Human beings have difficulty incorporating potential worst-case scenarios into their decisions. This limitation applies as much to risk managers and heads of large organizations as to anyone else. Christine Cumming of the Federal Reserve Bank of New York recalled that many have characterized the current crisis as a failure of imagination. The scale of this crisis is in part a reflection of the multiple layers of modeling and technology and associated opacity that swamped the capability of risk analysis systems to produce reliable metrics. A great deal is learned about the financial system when it is under stress, including how people behave. Cumming suggested that the methods of science might help extract from our recent experience lessons about the interplay between human behaviors and market stability.

Scholes pointed out that there is an inherent timescale associated with human decision making within organizations and that in times of high volatility, that timescale constrains the ability to make decisions as fast as the situation demands. When a shock occurs, intermediaries need time to reassess the calibration of their models, both formal and heuristic. In the meantime, intermediation can halt, leading to credit markets freezing up and a sudden lack of liquidity.

Sugihara suggested that there could be value in an increased use of behavioral surveys to monitor and understand convergence within evolving behavioral models. That approach might improve regulators’ understanding of important trends, such as the actual underwriting standards applied in practice and how they are changing over time. For example, Beder reported that her breakout group mentioned firms’ use of similar risk limits as a contributor to systemic risk. She illustrated this with the common rule of limiting exposure to no more than the average 20-day trading volume. Her group suggested that it might be valuable for a systemic risk regulator to collect information on such rules. Such knowledge might also, for instance, inform the understanding of when traditional, stylized forms of risk management should be overruled by other, more dominant considerations such as sudden and contagious shifts of public mood. Several workshop participants said that such shifts of mood had contributed to the run-up to the current crisis. Sugihara speculated that emerging regulations may shape the next systemic event and that behavioral models designed to evolve stylized innovations that “skate the edge of regulation” are likely to be useful.



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