Understanding Financial Risk Tolerance Institutional Behavioral and Normative Dimensions Caterina Cruciani Full Chapter PDF
Understanding Financial Risk Tolerance Institutional Behavioral and Normative Dimensions Caterina Cruciani Full Chapter PDF
Understanding Financial Risk Tolerance Institutional Behavioral and Normative Dimensions Caterina Cruciani Full Chapter PDF
https://ebookmass.com/product/banking-and-beyond-the-evolution-
of-financing-along-traditional-and-alternative-avenues-1st-ed-
edition-caterina-cruciani/
https://ebookmass.com/product/2017-financial-risk-manager-frm-
exam-part-i-financial-markets-and-products-garp/
https://ebookmass.com/product/suicide-tourism-understanding-the-
legal-philosophical-and-socio-political-dimensions-daniel-
sperling/
https://ebookmass.com/product/understanding-disaster-risk-a-
multidimensional-approach-pedro-pinto-santos/
Understanding Risk Management and Hedging in Oil
Trading: A Practitioner's Guide to Managing Risk 1st
Edition Chris Heilpern
https://ebookmass.com/product/understanding-risk-management-and-
hedging-in-oil-trading-a-practitioners-guide-to-managing-
risk-1st-edition-chris-heilpern/
https://ebookmass.com/product/basic-statistics-for-risk-
management-in-banks-and-financial-institutions-arindam-
bandyopadhyay/
https://ebookmass.com/product/financial-institutions-management-
a-risk-management-approach-9th-edition-saunders/
https://ebookmass.com/product/sustainable-finance-and-esg-risk-
management-regulations-and-implications-for-financial-
institutions-chrysovalantis-gaganis/
https://ebookmass.com/product/understanding-risk-taking-1st-
ed-2020-edition-jens-o-zinn/
Understanding Financial
Risk Tolerance
Institutional, Behavioral
and Normative Dimensions
Caterina Cruciani
Gloria Gardenal
Giuseppe Amitrano
Understanding Financial Risk Tolerance
Caterina Cruciani · Gloria Gardenal ·
Giuseppe Amitrano
Understanding
Financial Risk
Tolerance
Institutional, Behavioral and Normative Dimensions
Caterina Cruciani Gloria Gardenal
Department of Management Department of Management
Ca’ Foscari University of Venice Ca’ Foscari University of Venice
Venice, Italy Venice, Italy
Giuseppe Amitrano
WieldMore Investment Management
London, UK
This Palgrave Macmillan imprint is published by the registered company Springer Nature
Switzerland AG
The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
To our loving families
Preface
vii
viii PREFACE
events. The different chapters focus on the debate on financial risk toler-
ance in specific time frames marked by regulatory events and provide
an in-depth overview of two important changes in European financial
markets—sustainable investment and fintech and robo advisory. A prac-
titioner’s view section authored by the CEO of a UK-based investment
firm is included as a commentary and includes relevant insights from the
world of financial advisory tied to the academic debate discussed in the
text.
This book represents a valuable contribution to both the academic and
the professional debate as it brings together different streams of litera-
ture in a critical review, exploring the feedback loop between academic
research and financial practice to draw insights on the regulatory future
of financial services.
The idea to write this book stems from the thought-provoking and
fruitful discussions between persons with different jobs but a similar
passion for knowledge and understanding.
Bringing together a practitioner with decades of experience and two
academic scholars studying financial markets and institutions was our way
to prove that contamination between different approaches is the best way
to look at ever-changing concepts like financial risk tolerance. As financial
markets continue to evolve, there is a profound need for open discussion
and exchange of ideas and we hope that this book provides useful material
in this respect.
A very important part of this book could not have been written
without the support of Federico Melotti and Andrea Papoff at Wield-
More Investment Management, who organized and chaired the webinar
in which we launched the practitioners’ questionnaire discussed in the
last chapter of this book. Caterina Cruciani and Gloria Gardenal wish to
thank Giuseppe Amitrano and all the WieldMore Investment Manage-
ment team for believing in the soundness of the project and for helping
in the promotion of the survey among practitioners.
