The Global Financial Crisis – A Behavioral View

Abstract

This paper explores the problem of the global financial crisis of 2008-9, using a behavioral perspective to examine in some detail the issues of market and institutional failure. These failures are evident in the inadequate oversight/regulation provided by financial market regulators (especially the Federal Reserve and the SEC), as well as the inability of financial market participants to adequately judge and assign risk measures to key financial instruments, particularly collateralized debt obligations. The paper shows how specific adjustments in government policy (dealing with market structural imperfections) and company strategy (dealing with risk management) can respond to the key elements of the crisis.

Four categories of behavioral element are identified in the crisis: irrational exuberance of home lenders and borrowers; market structural imperfections, especially the lack of short-term financing available to investment banks in 2008; lack of adequate regulatory oversight; lack of adequate financial institution internal oversight. Each of these elements falls into a category of behavioral finance, from psychological aspects such as overconfidence and anchoring to lack of arbitrage possibilities. Government policy interventions are recommended for each of these failings, which fundamentally will allow the market to function with new safeguards on the overall financial system.

Keywords: financial crisis, behavioral finance

JEL Classification: G20, G28, D23