Short version: bailouts and asymmetric payoffs add to the incentive to take risks. Managers learned this faster than other stakeholders (shareholders, auditors, and regulators) could adapt their monitoring. We have created an incentive to take risks.
From a Bloomberg editorial:
"...to fully grasp their position, it helps to understand why they find leverage so attractive. Consider two banks, both with $100,000 in assets. The first got the entire $100,000 from its shareholders, giving it a 100 percent capital ratio. The second raised only $1,000 in equity and borrowed the rest, giving it a 1 percent capital ratio. In the first case, a $1,000 profit on the assets will generate a meager 1 percent return on the shareholders’ $100,000 investment. In the second case, the same $1,000 gain will produce a 100 percent return on equity. The second option also has a steep downside: A loss of only $1,000 can wipe out the shareholders.
No Fear
At a big, systemically important bank, high leverage allows executives to play a heads-I-win-tails-you-lose game with taxpayers. In good times, the leverage makes the bank extremely profitable to shareholders, allowing executives to collect juicy bonuses. In bad times, as the European experience yet again demonstrates, governments have no choice but to step in and bail out the banks, and executives have nothing to fear but a highly remunerative exile."
Class: be able to talk about this today! For instance: with bailout promises (explicit or implicit) do shareholders have an incentive to allow managers to take large risks.
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