BEHAVIORAL FINANCE: THE PSYCHOLOGICAL DIMENSION OF SYSTEMIC RISK

Abstract

Behavioral Finance: Introduction Behavioral finance is the application of psychology to financial decision making and financial markets. This section consists of three chapters whose content provides perspectives and tools to facilitate the integration of psychological variables into the analysis of systemic risk. FCIC Report To set the stage for the issues discussed in this part of the Handbook, consider a series of comments made by the Financial Crisis Inquiry Commission (FCIC) in connection with regulatory failures that occurred before and during the financial crisis that erupted in 2008. In its report, the FCIC draws attention to a series of issues that include the mistaking of concentrated risk for diversification, the lack of a comprehensive framework for assessing systemic risk, and the failure to appreciate the role played by the bubble in housing prices. The following series of excerpts, taken from page xxi of the FCIC report, provide the FCIC's perspective. As our report shows, key policy makers – the Treasury Department, the Federal Reserve Board, and the Federal Reserve Bank of New York – who were best positioned to watch over our markets were ill prepared for the events of 2007 and 2008. Other agencies were also behind the curve. They were hampered because they did not have a clear grasp of the financial system they were charged with overseeing, particularly as it had evolved in the years leading up to the crisis. This was in no small measure due to the lack of transparency in key markets. They thought risk had been diversified when, in fact, it had been concentrated.