The Behavioral Paradox: Why Investor Irrationality Calls for Lighter and Simpler Financial Regulation

By Juurikkala, Oskari | Fordham Journal of Corporate & Financial Law, March 31, 2012 | Go to article overview

The Behavioral Paradox: Why Investor Irrationality Calls for Lighter and Simpler Financial Regulation


Juurikkala, Oskari, Fordham Journal of Corporate & Financial Law


ABSTRACT

It is widely believed that behavioral economics justifies more intrusive regulation of financial markets, because people are not fully rational and need to be protected from their quirks. This Article challenges that belief. Firstly, insofar as people can be helped to make better choices, that goal can usually be achieved through light-touch regulations. Secondly, faulty perceptions about markets seem to be best corrected through market-based solutions. Thirdly, increasing regulation does not seem to solve problems caused by lack of market discipline, pricing inefficiencies, and financial innovation; better results may be achieved with freer markets and simpler rules. Fourthly, regulatory rule makers are subject to imperfect rationality, which tends to reduce the quality of regulatory intervention. Finally, regulatory complexity exacerbates the harmful effects of bounded rationality, whereas simple and stable rules give rise to positive learning effects.

Introduction

The recent financial crisis fostered lively debates about fundamental issues in financial law and regulation, with many commentators blaming the crisis on animal spirits and the irrationality of investors.1 Such sentiments are supported by behavioral economics, which challenges standard economic assumptions about rational human behavior. 2 From a legal and regulatory viewpoint, the ordinary perception is that neoclassical economics emphasizes the importance of competition, whereas the behavioral paradigm strengthens the case for paternalist and interventionist policies, as it highlights the limits of human rationality and willpower.3

The debate on behavioral law and economics has often led to a simplistic division in which proponents of the behavioral paradigm advance pro-regulation arguments while advocates of the neoclassical paradigm make anti-regulation critiques.4 Critics of the interventionist tendencies of behavioral law and economics have also sought to point out the theoretical and empirical weaknesses of the behavioral apparatus in its entirety. It may be argued that some of the opposition to behavioralism may be motivated by the political implications it has, or seems to have.6

This Article proposes a different perspective. While accepting some of the criticism of behavioral economics, it argues that the behavioral paradigm is broadly valid, but it does not imply a systematically interventionist policy. In fact, a number of reasons can be found for why behavioralism may have markedly anti-regulatory implications. In other words, there may be good reasons to regulate certain financial activities, but the behavioral perspective specifically seems to favor light-touch regulations and regulatory simplicity.

This thesis is based on five arguments. First, behavioral economics does not necessarily imply the need for heavier regulation, but rather presents the possibility for novel light-touch regulations that would not be possible within the neoclassical, rational-choice economic framework.7 The principal forms of light-touch regulation examined here are default rules, targeted information disclosure, and cooling-off regulations. While it is not entirely clear whether these light-touch regulations result in more or less intervention overall, it is evidently possible to replace certain intrusive regulations with lighter ones.8

Second, it is argued that faulty market perceptions seem to be best corrected by market-based solutions. Behavioral economics implies that financial market participants tend to be misled by a range of factors about investment prospects, and some commentators have called for the establishment of regulatory tools to help "debias" faulty market perceptions.9 While such measures seem plausible, the prospects of regulatory debiasing in financial markets are not very promising since the track record of public authorities in predicting crises is poor, and their resources and incentives for doing so are weak in comparison with the private sector. …

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