Risk Homeostasis

Risk homeostasis  is a theory on the evaluation of risk, developed by Queen's University (Ontario, not Belfast!) professor Gerald J.S. Wilde .  The basic idea is that when a way to reduce risk is introduced into a system, something inherent in human nature leads us to take greater risks in another area of that system.  


To illustrate the point, let's take a look at Wilde's now famous 1990s study of taxi-drivers in Munich, where  ABS (anti-lock braking system) was fitted to half of the cars within a fleet of taxis and at the end of the study, the crash rates of the two sets of taxis were compared. 

To briefly outline the impact of ABS, in June 1999, the National Highway Traffic Safety Adminstration (NHTSA) found that, on average, ABS increased stopping distances by 22% (on a gravel surface).  That 22% could be the difference between having an accident and escaping with a near miss, so you would think that the taxi drivers with ABS in their cars would have a lower crash rate but this wasn't to be the case. 



The crash rate remained the same for both sets of drivers, suggesting that because drivers knew they had better brakes, they could drive faster, tailgate other cars and rely on their brakes to get them out of trouble.  This is risk homeostasis - increasing the riskiness of your driving because risk is reduced in another area; in this case, by the braking system.



And if you think about it, we all do it!  Look out for it next time you're crossing the street.  If you're at a busy pedestrian crossing, odds are someone standing beside you will be texting a friend whilst listening to their i-pod.  They rely on the "green man" to get them across the road safely, paying no attention to the flow of traffic.  This is another example of risk homeostasis.  How often do you see someone cross the road at a place where there is no crossing, behaving in the same way?  If the same care and attention was displayed crossing the road in both instances, accidents at pedestrian crossings would be virtually non-existant but unfortunately, it isn't and they aren't.  In 2005 for example, the AA found that fatalities on pedestrian crossings accounted for 2.2% of total road fatalities in the UK.
http://www.theaa.com/public_affairs/reports/aa-pedestrian-crossings-survey-in-europe.pdf



I think that this result is an important one for the field of finance, particularly in wake of the 2008 financial crisis.  The development of the mortgage backed security (MBS) and the credit default swap (CDS) meant that financial institutions could hedge their risk through securitization.  But when the risk in this area was reduced, what happened?  The development of sub-prime mortgages; institutions lending money to people who were previously deemed too high-risk to be considered for mortgages, and the fuelling the property bubble in the US.

For a more detailed read on the Munich taxi-driver study and risk homeostasis  in general, I'll refer you to Malcolm Gladwell  once again!