The Custom-to-Failure Cycle

Abstract:     
In areas of complexity, people often rely on heuristics — by which we broadly mean simplifications of reality that allow us to make decisions in spite of our limited ability to process information. When this reliance becomes routine and widespread within a community, it can develop into a custom. As long as such a heuristic-based custom reasonably approximates reality, society continues to benefit. In the financial sector, however, rapid changes in markets and products have disconnected some of these customs from reality, leading to massive failures; and increasing financial complexity is accelerating the rate of change, threatening future failures. We examine this “custom-to-failure cycle,” considering how law can help to manage the cycle and mitigate its failures. In that context, we also analyze whether individuals and firms who follow heuristic-based customs should be subject to liability if the resulting failures harm society.

Number of Pages in PDF File: 29

Keywords: market risk, value at risk models, rating agencies

Accepted Paper Series