The list of acknowledgments would not be complete without
mentioning our supporting and loving families. Writing a book is no easy
feat and we all owe the biggest thank you to our spouses and children,
who cheered us along the process, provided inspiration, and much-needed
entertaining breaks and to whom this book is dedicated.
ix
Contents
xi
xii CONTENTS
Index 179
About the Authors
xv
xvi ABOUT THE AUTHORS
Chapter 3
Fig. 1 Information flows and market players affected
by sustainability disclosure 94
Chapter 4
Fig. 1 The four types of financial services that currently are and will
be affected by Fintech (Source Adapted by [Basel Committee
on Banking Supervision, 2018; Thakor, 2020)] 123
Chapter 5
Fig. 1 Sustainability and relevant sustainability concerns 160
Fig. 2 Information that may be useful in BETTER dealing
with clients in an Open-Finance framework 164
xvii
List of Tables
Chapter 1
Table 1 Factors influencing financial risk tolerance—an academic
view before MiFID 21
Table 2 Subjective measures of financial risk tolerance
from large-scale representative surveys 28
Chapter 2
Table 1 Factors influencing financial risk tolerance—an academic
view before MiFID2 (2005–2014) 50
Table 2 Factors influencing financial risk tolerance—an academic
view before MiFID2 (2015-now) 61
xix
CHAPTER 1
For what concerns supply, a general trend, that affected countries all
over the world, regards the wave of privatization of public utilities that
brought to the market well-known stocks with a large potential investor
base. Already started in the late 1970s, the privatization of State-owned
enterprises saw almost 2500 deals in 121 countries being concluded over
the period 1977–1999 for a net worth of over 1110$ billion (Bortolotti
et al., 2004). Privatizations benefit from more liquid stock markets that
can accommodate larger issues easily, increasing the speed and size of
the revenues. Using a panel of 34 countries over the 1977–1999 period,
Bortolotti and colleagues empirically show that privatization waves tend
to exploit hot market periods: the increase in the extent of privatization
activities thus signals that domestic stock markets have already become
more liquid.
In terms of direct entry costs, the blossoming of the mutual stock
fund industry finally brought to investors easy access to well-diversified
products, helping the transition from direct acquisition to fund subscrip-
tion (Guiso et al., 2003). The growth in the mutual fund industry was
remarkable all over the world: between 1992 and 1998 the average annual
growth rate of US mutual funds was over 22.4%, while European funds
grow by an annual rate of 17.7%. The development of equity mutual
funds was stronger in the United States than in Europe where bond funds
were more popular (Fernando et al., 2013). Mutual funds are naturally
targeted to households looking for a good level of diversification with
a relatively low level of fees and commissions: individual investment is
pooled and invested in very diversified funds, whose policy is defined in
advance and is not subject to the preferences of the investors participating
in the fund. While mutual funds require well-developed securities markets,
where market integrity and liquidity are high (Fernando et al., 2013),
they also have the potential to enlarge the investor base to less financially
educated individuals, who might otherwise refrain from investing (Guiso
et al., 2003). The overall effect of these trends is that new entrants—less
educated than experienced stockholders and with fewer financial means to
face the stock-market fluctuations—will influence the behavior of excess
returns on equity, as education tends to correlate negatively with risk
aversion (Guiso & Paiella, 2018).
Another macroeconomic factor that supported the increased pace in
the regulation of financial markets to support the demand for financial
products is that improved levels of well-being led to the progressive aging
of the population in many countries. Economists were already puzzled
1 FINANCIAL RISK TOLERANCE: WHERE DOES IT ALL START FROM? 5
by the evidence that many individuals tend to save too little to ensure a
similar standard of living after retirement (Bernheim et al., 2000). This
evidence was abundant, especially in the literature regarding the United
States, where individuals were already called upon to make important
decisions regarding their pension during their working life. For instance,
Bernheim finds that individuals undersave for retirement as they tend
to hold too optimistic expectations regarding their future wealth, do
not possess an adequate level of financial literacy—the ability to under-
stand and use correctly key notions in economics and finance—and do
not have access to high-quality guidance in making financial decisions
(Bernheim, 1998). While the author called for more effective finan-
cial education programs, later evidence has shown that such programs
have at best a limited effect. Collins et al. (2010) find some positive
effects in 41 programs but highlights that any attempt at evaluating
such programs suffers from a self-selection bias, as one cannot rule out
that only the more motivated individuals sign up. Often the effect of
these programs is limited to some decision domains such as savings and
barely distinguishable from what happens in control groups (Miller et al.,
2015); moreover, the decay is as rapid as 20 months after the program is
complete (Fernandes et al., 2014). An increase in life expectancy has the
potential to magnify the scale of this pension unpreparedness with a major
impact on the economy. At the same time, the 1990s saw the beginning of
a transition from defined-benefit to defined-contribution welfare systems
in Europe, which further increased the need for efficient financial plan-
ning for retirement even in countries where stock-market participation
was low.
currency, and created the banking Union with the Single Supervisory
Mechanism (Treaty on the European Union, 1992).
