thinking about what to do if the hole in Lehman’s balance sheet was too deep for Lehman to be sold with a small amount of public support. Timothy Geithner, then president of the Federal Reserve Bank of New York, asked one of the working groups formed at the meeting to ‘put foam on the runway,’ in case Lehman’s sale could not be orchestrated, and ‘be prepared to do something.’”

“As the weekend drew to a close, it turned out that unusual times had occurred: Lehman Brothers had a sizable negative net present value and therefore could not be sold with only a small amount of public support. The policy-makers had thought little about what to do in that regime. They had to decide quickly and chose to take the action ‘don’t intervene.’ Lehman filed for bankruptcy. Within days, the policy-makers reversed themselves as they offered a large amount of public support to American International Group, money market funds, and so on. We take this policy reversal as an indication that the optimal action on the weekend of September 13-14, 2008, would have been a different one.”

Case study 3: European sovereign debt crisis

“Greece entered the post-Lehman era with a large amount of government debt. In October 2009, a new Greek government announced that the fiscal situation was a lot worse than had previously been understood. The immediate problem was that a sizable amount of public debt was due to mature in May 2010. There was uncertainty whether by that time Greece would turn out to be in ‘normal times’ or ‘unusual times.’ The possible actions of the euro-area policy-makers in normal times were ‘don’t intervene’ and ‘make Greece a loan.’

“Possible actions in unusual times were likewise ‘don’t intervene’ and ‘make Greece a loan,’ but possible actions in unusual times also included ‘give Greece a transfer,’ ‘guarantee Greek government debt,’ and ‘help Greece organize an orderly default.’”

“Importantly, preparing for unusual times is a very different activity than preparing for normal times. Preparation for normal times involves figuring out the size and conditions of a loan. On the other hand, figuring out how to make government default orderly is a very different task from designing the conditions of a loan. Figuring out the modalities of an inter-country transfer or an inter-country debt guarantee is also a very different thought process because it would change the way EMU works.”

“The euro-area policy-makers processed information about what to do in each regime. Far-reaching options such as different forms of a public debt guarantee were on the table. However, our interpretation of the events is that the policy-makers spent most of the time between October 2009 and April 2010 thinking about the size and conditions of any loan to Greece. In particular, much attention was given to figuring out the interest rate on the loan and designing the reform measures Greece would have to promise in order to get the loan. By contrast, we are not aware of any planning for an orderly default by the government of a euro-area country during that period. In the end, the news coming from Greece between October 2009 and April 2010 turned out to be bad. Greece found itself in unusual times. Nevertheless, in response to the prime minister’s request in April 2010, the euro-area policy-makers together with the International Monetary Fund made the Greek government a loan on May 2, 2010. “

“By October 2010, the chancellor of Germany and the president of France decided that government default would have to be an option in the euro area. Preparation for an orderly default by Greece began. In October 2011, a new assistance package for Greece was announced, this time including provisions for default. We take this policy reversal as an indication that the optimal action in the spring of 2010 would have been a different one.””