Banker Compensation and Con…rmation Bias

Con…rmation 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, we present three related scenarios where rational behaviour leads to outcomes that are observationally equivalent to di¤erent types of conformation bias. As an application, the model provides an explanation for how the reward structure in the …nancial services industry led to the seemingly irrational behaviour of bankers and other employees of …nancial institutions prior to the …nancial crisis of that erupted in the summer of 2007. JEL classi…cation: D81, D82, D83, G21 Key words: con…rmation bias, belief persistence, overcon…dence, signalling, …nancial crisis.