The article, The Custom-to-Failure Cycle, which I wrote with my research assistant Lucy Chang (Duke Law School class of 2012), examines how reliance on heuristic-based customs can lead to financial failures. 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. This type of custom may not—and indeed, our article assumes, does not—become the basis for law per se. Rather, it is a custom in the sense of a usual or habitual course of action, a long-established practice, which is merely one element of the law-creating fact called custom.
As long as such a heuristic-based custom reasonably approximates reality, society continues to benefit. Modern finance, for example, has become so complex that the financial community routinely relies on heuristic-based customs, such as determining creditworthiness of securities by relying on formalistic credit ratings and assessing risk on financial products by relying on simplified mathematical models. Without this reliance, financial markets could not operate.
When a heuristic-based custom no longer reflects reality, however, reliance on the custom can become harmful. In recent years, for example, financial markets and products have innovated so rapidly that heuristic-based customs—and thus behavior based on those customs—have lagged behind the changing reality. The resulting mismatch, in turn, has led to massive financial failures, such as investors relying on credit ratings that no longer are accurate and members of the financial community assessing risk using simplified models that have become misleading. (As one such example, our article relies on the work of Professor Kathryn Judge in her piece on Fragmentation Nodes to analyze how heuristic-based customs can build incrementally, with small financial innovations building on past heuristic-based customs with which financial-community members have become comfortable. Professor Judge has shown how such incremental innovation in the mortgage-securitization industry in the decades preceding the global financial crisis ultimately resulted in an incredibly complex and unwieldy fragmentation of cash flows.)
We call this four-part cycle—(i) reliance on heuristics that reasonably approximate reality; (ii) the development of customs based on those heuristics; (iii) changes that disconnect those customs from reality; and (iv) failures resulting from continued reliance on those customs—the custom-to-failure cycle. Our article examines how law can help to manage this cycle and to mitigate its failures, such as requiring financial firms to engage in more self-aware risk management and reporting in order to reevaluate their heuristic-based customs periodically.
Our article also examines an important normative, yet real-world, dilemma resulting from this cycle. Heuristic-based customs, like any other customs, can become internalized as social norms of appropriate behavior. The creation of these norms in private groups, such as the financial community, is a standard explanation for successful self-regulation. The dilemma is whether individuals and firms following heuristic-based customs that have become norms—assuming the norms have not themselves become law—should be subject to criminal or civil liability when their behavior causes failures that harm society. This dilemma is at the root of the frustration as to why, after the worst financial crisis since the Great Depression, so few have been fined or gone to jail.
The full article, which was recently published in the Duke Law Journal, is available for download here.