Basketball fans may know the “hot hand” theory. When a player hits several consecutive shots, conventional wisdom suggests their team should keep feeding that player the ball.
It makes sense, right? If a player hits three in a row, the likelihood of them making their next shot should be higher than average. It appears this way for fans, coaches, and players.
But as statisticians and psychologists point out, the “hot hand” theory is a fallacy. Players make or miss shots at the same average, whether it's their first shot or their fifth.
The “hot hand” fallacy is an example of what behavioral economists call recency bias. Recency bias refers to our tendency to overestimate the importance of recent events and underestimate historical ones.
Bankers and basketball fans have a lot in common. When a player makes six shots in a row but misses the next one, fans assume they’ve lost their “hot hand.” Next time down the court, they should pass.
After years of economic growth, the Fed raises interest rates, and some financial institutions feel pinched. As a result, a financial institution might decide to dramatically cut expenses because it “knows” a recession is coming.
Recency bias causes financial institutions to act against their own best interests. Maybe they shouldn’t cut expenses? Perhaps a recent downturn is just a blip in an otherwise healthy market. What opportunities might an FI miss in eliminating staff or postponing technology initiatives? Maybe the player who’s sunk seven shots in a row should pass to the wide-open player under the basket.
Recency bias and economic downturns: are recessions self-fulfilling prophecies?
The Fed uses several data points to determine monetary policy – the Consumer Price Index (CPI), unemployment data, the core inflation rate (which excludes volatile food and energy prices), and more.
But it also pays attention to consumer and business sentiment – most famously captured in the University of Michigan’s Consumer Sentiment Index. Consumer and business sentiment surveys don’t assess the actual state of the economy, but instead how people and institutions feel about the economy.
Why would this matter?
As it turns out, feelings greatly affect the economy's health. For instance, if consumers expect prices to rise, prices are more likely to rise.
Consumer sentiment tends to correlate with recency biases. According to the University of Michigan’s consumer sentiment survey, Americans' confidence in the economy dipped in September 2023 following the announcement of the UAW strike and possible government shutdown.
Following the ups and downs of consumer sentiment shows recency bias in action – the latest news headlines substantially impact how consumers feel about the economy.
These feelings become a reality, leading us to the trillion-dollar question: if recent events cause consumers and businesses to expect a particular outcome, are recessions a self-fulfilling prophecy? Are economic dips the result of recency bias?
Recessions and economic downturns have external causes – interest rate hikes, Wall Street asset bubbles, oil crises, etc. – but also psychological ones, such as how consumers, businesses, and banks react to these external events.
Consumers stop spending, businesses stop hiring, and banks stop lending when they see storm clouds on the horizon. These actions end up making recessions worse than they would otherwise be.
Should businesses, consumers, and financial institutions change their approach before a recession?
Let’s look at the historical record to understand the difference between financial institutions that thrived during the last recession and those that merely survived. Moving beyond recent events and the daily news cycles, how should FIs plan for a possible recession?
Prepping for the next economic downturn
Assume that an economic downturn will happen at some point. The U.S. has experienced 12 recessions since 1945 – approximately one every 6.5 years. The problem? No one knows the severity of a recession in advance.
Economists have a notoriously bad track record predicting the future of the American economy. In 2007, economists noticed a bubble brewing in home prices but failed to recognize that this would tip the economy into the largest economic downturn since the Great Depression.
Currently, the odds of a recession in 2024 are a coin flip. Economists don’t know what will happen, although an economic downturn is not out of the realm of possibility. The good news? How we respond to a recession is entirely up to us. We can come out of it stronger than ever or buckle under its weight.
The 2008 Great Recession provides a guide to how financial institutions, especially smaller FIs, should react if we experience an economic downturn in 2024.
In a report published in 2019, the Filene Institute examined the difference between credit unions that prospered during the 2008 recession and those that barely managed to stay afloat.
The study found that financial institutions that prospered did three things:
- Focused on growing rather than taking a reactionary or defensive stance
- Invested in technological solutions
- Embraced a long-term perspective rather than concentrating on immediate events
A 2013 study of community banks by The Federal Reserve Bank of St. Louis similarly found that the institutions that most adeptly maneuvered their way through the 2008 crisis:
- Took a proactive approach to risk management with an emphasis on long-term performance
- Made a substantial investment in new technology to drive operational efficiencies
- Had patient owners looking for consistent but not spectacular returns
The smaller financial institutions that thrived during the 2008 recession adopted a long-term strategy for consistent growth backed by technology and sound risk mitigation strategies. They paid less attention to recent events and showed perseverance in adversity.
Taking a long view gives financial institutions a competitive advantage over their shell-shocked peers. Resiliency also demonstrates to your community that you’re there for them in their time of need.
What can we learn from the earlier recessions?
Financial institutions’ natural tendency for knee-jerk responses to the favorable or unfavorable needs a counterbalance. When businesses suffer losses during an economic downturn, they may be inclined to take drastic measures, including laying off employees and postponing new investments.
However, adopting new technology and investing in human capital sets businesses and banks up for success following an economic downturn. Economists have offered several explanations for why institutions should invest more in technology in preparation for and during recessions.
Some theorize the opportunity costs of implementing technology drop during a recession – when the economy is bustling, companies are disinclined to divert money away from production. During a downturn, companies spend more on IT initiatives because they produce less.
As an economic theory, this makes sense, but for many companies, including financial institutions, adopting new technologies enables them to automate many routine tasks that drag down productivity.
Over the past year, financial institutions navigated choppy waters as liquidity pressures from a possible slide in credit quality have led them to build up reserves. At the same time, a top priority for FIs looking to seize future growth opportunities should focus on technology investments.
“Exploiting technology to improve productivity, talent management, and the delivery of [innovative] products and services” was identified as the course FIs should take in 2023-2024 by McKinsey’s report on the state of banking.
Related: Banking-as-a-Service (BaaS) Explained
The most successful financial institutions take the long view when it comes to technology investment – the cyclical nature of markets means that periods of growth follow every economic downturn. FIs infected by recency bias look at the market risk today and decide to scale back – these institutions will struggle to reclaim lost ground when the economy turns a corner.
Forward-thinking financial institutions consider downturns an opportunity to make themselves more strategic, efficient, and compliant. They embrace increased market risk and discover opportunities in the chaos.
Podcast: Economic Trends in a post-COVID World
Understand your risk exposure now
There is no way to tell what the future holds. Recession or soft landing, your financial institution should ensure it has the right personnel, systems, and processes to capitalize on whatever situation unfolds.
The best tools establish a risk management framework for any market conditions. You must:
- Understand events that could impact your institution
- Reasonably estimate the likelihood of these events occurring
- Implement controls to handle the risks of these events
- Monitor your key risk indicators (KRIs) to test your controls and adjust as necessary
- Report any critical developments to management and the Board
Recessions shouldn’t derail your strategic goals. You won't sweat the most recent news headline when you have the tools to oversee your risk management lifecycle. Build a risk management culture that succeeds in any economic situation.
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