The Custom-to-Failure Cycle
Schwarcz, Steven L., Chang, Lucy, Duke Law Journal
In areas of complexity, people often rely on heuristics--by which we broadly mean simplifications of reality that allow people to make decisions in spite of their limited ability to process information. When this reliance becomes routine and widespread within a community, it can develop into a custom. As long as such a heuristic-based custom reasonably approximates reality, society continues to benefit. In the financial sector, however, rapid changes in markets and products have disconnected some of these customs from reality, leading to massive failures, and increasing financial complexity is accelerating the rate of change, threatening future failures. We examine this "custom-to-failure cycle" and consider how law can help to manage the cycle and to mitigate its failures. In that context, we also analyze whether individuals and firms who follow heuristic-based customs should be subject to liability if the resulting failures harm society.
TABLE OF CONTENTS Introduction I. The Development of and Failure To Reassess Heuristic-Based Customs A. Reliance on Heuristics Can Develop into Heuristic-Based Customs B. Heuristic-Based Customs Can Discourage Reassessment of Their Underlying Heuristics II. Failures Can Result When Heuristic-Based Customs No Longer Reflect Reality A. Failure Resulting from Reliance on VaR Models B. Failure Resulting from Reliance on Credit Ratings C. Failure Resulting from Reliance on Collateral D. Failure Resulting from Incremental Innovation III. How Law Can Help A. Making It Less Likely That Parties Will Follow Outdated Heuristic-Based Customs 1. Requiring More Self-Aware Operational Risk Management and Reporting 2. Limiting Complex Financial Products 3. Criminalizing the Following of Outdated Heuristic-Based Customs B. Addressing Failures That Result When Parties Follow Outdated Heuristic-Based Customs 1. Applying the Theory of Civil Damages to Natural Persons and Firms 2. Ex Post Facto Considerations Conclusion
Human beings are "limited-capacity information processors." (1) In areas of complexity, we tend to compensate by relying heavily on heuristics--broadly defined as simplifications of reality that allow us to make decisions in spite of our limited ability to process information. (2) Sometimes these simplifications are based on models. (3) Other simplifications are more psychologically based. (4)
Reliance on a heuristic can become so routine and widespread within a community that it develops into a custom, which we refer to in this Essay as a "heuristic-based custom." (5) This type of custom may not--and indeed, as this Essay assumes, does not (6)--become the basis for law per se. Rather, it is a custom in the sense of a "usual or habitual course of action, a long-established practice," (7) which is merely "one element of the law-creating fact called custom." (8)
When a heuristic-based custom reasonably approximates reality, society should benefit. Modern finance, for example, has become so complex that the financial community routinely relies on heuristic-based customs, such as determining creditworthiness of securities by relying on formalistic credit ratings and assessing risk on financial products by relying on simplified mathematical models. (9) Without this reliance, financial markets could not operate. (10)
When a heuristic-based custom no longer reflects reality, however, reliance on the custom can become harmful. In recent years, for example, financial markets and products have innovated so rapidly that heuristic-based customs--and thus behavior based on those customs--have lagged behind the changing reality. The resulting mismatch, in turn, has led to massive financial failures, such as investors relying on credit ratings that no longer are accurate (11) and members of the financial community assessing risk using simplified models that have become misleading. …