Risk Taking Incentives and the Great Financial Crisis

International audienceThere is little debate that the main cause of the Great Financial Crisis (GFC) was excessive risk taking by large international financial institutions. Most observers would also agree that much has been accomplished under Basel 3 to address the problem. Banks today are required to have more and better equity capital, they are required to prepare Recovery and Resolution Plans (RRP), and they must finance themselves through debt instruments that are bailin able or can be converted into equity (Cocos) . Bank owners and their creditors thus have significantly more“ skin in the game” than before the GFC. Is it enough to reduce to an acceptable degree the risk of a repeat? I will focus here on a further element of the incentive dimension where I think more remains to be done. My main point is that the combination of very high leverage and limited liability, uniquely typical of modern banking, constitutes a toxic cocktail that continues to be a source of excessive risk taking and needs to be explicitly confronted. That convexity in remuneration patterns encourages risk taking is well-Known and for the most part intended. The circumstances and the numbers involved in the financial sector, however, Pervert the purpose of limited liability and generate highly problematic incentives that persistently undermine regulatory efforts and endanger financial stability