Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Providing Incentives for Excessive Risk-Taking

Bankers aren’t fools. They understand that the dangers of systemic risk (see Chapter 14 for a description) mean that governments are unlikely to let them fail. This implicit government guarantee acts a lot like a form of insurance – which unfortunately has an unintended effect.

In this section we take a closer look at the incentives that banks and bankers face, which encourage them to take excessive risks. We also discuss the government guarantee to bail out financial institutions as a form of insurance.

Rigging the game: Heads we win, tails you lose

Here we introduce a simple example that shows why financial institutions may want to take excessive risks.

Imagine that we’re sitting down with you to play the following game: a coin is tossed. If it comes up heads, £1 falls from the sky into our pockets; if, however, it comes up tails, £1 disappears from your pocket. How would you feel about this game? Probably not very good, because it’s impossible for you to win any money; the best possible outcome is that you break even. We, however, love this game: we can only win (or at worst break even), and in fact we’d play it over and over again!

Draw an analogy between this game and the financial sector. If banks take on large amounts of risk, they may do very well and make a lot of money – this is a case of ‘heads we (the bank) win’. But of course things can also go pear-shaped and the bank makes large losses. The thing is, no matter how large the bank’s losses, as we describe in the preceding section, the government is unlikely to let it fail. This corresponds to ‘tails you (the government) lose’.

Furthermore, the worst that can happen to you as a bank is that you make a loss and the government bails you out – despite their name, toxic assets don’t kill you and you don’t even go to jail (although policy makers are trying to change this). Therefore, arguably it makes sense for banks to take on as much risk as possible – if they win, they win big – and if they lose, well, they don’t

really lose because the government takes most of the losses!

Obviously this analogy is a massive simplification, but it contains more than a grain of truth.