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Epidemics of rules, rational negligence and market crashes

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  • Kartik Anand
  • Alan Kirman
  • Matteo Marsili

Abstract

Structural changes in an economy or in financial markets can arise as a result of agents adopting rules that appear to be the norm around them. Such rules are adopted by implicit consensus as they turn out to be profitable for individuals. However, as rules develop and spread they may have consequences at the aggregate level which are not anticipated by individuals. To illustrate this, we develop a simple model, motivated by the 2007--2008 crisis in credit derivatives markets. This shows how coordination on simple and apparently profitable rules may weaken regulatory constraints, rendering the whole system more fragile. The rule, in the specific example, consists in deciding not to exercise due diligence in the evaluation of complex credit derivative products, free riding on information and operational costs. We show that such "rational negligence", in the face of deteriorating macro-economic conditions, can bring a market to a sudden collapse.

Suggested Citation

  • Kartik Anand & Alan Kirman & Matteo Marsili, 2013. "Epidemics of rules, rational negligence and market crashes," The European Journal of Finance, Taylor & Francis Journals, vol. 19(5), pages 438-447, May.
    • Handle: RePEc:taf:eurjfi:v:19:y:2013:i:5:p:438-447
    DOI: 10.1080/1351847X.2011.601872
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    Cited by:

    1. Federico Guglielmo Morelli & Michael Benzaquen & Marco Tarzia & Jean-Philippe Bouchaud, 2020. "Confidence collapse in a multihousehold, self-reflexive DSGE model," Proceedings of the National Academy of Sciences, Proceedings of the National Academy of Sciences, vol. 117(17), pages 9244-9249, April.
    2. Federico Morelli & Michael Benzaquen & Marco Tarzia & Jean-Philippe Bouchaud, 2020. "Confidence Collapse in a Multi-Household, Self-Reflexive DSGE Model," Post-Print hal-02323098, HAL.
    3. Barreda Tarrazona, Iván J. & Grimalda, Gianluca & Morone, Andrea & Nuzzo, Simone & Teglio, Andrea, 2017. "Centralizing information improves market efficiency more than increasing information: Results from experimental asset markets," Kiel Working Papers 2072, Kiel Institute for the World Economy (IfW Kiel).
    4. Nuzzo, Simone & Morone, Andrea, 2017. "Asset markets in the lab: A literature review," Journal of Behavioral and Experimental Finance, Elsevier, vol. 13(C), pages 42-50.
    5. Kartik Anand & James Chapman & Prasanna Gai, 2012. "Covered bonds, core markets, and financial stability," SFB 649 Discussion Papers SFB649DP2012-065, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    6. Jean Philippe Bouchaud & Matteo Marsili & Jean-Pierre Nadal, 2023. "Application of spin glass ideas in social sciences, economics and finance," Post-Print hal-04145594, HAL.
    7. Ya-Chi Huang & Chueh-Yung Tsao, 2018. "Evolutionary Frequency and Forecasting Accuracy: Simulations Based on an Agent-Based Artificial Stock Market," Computational Economics, Springer;Society for Computational Economics, vol. 52(1), pages 79-104, June.
    8. Jean-Philippe Bouchaud, 2012. "Crises and collective socio-economic phenomena: simple models and challenges," Papers 1209.0453, arXiv.org, revised Dec 2012.
    9. Nneka Ene, 2019. "Implementation of a Port-graph Model for Finance," Papers 1902.02659, arXiv.org.
    10. Steven D. Moffitt, 2018. "On a Constructive Theory of Markets," Papers 1801.02994, arXiv.org.
    11. Jean-Philippe Bouchaud & Matteo Marsili & Jean-Pierre Nadal, 2023. "Application of spin glass ideas in social sciences, economics and finance," Papers 2306.16165, arXiv.org.

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