Financial risk tradeoffs

Risk homeostasis is the theory that people like a certain level of risk in their lives and will tend to change their behavior, possibly increasing risks in one area if the risks that they experience in another area are reduced. Experiments seem to show that there's some basis for believing that this actually happens in some cases, although it's not clear exactly how much behavior is changed and how important the effects of the changed behavior are.

If one risk is reduced, people may change their behavior to include other risky activities, and the new situation may actually either be better or worse than the original situation. If the new behavior causes more loss than the original behavior, then reducing the original risk will actually result in a net loss. If the new behavior causes less loss than the original behavior, then the reducing the original risk will result in a net gain. Two examples from the financial services industry may illustrate this.

At the heart of the recent financial crisis, for example, is the rate at which American home-buyers are defaulting on their mortgages. A careful look at the available historical data from the FDIC shows that the default rate for mortgages has actually been steadily increasing since 1972, and that the current situation was probably inevitable in light of this trend. The FDIC report that gives this historical data also shows that the trend  towards consumers accepting more and more financial risk is the most important cause of the increasing default rate on mortgages. So if the increased default rate on mortgages is caused by consumers' willingness to accept more financial risk, why have people been willing to accept more and more financial risk?

One possible explanation for this trend is that the increased acceptance of financial risk was caused by the safer environment caused by the stricter health and safety standards that were adopted over roughly the same period. Perhaps people that live and work in a safer environment found assuming additional financial risk as a new way to keep their lives exciting. If this is the case, the trillions of dollars in losses that we're now seeing in the financial services industry may actually outweigh the benefits from the safer environment.

Another example of substituting one risk for another may be seen in the ways in which credit unions make their money. One difference between credit unions and commercial banks is that more customers of credit unions have overdraft protection on their checking accounts than customers of commercial banks do. Having this service in place makes writing a bad check less risky than it would be otherwise, and credit union members probably make up for this decreased risk by being less careful about the checks that they write. The fact that over 60 percent of the revenue of credit unions comes from charges from overdrafts indicates that this may indeed be the case. For commercial banks, less that 18 percent of their revenue comes from overdraft charges.

So it seems that credit unions may essentially be possible because of the increased risks that they get their customers to accept and the fees that they can charge to support this risky behavior. Credit unions seem to serve very useful purposes, so it might be the case that the services that are subsidized by their customers carelessly writing checks may more than make up for the costs that the careless customers incur.

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