Heads We Both Win, Tails Only You Lose: the Effect of Limited Liability On Risk-Taking in Financial Decision Making

Steffen Ahrens and Ciril Bosch-Rosa
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Ciril Bosch-Rosa: TU Berlin

No 162, Rationality and Competition Discussion Paper Series from CRC TRR 190 Rationality and Competition

Abstract: One of the reasons for the recent crisis is that financial institutions took \"too much risk\" (Brunnermeier, 2009; Taylor et al., 2010). Why were these institutions taking so much risk is an open question. A recent strand in the literature points towards the \"cognitive dissonance\" of investors who, because of the limited liability of their investments, had a distorted view of riskiness (e.g., Barberis (2013); Benabou (2015)). In a series of laboratory experiments we show how limited liability does not affect the beliefs of investors, but does increase their willing exposure to risk. This results points to a simple explanation for the over-investment of banks and hedge-funds: When incentives are not aligned, investors take advantage of the moral hazard opportunities.

Keywords: moral hazard; cognitive dissonance; behavioral finance (search for similar items in EconPapers)
JEL-codes: C91 D84 G11 G41 (search for similar items in EconPapers)
Date: 2019-06-26
New Economics Papers: this item is included in nep-cbe, nep-exp and nep-reg
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