Epidemics of rules, rational negligence and market crashes

Abstract

Structural changes in an economy or in financial markets can arise as a result of agents adopting rules that appear to be the norm around them. Such rules are adopted by implicit consensus as they turn out to be profitable for individuals. However, as rules develop and spread they may have consequences at the aggregate level which are not anticipated by individuals. To illustrate this, we develop a simple model, motivated by the 2007–2008 crisis in credit derivatives markets. This shows how coordination on simple and apparently profitable rules may weaken regulatory constraints, rendering the whole system more fragile. The rule, in the specific example, consists in deciding not to exercise due diligence in the evaluation of complex credit derivative products, free riding on information and operational costs. We show that such ‘rational negligence’, in the face of deteriorating macro-economic conditions, can bring a market to a sudden collapse.

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