Free movement of capital1 extends from real investment and purchases
to security investments of all kinds, reducing the frictions and the entry
costs into any market within the European Union.
Investment services in this new operational landscape are regulated
by another landmark document in European history: the Investment
Services Directive (ISD) in the securities field, introduced in 1993
(European Commission, 1993). The Directive provides clear definitions
of key investment services and investment tools and defines rules for
offering these services in the Union introducing some key concepts
regarding the supply of financial services that will remain crucial in
EU legislation to come. The Directive has two key goals: setting up
the rules of conduct and practice for banks and investment firms to
ensure free movement of capital and strengthen the Union, and “to
protect investors” while taking “account of the different requirements
for the protection of various categories of investors and of their levels of
professional expertise” (Preamble, p. 2).
Concerning investment firms, the Directive clearly describes the
process through which they may be authorized to operate in a Member
State and includes financial products under the umbrella of the principle
of mutual recognition, by which all investment firms that are authorized
in one Member State are allowed to do so in others “as long as they
do not conflict with laws and regulations protecting the general good in
force in the host Member State” (Preamble, p. 2). Title V of the Direc-
tive defines more closely the rules regarding this mutual recognition that
require investment firms to either establish a branch in the Member State
where they wish to provide investment services or operate directly if they
already have the authorization for those services in their own Member
State.
The Directive spells out clearly the “conditions for taking up business”
in the Union (Title 2), and the necessary requirement an investment firm
needs to possess to be authorized are included in Article 3, where both
1 Any restrictions on the free movement of capital in the EU will be then safeguarded
also in the other key document forming the constitutional basis for the European Union,
the Treaty on the function of the European Union (Treaty on the Functioning of the
European Union, 2012), which states it explicitly in Article 63 and extends also to
payments (Art. 63 point 2).
1 FINANCIAL RISK TOLERANCE: WHERE DOES IT ALL START FROM? 7
2 Although these rules apply to all services, the Directive includes financial advisory
as a non-core service in Annex C and clearly states that investment firms that only
provide financial advice may not receive authorization to operate: “Authorization within
the meaning of this Directive may in no case be granted for services covered only by
Section C of the Annex” (Article 3).
8 C. CRUCIANI ET AL.
particular, the Plan mentions that any obstacles to the integrated market
should be removed to ensure that consumers have access to increased
choice and competitive terms, to build and support trust. The Plan calls
for the clarification of the “essential requirements” at the heart of the
EU financial legislation, highlighting that “a high consumer protection”
should be at their basis (p. 16). The Plan calls explicitly for clear rules
for business conduct in terms of sophisticated and retail investors since
Article 11 did not provide a criterion to distinguish between different
professional nature of clients but help in this respect was provided by the
Forum on European Securities Commission (FESCO) in March 2000.
FESCO brings together the securities regulators of the countries of the
European Economic Area (EEA) to provide their experience and support
to coordinate action toward the implementation of the Single Market and
is instrumental in the discussion and elaboration of common standards
to regulate financial services in areas where legislation did not provide
proper harmonization guidelines (Demarigny, 2000). For what concerns
the application of Article 11 of the ISD, FESCO provided precise criteria
to identify professional investors (FESCO, 2000) focusing on the needs
and professional competence of the client as required by the ISD. The
criteria suggest that professional investors require a less stringent degree
of protection considering their professional qualifications. Two categories
of entities are classified as professionals: the first includes entities that
are required to be authorized to operate in the provision of financial
services in the EU (such as credit institutions and investment firms) and
national governments and central banks; the second one includes large
and institutional investors which must explicitly request to be treated as
professional clients. The first category may also request to be treated as a
non-professional client and have access to a greater degree of protection
in the conduct of business.
