Disentangling the Epistemic Failings of the 2008 Financial Crisis

Abstract

I argue that epistemic failings are a significant and underappreciated moral hazard in the financial services industry. I argue further that an analysis of these epistemic failings and their means of redress is best developed by identifying policies and procedures that are likely to facilitate good judgment. These policies and procedures are “best epistemic practices.” I explain how best epistemic practices support good reasoning, thereby facilitating accurate judgments about risk and reward.

Failures to promote and adhere to best epistemic practices contributed to the 2008 financial crisis. I identify and discuss some of the ways in which best epistemic practices were violated in the events that led to the crisis, with a focus on the role of the credit rating agencies. I go on to discuss some of the ways in which these failings have been redressed. Specifically, the 2006 Credit Rating Agency Reform Act, including its expansion by Dodd Frank, and the subsequent statutory regulation by the SEC aim to facilitate best epistemic practices. These regulatory reforms are examples of proactive and forward-looking regulation, although they were implemented retroactively in response to perceived failures of the rating agencies. I conclude by observing how proactive regulation for best epistemic practices might help us to anticipate and avoid future crises.

Keywords: Applied Epistemology, 2008 Financial Crisis, Risk Culture, Banking, Credit Rating Agencies