Why do good bankers sometimes respond with the same disastrous strategies? Rooted in regulatory economics and behavioral finance, the paper offers a taxonomy of effects that narrows the scope of the banks' decision making into a funnel-shape and thus, prepares the ground for a financial crisis. The basic message of the paper is that inconsistent decision rules, rigid bank regulations, stakeholder-focused incentive structures within banks and uncritical adoption of innovations may force banks into decisions that are micro-functional, but macro-dysfunctional. Behavioral aspects play a key role in the suggested remedies on the regulatory side (macroprudential regulation, supervision of incentives) and on the banking side (proper reward systems and structured decision making) to re-establish prudent banking.

There is a growing interest in the literature on herding behavior (Hirshleifer and Teoh, 2003), contagion (Kodres and Pritsker, 2002; and Uchida and Nakagawa, 2007) and bubble phenomena (Shiller, 2002) of financial intermediaries and markets. In banking literature, herding is often evoked as an anomaly, as a cause of economic behavior if other explanations fail for banking crises (Reisen, 1999), bank runs (Samartín, 2003), credit crunches (Pecchenino, 1998), currency crises (Lam, 2002), foreign currency lending (Tzanninis, 2005) and with regards to the recent regulatory change, i.e., the Basel II Accord (Borio et al., 2001). There is also a related stream of literature that concerns itself with issues in banking regulation, financial market efficiency and growth (Levine, 2005; Haiss and Fink, 2006; and Hirshleifer, 2008), however without taking herding effects into account. Rajan (2006) and Llewellyn (2002) provide notable exceptions.

Building on Fink and Haiss (1999, 2002, 2003), and Haiss (2009), the goal of this paper is twofold. For one, to provide a more coherent overview of herding in financial services by integrating capital market and banking issues, and by establishing a crossover from rational to behavioral herding. This will add to the general understanding of financial services phenomena. For two, to show that regulation and the very industry-specific aspects of the banking sector can become natural causes for herding under specific circumstances, and that herding as unintended macro-side effect should receive explicit treatment in regulatory change overs. Kane's (1981) framework of "regulatory dialectic" is applied to explain the impact of regulation on the interaction between collective bank behavior and the economy. As a well-functioning financial sector plays a major role for financial intermediaries, and others engaged in the financial sector architecture and beyond. Conceptually, the paper contributes by (1) defining a coherent model (termed "bank herding funnel") and by (2) offering remedies for regulators and bank managers to mitigate the herding triggers that surfaced in the current global financial crisis.

Behavioral Finance Journal, Behavioral Finance, Financial Instruments, Efficient Market Theory, Financial Markets, Efficient Market Hypothesis, Stochastic Volatility Model, Financial Series, Virtual Market, Financial Time Series, Evolutionary Systems.