Sending the Herd Off the Cliff Edge: The Disturbing Interaction Between Herding and Market‐Sensitive Risk Management Practices

In the international financial arena, G7 policymakers chant three things: more market‐sensitive risk management, stronger prudential standards, and improved transparency. The message is that we do not need a new world order, but we can improve the workings of the existing one. While many believe this is an inadequate response to the financial crises of the last two decades, few argue against risk management, prudence, and transparency. Perhaps we should, especially with regards to market‐sensitive risk management and transparency. The underlying idea behind this holy trinity is that it better equips markets to reward good behavior and penalize the bad, across governments and market players. However, while the market is discerning in the long run, there is now compelling evidence that in the short run, market participants find it hard to distinguish between the good and the unsustainable; they herd; and contagion is common.