Abstract
The paper argues that the incidence of moral hazard played a significant role in the 2007/2008 credit crunch. In particular, bank traders subjected to asymmetric compensation structures have an incentive to take excessive risks even when the bank's shareholders would prefer prudent investment. Traders' incentives are shown to be unaffected by capital regulations, with the associated financial burden falling upon the taxpayer through deposit insurance or government bail-outs. Selected case studies further indicate that the phenomenon of “gambling traders” was widespread during the credit crunch, when high bonuses tempted bank employees to invest in risky subprime-backed securities. The intransparency of structured products and the inaccuracy of credit ratings contributed to the employees' ability to conceal the underlying risk from the banks' shareholders. The analysis points to an urgent need to reform compensation practices in the financial sector.
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