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Banker Compensation And Confirmation Bias

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Executive Summary

Confirmation bias refers to cognitive errors that bias one towards one's own prior beliefs. A vast empirical literature documents its existence and psychologists identify it as one of the most problematic aspects of human reasoning. In this paper, the authors present three related scenarios where rational behavior leads to outcomes that are observationally equivalent to different types of conformation bias. As an application, the model provides an explanation for how the reward structure in the financial services industry led to the seemingly irrational behavior of bankers and other employees of financial institutions prior to the credit crisis of that erupted in the summer of 2007.

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