Regulating Financial Guarantors: Abstraction Bias As a Cause of Excessive Risk-taking

Abstract

To improve financial regulation, scholars have engaged in extensive research over the past decade to try to understand why systemically important financial institutions engage in excessive risk-taking. None of that research fully explains, however, the unusually excessive risk-taking by financial guarantors such as bond insurers, protection sellers under credit-default-swap (CDS) derivatives, credit enhancers in securitization transactions, and even issuers of standby letters of credit. With tens of trillions of dollars of financial guarantees outstanding, the potential for failure is massive. This Article argues that financial guarantor risk-taking is influenced by a fundamental anomaly in perceiving risk. Financial guarantors commit to pay out capital only if certain future contingencies occur, in contrast to banks and other financial institutions that pay out capital—for example, by making a loan—at the outset of a project. As a result, financial guarantors are subject to a previously unrecognized cognitive bias, which the author calls “abstraction bias,” that causes them to underestimate the risk on their guarantees. The Article provides empirical evidence that supports the existence of abstraction bias and its influence on financial guarantors. The Article also examines how an understanding of abstraction bias can improve the regulation of financial guarantor risk-taking.