For me, one issue here is that tail risk, asymmetric information and agency problems interact nastily.
Put it this way. Imagine the safe interest rate is 1%. A banker than devises a strategy which as a 98% chance of paying 3% and a 2% chance of losing 100%, and these chances are random. This strategy then has an expected payoff in any one year of 0.94%. Logically, this is a bad investment. A rational non-risk-tolerant person wouldn’t accept it if in involved his own money.
However, over a 10 year period there’s a four-fifths chance of this gamble paying off every year. And there’s a two-thirds chance of it paying off every year for 20 years.
So, who has the incentive or ability to stop banks pursuing such a strategy?
Not bankers themselves. Given the high pay in the industry, you only need a few years in the business to make a fortune. The best case scenario - which is highly likely - sees you earning millions. The worst case scenario sees you leave the business and take up some reasonably paid job elsewhere. The balance of risks, then, pushes you to take the gamble.
Unfortunately, this gambling is what brought us to collapse, and it still exists. The post describes how nobody has a motivation to stop such risks.
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