Improving disclosure in the financial services industry is crucial to avoiding more financial crises in the future, according to Richard Thaler, a professor of behavioural science and economics at the University of Chicago’s Graduate School of Business.

Thaler spoke about behavioural finance at the CFA Institute’s annual conference in Orlando, Florida on Tuesday. He said a lack of information available to investors and regulators was a key factor contributing to the financial crisis. This is something Thaler calls “bounded rationality.”

For example, many people who took out sub-prime mortgages didn’t understand the terms of the loans, Thaler said. Furthermore, many financial institutions did not explain these terms to consumers.

“There were a lot of unscrupulous mortgage brokers that were pushing loans that they knew people wouldn’t be able to repay, but it didn’t matter to them because they were getting paid on volume, not on quality,” Thaler said.

A lack of awareness also existed among the top ranks of financial firms, he added, since many executives were simply chasing high returns without assessing the risks. “It’s clear that many CEOs of our largest financial services companies did not understand the risks that their employees were taking on their behalf.”

Thaler pointed to the example of former Citigroup chairman Robert Rubin, who admitted he was unfamiliar with the term “liquidity put”, even though the company was engaged in the complex agreements to a large extent.

This concept of bounded rationality challenges the traditional theory of a rational economy, which assumes that all individuals act rationally. Failing to recognize the importance of bounded rationality — and other realities of human nature — was the biggest mistake made by Alan Greenspan and financial industry regulators, according to Thaler.

He said it’s crucial for market regulations to account for the fact that humans are not always rational. He explores these ideas in a recently published book called Nudge, which he co-authored with Cass Sunstein, a professor at the Harvard Law School.

“We humans are mere humans, we’re imperfect, we need all the help we can get,” he said. “We have to expect that people are going to make errors.”

According to Thaler, better disclosure is necessary to improve the state of the financial system. Improved disclosure would allow for better decision-making among all market players, he said.

“We need to devise disclosure rules that will allow all of us — investors and regulators and competitors — to see enough of what’s going on to make sure firms are not risking our money, but not disclose so much that they are not able to make money,” he said.

“It would make everybody more intelligent consumers,” Thaler added, noting that better disclosure would also benefit the firms themselves.

But Thaler warned it would be a mistake for governments to respond to the financial crisis by implementing a slew of new, heavy-handed regulation. It’s unreasonable to think that greater power among government employees would improve the state of operations in the complex financial system, he said.

“The CEOs of these big companies did not understand what was going on inside their companies. What hope is there that some government regulator would?”

IE