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

• Date: 01 September 2011
• Published date: 01 September 2011
• Author: Gavin Nicholson,Geoffrey Kiel,Scott Kiel‐Chisholm
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00883.x

The Contribution of Social Norms to the Global

Financial Crisis: A Systemic Actor Focused

Model and Proposal for Regulatory Change

Gavin Nicholson,* Geoffrey Kiel, and Scott Kiel-Chisholm

ABSTRACT

Manuscript Type: Conceptual

Research Question/Issue: Conventional regulatory reforms of the f‌inancial system focus on standard economic assump-

tions 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 createdinformation 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. Thispresents 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 prob-

lems 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.

Keywords: Corporate Governance, Legal Effectiveness, Governmental Protection, Hard versus soft law

INTRODUCTION

Regulating market bubbles remains one of the most chal-

lenging tasks facing governments. The Global Financial

Crisis (GFC) is the latest in a long tradition of f‌inancial

bubbles leading to public outcry and extensive regulatory

intervention (Ferguson, 2008). The consequent f‌lurry of

regulatory reforms focuses on myriad issues: revised pru-

dential standards; new regulatory bodies; increased trans-

parency; limits on certain activities and trades; and so on

(Conyon, Fernandes, Ferreira, Matos, & Murphy, 2011). Yet

despite public outcry and government reaction, f‌inan-

cial sector behavior appears largely unchanged (Knyght,

Kakabadse, Kakabadse, & Kouzmin, 2011).

*Address for correspondence: School of Accountancy, Queensland University of Tech-

nology, GPO Box 2434, Brisbane, Queensland, 4001,Australia. Tel: +61-7-3138-9299;

E-mail: g.nicholson@qut.edu.au

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Corporate Governance: An International Review, 2011, 19(5): 471–488

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00883.x

It is timely, therefore, to question how we analyzebubbles

and design regulatory interventions. Overcoming the usual

cycle of crisis and reactionary regulation (Clarke, 2004)

requires an approach that allows for an evolution in prod-

ucts and f‌inancial institutional forms that is sure to occur.

Without a f‌lexible approach, products and actors will

develop ways to circumvent rules too specif‌ically targetedto

the last f‌inancial disaster.

Traditional economic assumptions of rational self-

interest are the focus of current f‌inancial market reforms

(e.g., Cukierman, 2011). This is despite signif‌icant evidence

that human behavior is not uniform, but varies with social

norms (e.g., Akerlof,2007; Güth, Schmittberger, & Schwarze,

1982; Kandori, 1992). Ignoring the underlying social norms

present in f‌inancial markets risks ignoring the generative

mechanisms behind the GFC, particularly when norms

vary between nations and markets (e.g., Boytsun, Deloof,

& Matthyssens, 2011; Stafsudd, 2009). Instead, effective

f‌inancial market regulation requires policy makers to target

human behavior by understandingthe context and nature of

relevant participant norms. In the case of the GFC, we argue

that f‌lawed f‌inancial innovation and the market norm of

caveat emptor (or buyer beware) provided the opportunity for

market participants to unfairly exploit information asym-

metries. Additional social norms governing remuneration

systems and ratings agency reliance encouraged this exploit-

ative behavior to spread through the f‌inancial network,

resulting in unintended systemic risk.

We commence by outlining the growing evidence of rela-

tionships between formal and informal institutions and

market behavior, focusing particularly on the neglected area

of social norms. We then provide a norm-based explanation

of the GFC by examining the role of a key f‌inancial instru-

ment, the Collateralized Debt Obligation (CDO). Based on

this explanation, we develop a model comprising six propo-

sitions that seeks to explain the development of systemic

risk during the GFC from a norms based perspective. We

conclude with the implications of our model, including

some suggested regulatory interventions.

LAW, SOCIAL NORMS AND

MARKET BEHAVIOR

Markets of all kinds have become important vehicles for

economic growth and are widely lauded as superior to

command and control systems. Staggering eff‌iciency gains

made possible by these self-organizing systems (Leiben-

stein, 1966) have led many to adopt a philosophy that favors

market freedom over government regulation(e.g., Friedman

& Friedman, 1980). Yet many commentators highlight

that this philosophical position can lead to insuff‌icient regu-

lation, particularly when based on “utopian economics”

(Cassidy, 2009:17). It is becoming increasingly apparent that

standard economic analysis is only useful where people’s

“preferences correspond to economists’ typical descriptions

of them” (Akerlof, 2007:6, original emphasis) and so interest

in norms and other non-traditional motivations continues to

grow within mainstream economics (e.g., Akerlof &

Kranton, 2005; Bandiera, Barankay,& Rasul, 2005; Gneezy &

Rustichini, 2000a, 2000b; McFadden, 2006).

Markets do not emerge naturally in isolation from society

and the rule of law, but rather require a strong set of insti-

tutions to provide the “rules of the game in a society or,

more formally,...the humanly devised constraints that

shape human interaction” (North, 1990:3). These institutions

are both formal (e.g., legislation, regulation, regulatory

bodies, etc.) and informal (e.g., conventions, codes of behav-

ior, etc.) that together provide a framework for human

behavior. While there is no doubt that formal institutions

(often termed hard regulation) shape market participant

behavior they are most successful when they reinforce and

inf‌luence informal institutions, particularly social norms

(often referred to as soft regulation). Effective market reform

requires an alignment between formal institutions and the

“rules of conduct that constrain self-interested behavior but

are not enforced by any authoritative body that can impose

a sanction” – social norms (Coffee, 2001:2171) because the

pattern of actors’ behaviors is sustained by the approval or

disapproval of a social group (Alm, McClelland, & Schulze,

1999).

While reform has focused on changing formal institutions

(laws, regulation, oversight bodies, and so on), little if

any attention has been paid to social norms. Consequently,

reforms largely ignore “informal protection...where the

community provides eff‌icient informal incentives...and

punishment for deviant behavior” (Boytsun et al., 2011:55)

irrespective of formal institutions. In the following sections

we use evidence from studies of national and regional dif-

ferences in norms to highlight the relationship between

informal institutions and market behavior before applying

this logic to an analysis of the GFC.

Markets Need a Norm-Based Social Framework

to Operate

Economics is peppered with seminal advice arguing that

people and entities make decisions within a social frame-

work that shapes behavior. For instance, Smith’s (1776)

support of markets was based on the observation that indi-

viduals have a fundamental and unself‌ish interest in others’

happiness and pleasure. This shared “sympathy of senti-

ments” develops into an unconscious system of standards

(e.g., see Younkins, 2008). Posner’s analysis of market

practices extends this view by highlighting that accepted

standards need not be positive. For instance, people who

“are unusually ‘fair’ will avoid (or, again, be forced out of)

roughhouse activities – including highly competitive busi-

nesses...” (Posner, 1997:1570). Thus, commentators and

scholars emphasize the importance of an appropriate moral

framework to underpin effective market governance

(e.g., Dawson, 2004).

Traditional economic assumptions about market partici-

pant motivations (i.e., that individuals pursue rational self-

interest) largely ignore the social forces that can contribute

to market behavior (Akerlof, 2007). While self-interest is a

major factor in individual decision-making, there is a distin-

guished research tradition highlighting that self-interest is

contextual rather than universal. People do not follow

“[a]lmost all economic models [that] assume that all people

are exclusively pursuing their material self-interest and do

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Volume 19 Number 5 September 2011 © 2011 Blackwell Publishing Ltd