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Regulators Must Get Grip on Traders’ Hormones

Why have the financial markets recently rallied so sharply in places such as America? If you ask a trader, they will cite “rational” explanations, such as US bank stress tests, an improved US economic outlook, and decline in euro zone concerns. But if you ask John Coates, formerly a senior trader at Deutsche Bank and Goldman Sachs, there may be another factor at work: hormones.

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Since he left banking, Mr. Coates has retrained as a neuroscientist at Cambridge university, where he has worked in a team analyzing the bioscience of financial traders. And, as a forthcoming bookwill explain, Mr. Coates and his fellow researchers now believe that unseen fluctuations in traders’ hormone levels play a crucial, but widely overlooked, role in finance; so much so in fact, that he wants regulators and bank managers to start tracking these hormone levels, as a matter of public policy.

By any standards, this marks a potentially important new twist in the debate about finance. A decade ago, disciplines such as economics tended to operate in something of an intellectual silo. However, since 2007, there has been renewed interest in the idea of combining psychology with economics and finance, in so-called “behavioral economics”, as it has become clear that individuals are rarely as “rational” as free market economists and models presumed.

But, until now, there has been less effort to blend economics with neuroscience, let alone biology. That is partly because the disciplines inhabit such different academic niches. Another issue is that bank directors and regulators typically consider it distasteful—or discriminatory—to look at staff through the prism of their bodies.

But Mr. Coates insists this blind spot is a mistake; fluctuations in traders’ biochemistry have big consequences, and could be easily tracked. Take, for example, the issue of testosterone, or the hormone most closely associated with masculine traits, as well as aggression and risk-taking. Studies suggest that financial traders typically have relatively high levels of testosterone relative to the wider population, and these levels often rise once they join a trading floor.

Now, in some senses, these high testosterone levels can be beneficial. One experiment Mr. Coates conducted was to map traders’ handprints against their “p and l” (profit and loss) statements; this showed a high correlation between individual “p and l” and the ratio between the length of index and ring fingers. Mr. Coates attributes this to the fact that this finger ratio—bizarrely—is a good guide to foetal exposure to hormones such as testosterone.

While an excess of testosterone can sometimes produce individual success, collectively it can create excessive aggression, dangerous overconfidence and herd behavior; so much so in fact, that Mr. Coates labels it the “irrational exuberance hormone”, since he believes this prompts bullish optimism and risk-taking to spiral out of control.

But another equally important chemical is cortisol, the hormone that regulates our bodies’ “fight or flight” reactions. When danger looms, cortisol levels typically rise, and for short periods this is beneficial since this sharpens our defensive instincts. But, if there is a period of long, unpredictable stress, cortisol levels become elevated. That can impair cognitive analysis and promote irrational pessimism and risk aversion. Mr. Coates attributes the behavior of financial markets in late 2008 and 2009 to an excess of cortisol.

Then there is the vagus nerve. Traders who are physiologically healthy have so-called good “vagal tone”, meaning their heart rate and adrenaline levels fluctuate sharply, rising in a crisis, but then (crucially) falling back. Traders whose functions have become impaired lose vagal tone. Their bodies and minds remain in a constantly “stressed” state.

Is there a solution? Mr. Coates proposes two. First, he wants banks and regulators to monitor traders’ biology; after all, he says, it would not be hard to install heart monitors, or blood tests in banks, to spot hormonal swings. Second, he wants banks to employ more women and older men on trading floors, not for reasons of political correctness, but because female tradersand older men tend to have lower testosterone and better functioning vagal nerves. A better biological mix, he insists, will mean fewer swings in testosterone and cortisol, and thus fewer market dramas.

These ideas are profoundly sensible. But don’t expect them to be adopted soon. As I noted above, there is a taboo against viewing traders through the prism of biology, let alone with intrusive tests, or gender and age-based hiring policies. But, if nothing else, the work of Mr. Coates suggests investors and regulators should debate these issues, particularly now that markets are rebounding. “Sick” financiers, after all, have a nasty habit of creating unhealthy finance. And that hurts not just traders, but the wider, low(er) testosterone population too.

Click here to read moreabout Coates and his book, ”The Hour Between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust.”

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