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

Applying the Prisoner’s Dilemma to bank risk-taking

Now consider the case of a number of banks each choosing between taking on a moderate amount of risk or an excessive amount of risk. Of course, things are a bit different compared to the original Prisoner’s Dilemma, with more (potentially many more) than just two decision-makers. Therefore, we look at the world from the perspective of a particular bank (Bank A) and consider how (a) its profits and (b) the overall stability of the financial system depend upon its actions and the actions of all the other banks.

Taking a look at Figure 15-2, you can see that, regardless of the risk-taking behaviour of the other banks, Bank A is better off taking excessive risk. As in the original Prisoner’s Dilemma, taking excessive risk is a dominant strategy.

© John Wiley & Sons


Figure 15-2: Bank risk-taking as a Prisoner’s Dilemma.

Any one bank taking excessive risk has little effect on the overall stability of the financial system. Sure, it certainly increases the chances that the financial system will find itself in trouble, but this negative impact is more than offset by the increase in profits that the bank earns from taking on more risk.

The problem is that all the banks notice the same thing: the marginal increase in financial instability is small if they engage in excessive risk-taking and the benefits to the bank are potentially large. This leads to the undesirable outcome where all banks take on excessive risk leading to an exceptionally unstable financial system.

As in the original Prisoner’s Dilemma, they’d have all preferred the outcome where none of them take on excessive risk, because this would guarantee the stability of the financial system. However, each of them pursuing their own private interests leads them all to take on too much risk!

The underlying problem is that when a bank is deciding whether to take on excessive risk, it considers only the cost of doing so for itself. It doesn’t consider the fact that taking excessive risk has a negative externality on all the other banks by making the financial system less stable.