Changing the rules of the game

The financial crisis is commonly blamed on excessive risk taking in the financial sector. One way to explain this is to refer to some irrational greed among banker. Economists tend to prefer to view bankers the same way they view all individuals, as an on average rational bunch responding to incentives. One explanation for the excessive risk taking that eventually lead to the financial crisis is that the rules of the game were gradually changed in such a way that utility maximizing individuals and profit maximizing firms developed an increasing taste for risk. When I say the rules were changed I mean that actors in the financial market became convinced that if their risky investments failed it was likely they wouldn’t have to bear the costs of those failures. Through precedent government had made it clear that they would not allow the key players in the financial market to fail.

So when an investor lends his money to a financial institution which then in turn invests this money in something risky, like some sort of mortgaged backed security, the original investor can be fairly certain that even if this mortgage backed security turns out to be worthless and the financial institution is left insolvent, the government will step in to save the day, ensuring that the money he lent out is paid back. This means that when he lends money to a financial institution to play with, this is a very safe investment no matter what type of risky things is then done with is money. The financial institution, be it a bank, an insurance company or whatever can then borrow very cheaply to finance risky activities investors otherwise would have shrugged away from.

Oftentimes a government rescue of a financial institution is accompanied by some sort of heavy penalty paid by the stock holders. This is assumed to prevent the rescue from setting a bad precedent and thereby encouraging increased risk taking. But it is forgotten that the banks creditors are left with their loans fully secured, without any penalty paid for their poor choice of investment. The stockholders might actually prefer the financial institution to behave in a risky manner, for without risk there is no reward, even if a failure would wipe out the value of their stocks. Since their stocks in this particular institution make up only a part of their portfolio such an event would be a catastrophe, they might even believe themselves able to balance out this risk by including some other stocks in their portfolio. It is up to the credit market to restrain the financial institution, for if it engages in a risky behavior this drives up the probability of default and also the interest rates normally demanded by the creditors. But when government in effect ensures the safety of these loans, the restraint normally placed on the financial sector disappears. Excessive risks become the norm and we eventually end up with a financial crisis.