CAMBRIDGE – Since the global financial crisis, regulators have worked hard to make the world’s big banks safer. The fundamental problem is well known: major banks have significant incentives to take on excessive risk. If their risky bets pay off, their stockholders benefit considerably, as do the banks’ CEOs and senior managers, who are heavily compensated in bank stock. If they do not pay off and the bank fails, the government will probably pick up the tab.
This confluence of economic incentives to take on risk makes bank managers poor guardians of financial safety. They surely do not want their bank to fail; but, if the potential upside is large enough, it is a risk they may find worth taking.