Heads We Both Win, Tails Only You Lose: the Effect of Limited Liability On Risk-Taking in Financial Decision Making

One of the reasons for the recent crisis is that financial institutions took \"too much risk\" (Brunnermeier, 2009; Taylor et al., 2010). Why were these institutions taking so much risk is an open question. A recent strand in the literature points towards the \" cognitive dissonance\" of investors who, because of the limited liabilityof their investments, had a distorted view of riskiness (e.g., Barberis (2013); Benabou (2015)). In a series of laboratory experiments we show how limited liabilitydoes not affect the beliefs of investors, but does increase their willing exposure to risk. This results points to a simple explanation for the over-investmentof banks and hedge-funds: When incentives are not aligned, investors take advantage of the moral hazardopportunities.