Bank Herding and Incentive Systems as Catalysts for the Financial Crisis
The IUP Journal of Behavioral Finance, Vol. VII, Nos. 1 & 2, pp. 30-58, March & June 2010
Posted: 30 Mar 2010
Date Written: March 25, 2010
Why do good bankers sometimes respond with the same disastrous strategies? Rooted in regulatory economics and behavioral finance, the paper offers a taxonomy of effects that narrows the scope of the banks’ decision making into a funnel-shape and thus, prepares the ground for a financial crisis. The basic message of the paper is that inconsistent decision rules, rigid bank regulations, stakeholder-focused incentive structures within banks and uncritical adoption of innovations may force banks into decisions that are micro-functional, but macro-dysfunctional. Behavioral aspects play a key role in the suggested remedies on the regulatory side (macroprudential regulation, supervision of incentives) and on the banking side (proper reward systems and structured decision making) to re-establish prudent banking.
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