Decision making is an essential skill of every successful business leader. While easier said than done, decision makers must interpret a wealth of relevant data, account for an ever-changing environment, and chart a course in the midst of relentless competition.

For leaders in community financial institutions, ALCO reports provide a wealth of relevant financial information and a comprehensive balance sheet perspective for decision making. When used correctly, ALCO reporting should be the “go to” data for strategic decision making (and your ALCO consultant should be on speed dial).

But even with ample financial data available, we rarely make business decisions based strictly on facts and financial information alone. Many successful business leaders make “gut decisions” that are supported by the facts. Consider the following:

With so many of our decisions being influenced by this “gut feeling,” how do we, as business leaders, know that we can trust this feeling? Where does this feeling even come from? 

In his book Emotional Intelligence, Daniel Goleman explains that there is a part of your brain in the Basal Ganglia that summarizes your emotional response during decision making. The problem is that language does not exist in that specific area of the brain. Nor does that part of your brain communicate with any other location where language does exist. It only connects to your GI track and your limbic system. So, it sends emotional feedback through felt sensations…a “gut feeling.”

So, now that we know the source of our gut feelings, can they always be trusted?

Well…sometimes our personal biases cunningly disguise themselves as a “gut feeling” or “intuition.” If you are caught off guard and rely on a personal bias, you may make a poor business decision and limit the long-term performance of your financial institution.

So, how do you tell the difference between a “gut feeling” and a personal bias?

Educate yourself. Be aware of the common types of personal biases and base your decisions on solid reasoning and hard facts, such as those found in ALCO reports.

But every good leader already does that, right?

Every good leader is human, and, by nature, we all have inherent personal biases that impact our decision making. The key is to be self-aware.

The following are some of the most common types of personal biases:

Recency Bias is the belief that what is most recent will continue “for the time being.” This is easily demonstrated with interest rates. When rates are increasing or high, and loan demand is generally good, we tend to believe that rates will likely go higher still, and that we must lock in long term deposits to fund this ever-increasing loan demand. So, we extend funding (both at the wholesale and retail levels) in an effort to lock in today’s rates before they go even higher. Similarly, when rates are declining or low, loan demand is generally weaker and short-term deposits are generally “cheap.” Consequently, we tend to stay short with funding, because the higher costing, longer term funding is considered relatively expensive. And low rates will likely be around for the foreseeable future (sound familiar?).

With rates at record lows and the Federal Reserve Board’s Dot Plot indicating a consistent rate for the foreseeable future, Recency Bias would influence our decision making and strategic development based on the current rate environment. So, when reviewing ALCO reports, the board of directors and key executives may be fully aware of the financial impact of increasing interest rates. However, because of the inherent bias, they may not seriously consider a strategic plan for rising interest rates, leaving their financial institution ill prepared for such an occurrence.

Some might say this is a bad example. After all, you might personally believe that interest rates will stay steady for the foreseeable future. No changes, right? The Fed thinks so. Most economists concur.

Well, let’s look at the historical fluctuations in interest rates. The graph below represents a statistical regression on the 10-year treasury yield. The Blue lines represent +/- 2 Standard Deviations (StD) from the mean.

History shows us that there is typically a reversion to the mean as rates fluctuate. If rates drop by 1 StD, there is a 64% chance they will increase, at +2StD, that probability increases to 95%. Consider the rise in the 2018 interest rates compared to the drop in 2020. Looking back, would we have changed our decisions given this information?

While data like that presented above cannot tell us when rate changes will happen, it does help us see the probabilities of those changes occurring. I also believe that many decisions made over the course of the past ten years were based on the assumption that “recent events” would continue. How many of those decisions were made from a recency bias perspective…to the detriment of the financial institution?  

Confirmation Bias is the natural tendency of people to favor information that confirms a preexisting belief or hypothesis. In fact, we don't just favor this confirming information, we actually seek it out to the exclusion of any contradictory information.

You know the perpetual market bears that always see a crash around the corner (and yes, every office has at least one)? They go seeking data that supports their expectations. They are much more likely to accept and recall that data than any information to the contrary. We are all guilty of this to some degree or another. But this can be dangerous, especially in today's world where there is an unlimited supply of readily available information and varied opinions. This fear of the next crash, I believe leads financial institutions to prefer shorter duration loans and investments, even if that strategy can be shown to cost them both in income and net interest margin.

The world of financial institutions and the markets in which they operate are dynamic and ever changing. Thus, leadership needs to be able to reform opinions and adjust strategic plans based on accurate information in an ever-changing environment.

A Misunderstandings of Statistics is a topic all by itself, but here are a few relevant examples:

Regressive Bias may be one of the most important biases to be aware of when managing a financial institution. It refers to the fact that we grossly overestimate events that have a high likelihood of occurring, and in contrast, underestimate events with a low likelihood. If we hear "there is a 97% chance that loans will pay as agreed," our brains think of it as a certainty. (when in reality, if only 97% of loans pay as agreed, we would almost certainly have lots of questions to answer). The flip side is essentially the "black swan" issue. Rare and unexpected events are more likely to happen than our brains allow us to believe. This can be catastrophic to your financial institution if you are caught unprepared. Do not ignore potential risks just because they rarely occur. Be prepared.

“We spent X dollars on the software, so we are sticking with it even though it is clearly not the best solution.”

or

“We just started cutting deposit rates last month, so we can't increase them this month.” 

Financial institutions should always be evaluating where they are currently, regularly conferring with their ALCO consultant, and making optimal decisions for the future.