The influence of survival thresholds and aspiration levels on bank trading activities

In 1987 Lopes developed Security/Potential, Aspiration (SP/A) Theory, a framework for risky choice under uncertainty. Similar to Prospect Theory, SP/A Theory seeks to combine the forces of Economics and Psychology. This means that the assumption that individuals make choices based on expected utility only is loosened. Instead, the frameworks include some sort of reference point, which is important to the decision maker. In the context of Prospect Theory the existence of such a reference point leads to risk-shifting behaviour around the reference point, with risk aversion above the reference point and risk-seeking behaviour below the reference point, resulting in a value function that is concave for gains and convex for losses. In case of SP/A Theory this reference point is called aspiration level. In a series of experiments Lopes shows that the risk attitude of a decision-maker is influenced by the attention paid to a particular aspiration level and the attached probability of achieving it. The concept of an aspiration level in decision-making processes has also been explored by March and Shapira (1992). The focus of their random-walk analysis is the impact of changing resource levels on the variability in risky choice. In their model they assume the existence of two target reference points. The first target reference point is a survival level. Once resources fall below this target reference point, resources are exhausted. The second target reference point is the decision-maker's aspiration level for resources. While the survival point is fixed at all time, the aspiration level might change over time. In their model they find that the location of the risk-taker in respect to the reference points as well as the risk taker's focus (survival versus achieving the aspiration level) are major influencing factors on the risk-taker's behaviour. The results of the above theories could be applied to diverse areas in finance. One area, in which the application of the theories could be useful, is a bank's trading area. Generally, traders are required to engage in risky activities to achieve profits. However, the level of risk is limited by the capital level that underlies their trading portfolios. In accordance with March and Shapira, this capital level could be seen as survival point, as the loss of total capital will probably lead to the termination of the trader's employment. Further, the actions of traders might be influenced by certain profit target levels determined by the institution. These profit target levels can be seen as aspiration levels. Each trader might face multiple aspiration levels with the first aspiration level being a minimum required profit target, and a further aspiration level being a profit target that, once exceeded, leads to a bonus payment for the trader. It is probable that the existence of a survival point will induce traders to be risk averse in some situations in order to maintain employment. This, however, might be in conflict with aspiration levels, which might incentivise traders to be risk seeking in other situations in order benefit from achieving set profit target levels. This paper examines to which extent models that combine economic and psychological thinking apply to the trading activities in banks. We analyse how the existence of a survival point and aspiration levels could result in unintended trading behaviour, and discuss the implications for setting target performance levels in banking