A year later FESCO published another paper commenting on the
application of Article 11 to address the lack of harmonization in busi-
ness conduct across the different Member States to ensure an equivalent
degree of protection throughout the EEA, improve investment flows in
the EEA and promote cooperation between competent authorities in
terms of conduct rules (FESCO, 2001). The paper asserts the principle
that all investment firms must act honestly fairly and correctly, dele-
gating to other firms only when professionally relevant and engaging
in interaction with authorized firms only (Principle 1). Investment firms
must communicate clear, fair, and not misleading information that should
1 FINANCIAL RISK TOLERANCE: WHERE DOES IT ALL START FROM? 9
Clear goals without as-clear directions might have been then informed
by the large and growing literature on financial risk tolerance coming
from empirical academic studies. The goal of this section is to summa-
rize the key insights coming from scientific work regarding risk tolerance
definitions and measures to understand the degree of interaction between
the regulatory needs to address risk tolerance for investor protection and
the scope of academic research. Given the importance of the MiFID
Directive in shaping the measurement in financial risk tolerance, all the
evidence presented in this chapter dates before its introduction, leaving
to Chapter 2 to pick up on this literature review for the years that follow.
3 FESCO establishes that it is the responsibility of the investment firm to identify the
most suitable products for its clients, after determining “client’s knowledge and experi-
ence in the investment field, his investment objectives and risk profile, and his financial
situation/capacity” (FESCO, 2001, p. 21).
16 C. CRUCIANI ET AL.
of the Capital Asset Pricing Model: (1) increased risk tolerance reduces
an individual’s propensity to purchase risk-free assets; and (2) higher risk
tolerance does not affect the composition of an individual’s portfolio of
risky assets. More specifically, they find that risk tolerant investors nearing
retirement do not reduce their bond allocations to buy more stock.
1988; Strube, 1991; Van Egeren et al., 1982). In their attempt to achieve
economic success, the Type A behavior pattern is associated with a will-
ingness to take greater risks in everyday financial matters than that of the
Type B behavior pattern. Moreover, as Type A individuals tend to possess
a higher income level than Type B individuals (Thoresen & Low, 1990),
such financial security might make it possible for Type A individuals to
be willing to take greater financial risks than Type B individuals. In their
study, (Carducci & Wong, 1998) analyze Type A and B individuals and
find that Type A subjects are significantly more risk tolerant than type B.
This can be explained by the tendency of Type A individuals to be gener-
ally more competitive and concerned with personal achievement (Ray &
Brozek, 1980) and to be recognized in an industrial society (Houston &
Synder, 1988). Type A subjects care a lot about their financial success, as
it is used by society to identify a successful person. Since financial success
is proportional, in a sense, to the financial risk taken, Type A individuals
would be more willing to take greater financial risks to achieve financial
success and be recognized as successful by society. The tendency of Type
A individuals to possess a higher income level than Type B individuals (cf.
Thoresen & Low, 1990) is another possible reason for their willingness
to take greater financial risks than Type B individuals.
The following table provides a summary of all the papers mentioned
organized by topics and subtopics (Table 1).
(continued)
21
22
Table 1 (continued)
Hispanics are more risk tolerant than Grable and Joo (1999)
non-Hispanics
Ethnic differences have no effect on risk Gutter et al. (1999), Sung and Hanna
taking (1996)
Personal characteristics Bernheim (1998)
Portfolio composition and RT Hariharan et al. (2000)
C. CRUCIANI ET AL.
Financial education Positive relation with RT Chang et al. (2004), Hawley and Fujii
(1993), Lee and Hanna (1995), Sung and
Hanna (1996), Warner and Cramer (1995)
Financial literacy Positive relationship with RT Bakken (1967), Cartwright (2004), Chen
and Volpe (1998), Fox et al. (2005),
Howells (2005), Langrehr (1979), Mandell
(1997)
Income and wealth Higher income determines higher RT Baker and Haslem (1974), Chen and Hanna
(1996), Cicchetti and Dubin (1994), Cohn
et al. (1975), Grable and Joo (1999),
Hanna and Chen (1995), Lee and Hanna
(1991), Malkiel (1996), Masters (1992),
Schooley and Worden (1996), Shaw (1996),
Zhong and Xiao (1995)
Retirement Years until retirement Sung and Hanna (1996)
Variable Effect References
Personality psychology Sensation seeking and Type A behavior Carducci and Wong (1998), Carver et al.
