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To improve financial regulation, scholars have engaged in extensive research over the past decade to try to understand why systemically important financial firms engage in excessive risk-taking. None of that research fully explains, however, the unusually excessive risk-taking by financial guarantors such as bond insurers, protection sellers under credit-default-swap (CDS) derivatives, credit enhancers in securitization transactions, and even issuers of standby letters of credit. With tens of trillions of dollars of financial guarantees outstanding, the potential for failure is massive. This Article argues that financial guarantor risk-taking is influenced by a previously unrecognized cognitive bias, which it calls “abstraction bias.” Unlike banks and other financial firms that pay out capital—for example, by making a loan—at the outset of a project, financial guarantors do not actually transfer their property at the time they make a guarantee. As a result, they may view their risk-taking more abstractly, causing them to underestimate the risk (even after discounting for the fact that payment on a guarantee is a contingent obligation). The Article provides empirical evidence showing that abstraction bias is real and can influence even sophisticated financial guarantors. The Article also examines how understanding abstraction bias can improve the regulation of financial guarantor risk-taking.

Library of Congress Subject Headings

Financial risk management, Suretyship and guaranty, Risk, Risk management, Empirical