Bank regulation, governance and the crisis: a behavioral finance view

Abstract

PurposeThe purpose of this paper is to analyze the 2008‐2009 financial crisis using a behavioral view, and suggest changes in government policy and company governance to deal with the key behavioral problems.Design/methodology/approachBehavioral elements of the crisis are identified and explained, intermediaries involved in the crisis are reviewed, and both financial institution strategies and public policies are presented to deal with each element.FindingsThe behavioral view of the financial market points out that over‐optimism, anchoring, hubris and herd behavior are human attributes, and that future crises involving excessive credit extension will occur because of such non‐rational behavior. Responses to these elements of the crisis focus on four points: overconfidence related to rising home prices; inability of the market to channel participant behavior in sustainable directions; inadequate financial institution management due to hubris and herd behavior; and inadequate regulation due to regulatory capture and information gaps.Practical implicationsPolicymakers must see that no policy can eliminate future crises, so they should focus on designing responses to the behaviors of market participants. Raising levels of capital adequacy will help convince the market that the environment is safer, but ultimately new crises will occur anyway. Policy should aim to pre‐establish responses to those future asset price bubbles and market‐failure conditions. Practitioners must recognize the realities of overconfidence and herd behavior, to design better management that will constrain overextension of credit and excessive risk‐taking.Originality/valueA behavioral view has not previously been applied systematically to explain the crisis and to develop responses to it.