The recent financial crisis gave rise to questions regarding fundamental issues of the current paradigm of finance. Dramatic events opened our eyes and let us see that behavior of financial markets is far from what we had imagined them to function like. In this paper first we look at systemic changes that financial institutions, markets, and instruments have undergone. We wonder if the these transformations and their effects give grounds to modify theoretical background of finance and to search for a new paradigm that could better describe processes occurring in the global financial market.
We confront the traditional neoclassical financial economics with behavioral finance focusing on key assumptions, predictions, and findings of each of these schools of thought. We state that the neoclassical paradigm might be seen as an idealized normative benchmark which predictions although derived from neat mathematical models and formulas are often very far from reality. On the other hand, behavioral finance is more intuitive and descriptive. Behavioral approach helps explain deviations from the neoclassical benchmark, however itself it lacks the normative character. Behavioral approach might be a valuable supplement when trying to understand financial markets, but so far should not be treated as a rigorous and completed alternative theory.
Later we discuss consequences for investors, corporate managers, and regulators of capital markets. We show how adopting the behavioral view impacts these three groups of market participants and how it should influence their actions. In the last section we present behavioral issues that demonstrated themselves particularly during the recent financial crisis. Although direct reasons for the crisis had macroeconomic grounds, behavioral aspects greatly contributed to the scale and scope of the trouble.
In this context we discuss psychological background of greed, underestimation of risk, herding, limited rationality and mistakes of rating agencies, as well as fear as a reason for excessive selling and resulting undervaluation. In final remarks we postulate an interdisciplinary approach in building a new adequate theory of financial markets.
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Systemic changes in the financial world and the search for the new paradigm of finance
