The limitations of human rationality constrain the efficacy of law. This policy brief examines how insights into human rationality could improve financial regulation. Four categories of limitations — herd behaviour, cognitive biases, overreliance on heuristics and a proclivity to panic — constrain the efficacy of financial regulation by undermining the perfect-market assumption that parties have full information and will act in their rational self-interest. Regulators could improve financial regulation by addressing these limitations. Since we do not yet fully understand our limitations, even improved regulation will remain imperfect. As a result, future financial failures are inevitable. Financial regulation should be designed to address that inevitability by not only deterring financial crises but also mitigating their harm when they inevitably occur.
Steven L. Schwarcz is a CIGI senior fellow and the Stanley A. Star Professor of Law & Business at Duke University. At CIGI, Steven leads research on systemic risk and financial regulation, corporate governance of systemically important firms, cross-border resolution measures and sovereign debt restructuring.