Bank Herding and Incentive Systems as Catalysts for the Financial Crisis
IUP Journal of Behavioral Finance, Vol. 7, Nos. 1 & 2, pp. 30-58, 2010
Posted: 10 Feb 2011
Date Written: June 7, 2010
Why do good bankers at times respond unanimously with the same disastrous strategy? Rooted in regulatory economics and behavioural finance, the paper offers a taxonomy of effects that narrow banks decision scope into funnel-shaped and thus prepared the ground for the financial crisis. The basic message of the paper is that inconsistent decision rules, too rigid bank regulation, stakeholder-shaped 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 suggest 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.
Keywords: financial crisis, behavioral finance, bank regulation, incentives
JEL Classification: D03, D71, K23, G21, L51, M12, M52, P16
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