Saturday, February 26, 2011

Corporate Deceit

Corporate Deceit


There was so much deceit in the last decade that we may have finally had enough. The Financial markets engaged in an escalating war for your money and they did not show much mercy. Deceit and manipulation became standard operating procedure and it happened on such a grand scale that we did not see the signs.

Communication Equals Deception

We all believe that we can spot a liar but this is simply not true. It is no more true for the cop who is convinced that he can ‘smell’ a lie than it is for you. Most of us are hard wired to live in a society and that means we are hard wired to believe people and to believe in people. Psychological research is very clear that none of us are very good at it. One man who has done exceptional research in the field and who has developed techniques to detect liars is Paul Ekman. His face analysis techniques usually require videotaping and slow motion to really detect it.

As social animals we developed the capacity to interact and work together in order to protect ourselves in a hostile environment. Deception is present even in other primates. It is related to brain size and the complexity of social groups. In most groups the consequence to discovery is exclusion but in small primate networks it might get you killed.

So what’s the problem? Why not lie if it gets you what you want?

Using social exclusion as a form of punishment for deceit would have been a powerful disincentive to freeloading. However, the underlying mechanisms which allow us to successfully and convincingly dissemble didn't go away. We are natural liars and we do it surprisingly often. Try and keep a diary for a single day and record every fib you tell: you'll be startled by the amount of not entirely truthful statements we make. Which brings us to the final nail: we deceive even ourselves about our lying natures.

The Collapse of Trust Mechanisms

In our much more diversely connected modern world it's not hard to see how these basic mechanisms for managing trust can break down. Social networks are so distributed and fragile that our ability to detect fraud and then to figure out how to punish people by exclusion are diminished almost to the point of being completely ineffective. Unless you're a celebrity, of course, and then your transgressions will get splattered all over the media and you'll be rewarded with a whole new stream of sponsorship deals. Strange inverted world we live in.

Given that the traits of casual deception, both of ourselves and others, seems to be built-in to our natures and that the main defence against this is through social networks then it should be obvious that the financial industry will aim to develop close, tight-knit communities with strong links between financial advisors and clients and two-way systems of social feedback - it's not sufficient to merely punish bad customers in the event of deceit, bad advisors need also to suffer the consequences.

When The Moral Compass Goes Missing ...

Of course, this is the exact opposite of what happens in modern business networks. The relentless approach to cost cutting means that the social networks which have traditionally connected customers and advisors have been eliminated and ruthlessly replaced with actuarial models that use historical data to show how much fraud will be committed. These models don't seek to prevent deceit but actually include it, estimating the number of freeloaders who will game the system and developing business models that include these factors.

Unfortunately, as financial institutions have found to their cost, when you take the human being out of its stabilising social network then you remove the guy-ropes that prevent our deceiving brains from coming loose and causing havoc. The surprise is not that more people than expected decided to game the system but that so few did. Actuarial models based on historical data generated in an entirely different context proved to be utterly hopeless at predicting levels of fraud in the new, socially disconnected world.

Liar Loans, Hopeless History

Liar loans are the most public of the problems and financial institutions have rightly been castigated for the lack of due diligence involved in accepting people's word for the fact they had the means to repay them. Many were simply hoping to flip the assets they were buying for a quick profit, although others appear not to have understood the basic principles of taking a loan out. Stuff like needing to pay it back.

The securitisation of these loans - chopping them up into little bits and then repackaging them before on-selling them to other institutions - was the actuarial way of protecting against defaults. In theory, the models told us, the level of default was sufficiently low to justify high credit ratings for these securities. Unfortunately the theory was based on a history generated under different circumstances, where the loan provider and their customer weren't totally divorced and where lying would have consequences for the former, if not the latter. Now, cut loose from the need for honesty, the historical numbers were meaningless.

Trust Psychologists, Not Economists

Of course none of this means that the lying loanees don't bear their share of responsibility but given that trust is determined socially because we're individually prepared to scheme and freeload if left to ourselves then the consequences of such business practices were all too predictable to anyone with even elementary knowledge of human psychology. Unfortunately it seems that the institutions involved never considered that people might behave differently under changed circumstances and left their actuaries alone to prove that historical numbers tell us about the past, not the future. Again.

That we're born liars and our honesty is determined by how likely we are to get away without being caught and punished isn't exactly a morally compelling message. However, being brutally realistic about ourselves is a better basis for making investment decisions than deluding ourselves with a bunch of numbers. Take a human being out of their social network and let them loose without moral constraints and what you have is a recipe for nasty things. But until financial institutions start taking financial lessons in mass deception from psychologists and taking less notice of economists engaged in their own mathematical arms race you'll likely see this happen again and again. And again.

No comments:

Post a Comment