Scott D. Kiel-Chisholm

The Contribution of Social Norms to the Global Financial Crisis: A Systemic Actor Focused Model and Proposal for Regulatory Change

Manuscript Type: Conceptual. Research Question/Issue: Conventional regulatory reforms of the financial system focus on standard economic assumptions of self‐interested, rational actors. The Global Financial Crisis (GFC) and similar financial failures highlight that there are limits to this approach. Instead we use a norm‐based (or soft law) perspective to examine how the systemic problems underlying the GFC lay not so much in neo‐classical economic assumptions of self‐interest, but in unchecked financial innovation exploited by norms of buyer beware and ratings agency reliance among market participants. Fueled by sector‐wide remuneration practices, these norms created information asymmetries that fundamentally undermined the integrity of the market. Research Findings/Insights: We present a model that highlights how investment banks, as professional service firms, have superior information to their clients. This presents an information asymmetry problem whereby they can exploit the market norm of caveat emptor (buyer beware) when developing innovative financial transactions. We propose a model highlighting how flawed financial innovation can lead to widespread, systemic problems of assessing and pricing risk because market participants can actively develop and promote flawed transactions. This problem is exacerbated where there is an over‐reliance on credit ratings agencies (due to the high information and search costs facing buyers) and a reduced emphasis on director fiduciary duties in financial Special Purpose Entities. Theoretical/Academic Implications: Social norms that underpin financial markets are central to market regulation. Our approach provides a re‐examination of the often unquestioned use of universal norms for differing market transactions in the financial sector. Researchers need to explore the interaction between social norms and market contexts (such as financial innovation) to better understand the behavior of financial markets. We contend that a mismatch between norms and market mechanisms can lead to significant unintended outcomes. Our approach of combining soft law (norms) and hard law (regulation) approaches to regulation provides added insights into agency, stewardship, and institutional theories. Practitioner/Policy Implications: Regulators need to understand norms and financial market contexts to develop better legislative interventions. Specifically, differentiating between transaction types in financial markets will address the problems associated with information and search costs facing buyers of flawed financial innovation. We also provide proposals for policy makers seeking to embed accountability for risk taking across the key participants in the financial system to minimize market distortions in the majority of the financial sector.