It's (Not) All About the Money: Using Behavioral Economics to Improve Regulation of Risk Management in Financial Institutions

Despite considerable recent legislative attention to risk management, including the passage of the Dodd-Frank Act, excessive risk-taking by financial institutions is still rampant. Risk-related decision makers do not make decisions about risk-taking in a vacuum, but in an environment where multiple factors, noticed and unnoticed, can influence the decisions. Such factors include cognitive-related biases and group-related biases. And there are tools, which have not yet been analyzed in literature that regulators can use to reduce undesired or excessive risk-taking. Indeed, by shaping such environmental factors in which risk-related decisions in financial institutions are made, regulation can help actors make better, less pro-risk-taking, choices. With the goal of reducing excessive risk-taking by financial institutions, this article builds on an emerging focus in behavioral law and economics on prospects for “debiasing” actors through the structure of legal rules. Under this approach, legal policy may reduce biases’ effects and judgment errors by directly addressing them. Doing so will then help the relevant actors either to reduce or to eliminate these effects and errors. Accordingly, the article suggests using behavioral economic-based legal guidelines to supplement the Dodd-Frank Act‘s risk management provisions, and specifically the requirement that financial institutions create separate risk committees. Such legal guidelines would help reduce the degree of biased behavior that risk committees exhibit. The legal guidelines proposed in the article focus on the composition, obligations and work procedures of the financial institutions’ newly mandated risk committees. These guidelines provide behavioral incentives that will not only help reduce excessive risk-taking, but may even raise social responsibility awareness, while not compromising financial institutions’ legal and financial responsibilities. The article uses JPMorgan’s 2012 multi-billion dollar loss and MF Global’s collapse in 2011 as case studies for certain behavioral effects and biases that are relevant in the context of risk-taking. Within the context of these two events, the article analyzes the impact that diversity has on group dynamics; the influence that prior experiences and internal honesty standards can have on decision makers; the choice shift phenomenon; the illusion of control; the framing effect; the impact of accountability; the impact that the association of risk with potential disastrous outcomes has on decision makers; the familiarity bias; and the hindsight bias. As demonstrated in the article, the proposed guidelines, which address these biases, could have helped avoid — or at least mitigate the damages from — the great JPMorgan losses and the MF Global collapse.