The role of behavioural finance in the risk management framework of banking institutions

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Cabral, Eviar
Issue Date
MBA in Finance
Dublin Business School
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The main purpose of this paperwork is to enlighten and expand the knowledge of the behavioural finance field of study by showing the importance of understanding the financial markets behaviour and evaluate if subsequent to psychological biases findings overall risk limits should be set at board level in the risk framework of banking institutions and converted to limits applicable to the individuals responsible for managing risks. Inspired by the studies of Kahneman and Tversky in the 1970’s, behavioural finance is a relatively new area of knowledge that has been gaining an exponential visibility especially over the past few years as a result of its managers and investors incapability of behaving according to the assumptions made in the traditional finance theory. The list includes events such as the bankruptcy of Lehman Brothers in 2008 followed by a global financial crisis having a behavioural bias at its root. To synthetize, the field of study attempts to enrich and enhance high quality of executive’s decisions offering complementary points of view and explanations in response to the difficulties faced by the traditional corporate finance. Within this context, it is important to emphasize that the aim of behavioural finance research in risk management is not to replace, but complement the assessment of other precise frameworks. The outcome this paperwork reveals that due to recent and continuous behavioural biases awareness, the investment community is already seeking new approaches that are less reliant on traditional investment theory in order to mitigate the role of biases in investment and managerial decisions, however there is still room for improvement, especially for large, complex and international financial institutions. Ultimately, several authors argue that we are unlikely to find a ‘cure’ for the biases, but the understanding of such behaviours along with appropriate financial planning policies can play a powerful role in avoiding behavioral biases. Author keywords: Behavioural Finance, Risk Management, Banking Institutions, Decision-Making