Regulating Complacency: Human Limitations and Legal Efficacy

Steven L. Schwarcz*

This Article examines how insights into limited human rationality can improve financial regulation. The Article identifies four categories of limitations—herd behavior, cognitive biases, overreliance on heuristics, and a proclivity to panic—that undermine the perfect-market regulatory assumptions that parties have full information and will act in their rational self-interest. The Article then analyzes how insights into these limitations can be used to correct resulting market failures. Requiring more robust disclosure and due diligence, for example, can help to reduce reliance on misleading information cascades that motivate herd behavior. Debiasing through law, such as requiring more specific, poignant, and concrete disclosure of risks and their consequences, can help to correct cognitive biases. Requiring firms to engage in more self-aware operational risk management and reporting can reduce the likelihood that parties will over-rely on heuristics. And legislating backstop market liquidity and other stabilizing controls can help to minimize panics. Regulation, however, can only partly overcome these limitations. Effective financial regulation should therefore be designed not only to address these limitations but also to try to mitigate the harm of inevitable financial failures.

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© 2018 Steven L. Schwarcz. Individuals and nonprofit institutions may reproduce and distribute copies of this Article in any format at or below cost, for educational purposes, so long as each copy identifies the author, provides a citation to the Notre Dame Law Review, and includes this provision in the copyright notice.

*Stanley A. Star Professor of Law & Business, Duke University School of Law; Founding Director, Duke Global Financial Markets Center; Senior Fellow, the Centre for International Governance Innovation. Email: schwarcz@law.duke.edu. The author thanks Aleaha N. Jones, Audrey S. Kim, Michael P. Sweeney, and Ryan A. Berger for excellent research assistance and Lynne Dallas, Gregory Makoff, and Susanna K. Ripken for valuable comments.