Behavioral Basis of the Financial Crisis

Abstract

Financial institutions suffered large losses following the collapse of the credit markets despite making huge risk management investments. Major risks are frequently ignored due to behavioral biases resulting in incorrect decisions. These biases are reinforced by organizational obstacles, such as misaligned compensation systems. This article outlines a supplemental behavioral risk framework, and applies it to the structure finance market. Behavioral finance can improve how risk decisions are made. You ignore behavioral risk at your peril.