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

Author

Listed:
  • Ahrens, Steffen

    (TU Berlin)

  • Bosch-Rosa, Ciril

    (TU Berlin)

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.

Suggested Citation

  • Ahrens, Steffen & Bosch-Rosa, Ciril, 2019. "Heads We Both Win, Tails Only You Lose: the Effect of Limited Liability On Risk-Taking in Financial Decision Making," Rationality and Competition Discussion Paper Series 162, CRC TRR 190 Rationality and Competition.
    • Handle: RePEc:rco:dpaper:162
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    References listed on IDEAS

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    More about this item

    Keywords

    moral hazard; cognitive dissonance; behavioral finance;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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