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The Banking Game: Literature Review Part Two by Doreen Soutar

The Banking Game: Analysis of the extinction of the bank as trusted institution and NONIIs as an indicator of non-reciprocal strategies by Doreen Soutar. This is the second part of her literature review…

Banking: A Dual-Strategy Model

The banking industry operates in two distinct environments: financial trading and retail savings and loans (Casu et al 2006) and this has in the past resulted in the banks developing two distinct behavioural patterns to cope with these environments: a competitive model and a cooperative model. The competitive model was suitable for environments such as the stock market, where the inhabitants agreed to fight each other for available resources. The cooperative model was more suitable for retail banking environment, where customers assume that there is a fundamental principle of honourable group-focused behaviour (King, 2010; Kennedy, 2010).

Stock market

A Competitive Environment: The Stock Market

There can be few more obvious examples of the drive to competition than on the trading floor of the stock market, and it demonstrates the principle of evolutionary theory with which we are most familiar: “nature red in tooth and claw” (Tennyson, 1850 in Dawkins, 1976).

There are two main assumptions which can be made about stock market trading: it involves very large sums of money over very short periods of time (Johnston et al 2003). Through a combination of factors such as the speed of information technology (Haydock, 2000) the lack of loyalty in shareholders over the medium to long term (Johnston et al 2003) and the introduction of quarterly reporting, the investment division are under pressure to produce profits over a period of ninety days (ibid.). This means that medium and long term investments have reduced in favour of deals which produce a quick turn-around (ibid.).

Investment banking tends to employ very intelligent and motivated employees who have the skills necessary to produce methods of profit-making which are on the cutting edge of financial juggling (Johnston et al, 2003; Ingo, 2004) They are also in a highly competitive sector whereby they are under continuous pressure to outwit their rivals (ibid.). This means that the primary job of an investment banker is to be innovative in the methods they employ, even if that means occasionally taking the risk of introducing a new method of profit creation (Chorafas, 1994).

This model is not specific to banks, and can be readily recognised in many knowledge-based companies (Sveiby 1989), and indeed some of their innovations can be adapted to suit the retail division, such as the introduction of digital technology in banking, with considerable success.

 

Trading Theories

The nature of the trading environment has itself evolved, and with it the nature of today’s traders (e.g. Greenspan, 1998). They operate through digital technology in a highly volatile and competitive workplace. Known as Chartists, today’s traders are undoubtedly highly intelligent and intellectually sharp operators who have utilised some of the most complex mathematical theorems to enhance their performance (Johnston et al 2003).

From this perspective, traders provide a focal point of cross-fertilisation of blue-sky domains which rarely exists even in the academic establishments teaching them. For example, a large literature developed at the beginning of this century of the connection between the unpredictability of financial trading and chaos theory (e.g. Chorafas, 1994). However, this is not to say that banking cannot be examined for trends, and game theory provides a useful tool for doing this.

 

Game Theory and Banking

Game theory is a way to look at individual co-operation or competition in a range of environments (Nowak & Sigmund, 2000). It is a deceptively simple concept at heart, and has been applied to a variety of paradigms, particularly in evolution, where the theory is used over several repetitions to chart the flow of types of behaviour within communities. Figure 1 below shows the basic principles of game theory, where points are awarded for particular behaviours. This is known as the coordination game, and demonstrates the benefit of working together in cooperation.

Banking Game

From this graph, we can see that to gain the most points is to cooperate in both using strategy A. Where both players select the same strategy, and neither player has any incentive to change their position, this is known as a Nash equilibrium (Nash, 1950). In the coordination game, disagreements between players as to strategy can only result in a smaller payoff. So, for example, deciding which side of the road cars should drive on works best when all parties agree. One type of agreement may be more profitable than the other, but they both constitute equilibrium points.

However, what if the greatest benefits could be gained from disagreeing with the other player? Figure 2 below shows the basic principles of one of game theory’s most well known examples, the Prisoner’s Dilemma.

 

Banking Game part two

 

Simply put, the Prisoners’ dilemma is a game for two players where each player has to decide whether to cooperate or defect (e.g. Nowak & Sigmund, 2000) with the other player. Players score 3 points each if they both cooperate, one point each for both defecting, five points for defecting where the other person cooperates, and 0 points for cooperating when the other person defects.

The most profitable overall position within this game is for both parties to co-operate to gain six points between them (Nash, 1950), but the individual profit is greatest when the parties disagree, and the loss is greatest through unilateral co-operation.

Therefore, the temptation to defect is great, as even if the other person defects as well, neither player gains 0 points, but can gamble on the other player’s co-operation to reap the maximum rewards.

 

Game Theory

Game Theory Within The Banking Industry

On the trading floor, however, the common good is not a priority, individual gain is (Myerson 1997). Therefore, according to a single game of Prisoners’ Dilemma being equated to competing with other traders to make profit, the best a trader can do is to ‘do unto the other person before they do it to you’.

However, given that analysts such as Johnson (2003) describe the trading markets as being non-linear – the future cannot be assessed by previous behaviour – the social context of the trading floor can be envisaged as a series of single-round Prisoners’ Dilemma games, played between individuals who understand that their job is to defect on co-operators as much as possible. That is, they become a community of mutual defectors (Nowak & Sigmund, 2000).

Of course, defection does not engender trust, and in Axelrod’s version of the game, Tit for Tat (Axelrod & Hamilton 1981), the Prisoner’s Dilemma game is played several times, and co-operators respond to defectors in kind in second and subsequent rounds of the game, becoming defectors themselves. However, over the long term, where defection has become the norm, and might be expected from other players, rogue co-operators can thrive and grow within a population of defectors, until the point at which co-operation once more becomes the norm (e.g. Nowak & Sigmund 2000; Kolm, & Ythier, 2006).

Therefore, in an industry such as retail banking, customers have come to trust banks as social institutions which are co-operating with their customers for a modest but reliable gain.

 

Game Theory Between Banks And Their Customers

The connection of the highly competitive trading divisions of banking to the co-operative retail sector means that there is potential for the Prisoners’ Dilemma strategy to leak from one division to the other, with bankers treating their relationships with their retail customers as a one-shot Prisoners’ Dilemma game rather than a Tit for Tat ongoing relationship (Axelrod & Hamilton, 1981).

The potential for this corporate culture to extend from the trading division to the retail division is nourished by the tendency of the UK banking system to be comprised of a few large banks in an industry with high barriers to entry: a small sub-group of individuals develops where defection has become fixed and mutual altruism is effectively extinct. Thus, given that the customer is in the position of being a perpetually co-operating player in the game theory analogy, the corporate mindset would tend to view the customer as an easy target for competitive benefit. In addition, of course, banking has become a way of life for customers, and to refuse to play the game has become almost impossible. The customer, therefore, becomes a trapped ‘cash cow’ (Kennedy 2010) at the mercy of a competitor they thought was an ally.

 

Globalisation

The Globalisation of Gaming

Having been brought to an awareness of a perpetual defection model, it might be imagined that corporate strategy would alter to create a more co-operative model of behaviour. Indeed, the proposals for breaking up banks and tighter regulation proposed by the Bank of England (King, 2010) may affect this shift. However, Nowak and Sigmund (2000) note that a defection strategy is easier in a mobile social context than in a static one. Disturbingly, the global operational sphere of banks would tend to predict that banking defection strategy may shift from one social context to another. Very recent reports suggest that this is the case in emerging markets (FT 2010), who face issues similar to those of the sub-prime markets in the US. Thus, the competitive strategy of the trading floor continues to permeate through to another environmental context which is naïve of its intentions (Mirabet et al 2008).

 

 

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