Behavioral risks at the systemic level

Patrick McConnell

Abstract

The possibility of Deutsche Bank being fined some US$14 billion by US regulators for grave misconduct before the global financial crisis (GFC) has recently raised the specter of a systemic banking crisis, as Deutsche Bank is considered to be a systemically important bank (SIB). Since the GFC, Deutsche Bank and several other SIBs have been made to pay over US$200 billion in fines and remediation costs for misconduct in a number of areas, beyond misselling of mortgages, such as manipulation of the London interbank offered rate (Libor) and foreign exchange (FX) benchmarks; misselling of insurance products (such as payment protection insurance); sanctions busting; money laundering; and other misconduct. This paper points out that these events are the result of a failure to manage operational risks, both at the level of the firm and across the banking system. Although research into individual and group behavioral biases has increased, less research has been conducted into misbehavior at the level of the banking system, that is, misconduct which occurs in multiple financial institutions, seemingly independently, at the same time. By comparing the Libor and FX benchmark manipulation scandals, this paper describes how misbehavior emerged independently in both of these markets and the conditions that permitted the misconduct to survive and thrive. This paper also identifies areas for further research in the field.