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.