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Abstract

This Article examines how insights into limited human rationality can improve financial regulation. The Article identifies four categories of limitations—herd behavior, cognitive biases, overreliance on heuristics, and a proclivity to panic—that undermine the perfect-market regulatory assumptions that parties have full information and will act in their rational self-interest. The Article then analyzes how insights into these limitations can be used to correct resulting market failures. Requiring more robust disclosure and due diligence, for example, can help to reduce reliance on misleading information cascades that motivate herd behavior. Debiasing through law, such as requiring more specific, poignant, and concrete disclosure of risks and their consequences, can help to correct cognitive biases. Requiring firms to engage in more self-aware operational risk management and reporting can reduce the likelihood that parties will over-rely on heuristics. And legislating backstop market liquidity and other stabilizing controls can help to minimize panics. Regulation, however, can only partly overcome these limitations. Effective financial regulation should therefore be designed not only to address these limitations but also to try to mitigate the harm of inevitable financial failures.

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