“There were two ways in which these credit default swaps led to trouble. The first is simply that having insured some of their gambles, the banks felt confident in raising the stakes. Regulators approved; so did the credit rating agencies responsible for evaluating these risks; so did most banks shareholders. John Lanchester, A chronicler of the crisis, quips, ‘it’s as if people used the invention of seatbelts as an opportunity to take up drunk-driving.’ Quite so – and in fact there is evidence that seat belts and airbags do indeed encourage drivers to behave more dangerously. Psychologists call this risk compensation. The entire point of the CDS what to create a margin of safety that would let banks take more risks. As with safety belts and dangerous drivers, innocent bystanders were among the casualties.”
I realise the extract is a little opaque without its surrounding context.
So I’ll try and boil its central concept down.
When the level of risk decreases, people compensate by increasing the size of the gamble.