What’s so Bad about Bad Rules?

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By Marlys Lipe – University of South Carolina

Many studies investigate the ability of financial reporting rules (i.e., rules regarding how items are shown in financial reports) to exacerbate or mitigate judgment problems of the reports’ users when these problems are due to users’ cognitive constraints and information processing difficulties (for a review, see Libby and Emett, 2014).  In their BPP article, Hirshleifer and Teoh (hereafter, H&T) describe this as research related to the development of Good Rules for Bad Users.  In contrast to prior work, H&T consider the impact of social and psychological factors on the rule-makers themselves – or persons influencing the rule-makers – positing that these factors can lead to “Bad Rules”.

The Psychological Attraction Approach to regulation, described previously by these authors (Hirshleifer and Teoh, 2009), states that financial regulations and regulatory ideologies gain traction by appealing to human psychological and social tendencies (i.e., “behavioral factors”).  For example, human preferences for “fairness” lead to support for the progressive individual income tax rates used in the USA or special taxes and disclosures required when a firm’s executives earn “excessive” amounts of compensation.

The idea that human behavioral tendencies—such as the in-group bias wherein persons similar to or close to oneself are viewed more favorably than those unlike or located far from oneself—can be used to garner support for an ideology has special appeal after recent political events such as the vote of citizens in Great Britain to leave the European Union and the election of US presidential-candidate Donald Trump who promised to close the country’s borders to immigration.  Applying the Psychological Attraction Approach to financial regulation, H&T argue this in-group bias also plays a role in regulations on foreign shareholding or investment.

H&T discuss a great number of social and psychological biases or tendencies that have potential to affect financial regulation (i.e., lead to Bad Rules).  For example, limited attention capacity leads to an exaggerated focus on salient factors; H&T suggest the salience of Enron employees losing their pensions after the Enron accounting-scandal and collapse, relative to the pallid or opaque costs of regulatory compliance, contributed to the promulgation of financial regulations post-Enron (eg the US Sarbanes-Oxley Act of 2002).

While the detailed examples linking behavioral factors and financial regulation can be compelling, H&T’s discussion leaves me with several questions.  First, why does the influence of behavioral factors on financial regulations result in “Bad Rules”?  That is, is there a reason to believe these behavioral factors are more likely to lead to bad regulations than to good regulations?  I am not convinced that the influence of behavioral factors will necessarily—or even, more probably—lead to bad regulation than good.  I look forward to evidence or analyses that will address this question.

Second, how do we judge the rules’ “badness”?  Is a progressive income tax rate “bad”?  Is a limit to foreign investment “bad”?  Since all humans are subject to psychological and social (i.e., behavioral) factors, who is able to judge the quality of these regulations?  Cognitive psychology researchers studying judgment and decision making have long grappled with issues of decision quality while economists, and their counterparts in finance and accounting, have often used models based on rational agents to define optimal choices.  H&T are using the pejorative (i.e., “bad”) in the sense of the economic models, but in the case of regulation should it perhaps be the collective that judges regulation quality?  While these are, of course, philosophical questions, they are nonetheless of some importance when labeling financial regulations as “Bad Rules.”

A third question raised by H&T’s examples is when is it important to link specific behavioral factors to particular financial regulations and when is a more general understanding of this relation sufficient?  My opinion is that the necessary level of specificity depends on the goal of the analysis.  For example, I think it would be important to identify specific behavioral factors at work if one’s goal is to expand economic models of markets and regulations or to provide information to regulators or market participants so they can influence regulation through exploiting the behavioral factors (similar to marketing campaigns informed by consumer behavior research).  In contrast, less specificity is likely needed if one’s goal is to better understand the regulatory process in a general sense. Since I believe this general understanding is H&T’s goal for the current article, I encourage readers to enjoy the article’s examples as interesting illustrations and hypotheses rather than argument or evidence of specific causes of particular regulations.

Hirshleifer and Teoh are masters at applying a social or psychological perspective to the study of financial markets.  Their Psychological Attraction Approach is an example of this and leads to many interesting questions.

Read the full article from Hirshleifer and Teoh How psychological bias shapes accounting and financial regulation for free in the first issue of Behavioural Public Policy here.

References

Hirshleifer D. and Teoh S. H. (2009) ‘The Psychological Attraction Approach to Accounting and Disclosure PolicyContemporary Accounting Research 26(4) 1067-1090.

Libby R and Emett S. (2014) ‘Earnings Presentation Effects on Manager Reporting Choices and Investor DecisionsAccounting and Business Research 44(4) 410-438.

 


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