1
theory, but also the risk-return framework typical of finance is used, while
decision theory and psychology focus also on psychometric scales (Betz
et al., 2002). The different approaches have different focuses but overall
managed to establish a series of important results to build upon in the
following decades. The following sections will try to provide an orga-
nized overview of the different tools put forward before the advent of
the MiFID and discuss the approach and the merits of each of them. As
the review will show, elicitation methods matter: the way in which risk
preferences are assessed may lead to different results.
This section will discuss the merits and limitations of the key categories
of tools used to measure financial risk tolerance, focusing on whether
the measures tend to be purely descriptive or if they somehow advance
knowledge in understanding the process of risk aversion in this domain.
Which of the following Indicate on a scale from 0 When people invest their
statements comes closest to to 10 how you see yourself savings they can choose
describing the amount of in terms of your willingness between assets that give
financial risk that you are to take risks, with 0 low return with little risk
willing to take with your representing no tolerance to lose money, for instance
spare cash? That is, cash for risks and 10 a bank account or a safe
used for savings or representing the greatest bond, or assets with a high
investment willingness to be exposed to return but also a higher
Participants can choose risk risk of losing, for instance
from the following stocks and shares. Which
responses (emphasis not of the statements on the
added) card comes closest to the
1. I take substantial amount of financial risk
financial risks expecting to that you are willing to take
earn substantial returns. when you save or make
2. I take above-average investments?
financial risks expecting to 1. Take substantial financial
earn above-average returns. risks expecting to earn
3. I take average financial substantial returns
risks expecting to earn 2. Take above-average
average returns. financial risks expecting to
4. I am not willing to take earn above-average returns
any financial risks. 3. Take average financial
5. I never have any spare risks expecting to earn
cash. average returns
In the waves used in this 4. Not willing to take any
study, people who choose financial risks.
option 5 are given the
following follow-up
question
Assume you had some spare
cash that could be used for
savings or investment.
Which of the following
statements comes closest to
describing the amount of
financial risk that you
would be willing to take
with this money?
They are then asked to
choose from 1 to 4 above
1 FINANCIAL RISK TOLERANCE: WHERE DOES IT ALL START FROM? 29
Grable and Lytton (1999) highlight the key features of a valid and reliable
measure of risk tolerance including specific dimensions of risk like the
probability and size of gains and loss, the need to focus specifically on the
financial domain and the trade-off between length and clarity. In the paper
they introduce the Grable and Lytton risk tolerance scale and discuss how
the 13-item tool was developed and validated.
laws affecting the right of both insiders and outside corporate investors.
Therefore, the good functioning of the markets and the protection of
investors developed at the same time with the capability of the different
regulators and courts to guarantee and, if necessary, enforce these laws.
The protection of corporate investors became the first step to create the
confidence for attracting investments, and through financing companies,
creating a well-functioning financial market.
Limits and checks have always been a characterizing trait of financial
firms. The role of compliance has been more of a gatekeeper rather than
a driver, but the concept that there was a defined area of operation and
amount of risk-taking has always been present. However, in the very early
days of modern financial markets, during the end of the 80s, the role
of compliance was less relevant, in the sense that operativity was more
flexible and implied less bureaucracy. Compared to nowadays, there was
a more limited control from the regulators, performing less checks which
created room for irresponsible management behavior (like MF, LTCM,
and Lehman).
Was there a perception that investors were to be protected from or
rather encouraged to take on risk? Based on what?
One of the main provisions in terms of investor protection was that
investment firms must match the client’s investment profile with suitable
products. Today, the idea of suitability itself is to find a product and an
overall portfolio that is tailored for the client himself/herself, like a suit.
That means it should not push investors to take risks they are not able to
bear. On the other hand, it is important that regulation does not create
barriers where they are not needed, because that would imply a cost-
opportunity situation. The core idea that led to the MiFID was to increase
transparency to deliver the perfect suit for the client. Nevertheless, the
bumpy rides financial markets faced during the early years probably moved
the industry to look at risk through a more conservative lens, from a regu-
latory point of view. This resulted in the provision of a target market and
compatible customers from the very beginning of the product life cycle.