Bank Herding and Incentive Systems as Catalysts for the Financial Crisis

Abstract

Why do good bankers sometimes respond with the same disastrous strategies? Rooted in regulatory economics and behavioral finance, the paper offers a taxonomy of effects that narrows the scope of the banks ’ decision making into a funnel-shape and thus, prepares the ground for a financial crisis. The basic message of the paper is that inconsistent decision rules, rigid bank regulations, stakeholder-focused 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 suggested 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.

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