Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

there are huge incentives at every level in the financial system to take on these tail risks if they can be concealed from those assessing performance. Those giving up the tail risk are willing to pay a premium to do so, while those taking it on and downplaying the eventual risk of payout can treat the premium as pure profit, the product of their natural brilliance rather than merely a compensation for risk. The premium paid by those selling the risk increases in proportion to the anticipated loss if the risk actually hits (they pay more if they think earthquakes will do more damage); and the higher the premium, the more of the risk the sellers are willing to take on (because they do not anticipate being around when their firms have to make good the loss). Too many firms will be eager to take on risks that have extremely costly consequences, and they will compete to take the risk at too low a price. The net result is that too much of the risk will be created.