Wednesday, February 25, 2009

frames and prospects

When I think about "prospect theory" and behavioral economics in general, I tend mostly to think about loss-aversion and to be bemused by framing effects, but one of the other reliable findings is that agents who face losses become risk-seeking rather than risk-averse. Someone presented with a sure $25 or a coin-toss for $50 will usually take the bird in hand, but presented with losses of the same magnitude, people will frequently prefer the coin toss — any chance to maybe, possibly reduce the losses.

It occurs to me that this is something we observe on the macro level. Insurance companies do well for a while, rates start to come down, they start seeking out riskier insurees and refuse to give up share of unprofitable business, and eventually KABOOM! Financial institutions see risk premia or even just interest rates come down, they think they're entitled to higher returns, they go "yield-chasing" (buying up riskier assets) and increase leverage, and eventually KABOOM!

I wonder if there's a good institutional way to check this propensity for making a bad thing worse. Getting insolvent companies into bankruptcy before they can cause harm seems like a good start.