The Custom-to-Failure Cycle

by Steven L. Schwarcz and Lucy Chang

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Abstract

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.

The Custom-to-Failure Cycle

by Steven L. Schwarcz and Lucy Chang

Click here for a PDF file of this article

Abstract

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.