When individuals or institutions are shielded from the full consequences of their decisions, they take greater risks. This effect of limited liability is well established in economic theory and is a key concern for regulators, who attempt to counteract excessive risk-taking by correcting these “bad” incentives. However, our recent research shows that limited liability does not just distort financial incentives, it also distorts beliefs.
At the heart of the problem are motivated beliefs, a psychological mechanism where people unconsciously adjust their beliefs to justify actions they would otherwise find morally questionable. Investors facing limited liability may feel a tension between the financial incentive to take greater risks and the moral discomfort of knowing that others will bear the losses. To resolve this cognitive dissonance, investors under limited liability convince themselves that their investments are safer than they really are.
This bias leads to a paradoxical outcome: individuals take even greater risks when their decisions have the potential to harm others. Rather than being restrained by social preferences—the tendency to care about others’ well-being—decision-makers use these concerns as a trigger for self-deception, downplaying the true level of risk. This finding is important for financial regulation which should not focus only on addressing bad incentives in financial decision-making, but should also try to address the role of “bad beliefs”.
The Experiment: When Limited Liability Becomes Self-Deception
To isolate the role of motivated beliefs, we conducted an economic experiment in which participants determined their level of investment in a risky asset under different conditions. In one setting, participants bore the full risk of their decisions. In others, they shared the downside with a passive third party, introducing moral hazard. In a third condition, participants had limited liability, but their losses did not negatively affect a third party.
Before each decision, participants received a noisy signal about the likelihood that the investment would succeed. However, the ambiguity of this signal allowed investing participants to form self-serving motivated beliefs.
The results revealed a clear pattern. As expected, limited liability led participants to invest significantly more. However, this increase in risk-taking was not purely a response to incentives, participants also became more optimistic about their chances of success, inflating their expectations and, indirectly, self-justifying their decisions. Most strikingly, risk-taking was highest when moral hazard was present. Paradoxically, participants invested more when their failures could harm others than when the limited liability had no negative externality.
The Paradox of Social Preferences: Why People Take Bigger Risks When Others Can Get Hurt
It is well known in economics that people hold social preferences, that is, people care not only about their well-being but also about the well-being of others and the fairness of outcomes. In theory, such preferences should push participants in our experiment to invest less, when a failed investment harms others. This is also, what we observe, when subjects were informed about the precise probability of an investment’s success. However, if the signal was ambiguous, subjects raised their beliefs about success so much that they invested more than for the same signal without negative externality.
When participants knew that someone else would bear most of the losses, they faced a psychological conflict: on one hand, they were incentivized to take greater risks since they were shielded from the downside; on the other, they did not want to feel responsible for taking reckless risks that could harm others. To resolve this tension, they unconsciously adjusted their beliefs whenever they could harm others, convincing themselves that their investments were safer than they actually were. This self-deception allowed them to take even greater risks without feeling guilty, paradoxically turning their social preferences—meant to encourage caution—into a psychological mechanism that fueled risk-taking.
Conclusion
Our study reveals a hidden danger of motivated beliefs under limited liability. When individuals take risks that could harm others, they don’t necessarily feel guilty or act more cautiously. Instead, they unconsciously inflate their optimism, convincing themselves that the risk is smaller than it really is, leading to more extreme risk-taking, not less.
This result presents a significant challenge for financial regulation. Standard regulatory approaches assume that individuals respond predictably to incentives, leading to policies such as higher capital requirements for banks or increased accountability for executives. However, if decision-makers unconsciously distort their own risk perceptions, then merely adjusting financial incentives might not be enough. Whether or not social preferences backfire depends on the leeway to form beliefs that accord with the observed information. If precise success probabilities are given, social preferences reduce risk taking, but if there is sufficiently large wiggle room to form motivated beliefs, the opposite result occurs. Thus, an obvious consequence is that financial market regulation should come along with more precise and objective rules for estimating the distribution of asset returns as excessive risk-taking is driven not only by bad incentives but also by the ability of investors to form “bad” beliefs.
This study is published in Management Science:
Bosch-Rosa, C., Gietl, D., & Heinemann, F. (2024). Risk Taking Under Limited Liability and Moral Hazard: Quantifying the Role of Motivated Beliefs. Management Science.
