Banks, too, faced a prisoner's dilemma. If, before the crisis, they had exited the riskier types of lending, stopped buying complex derivative instruments and reduced their leverage they would, in the short term, have earned lower profits than their competitors. The chief executive would likely have lost his job, and other staff defected to banks willing to take risks and pay higher bonuses, well before the wisdom of the new strategy had become evident. Even understanding the risks, it was safer to follow the crowd. [...]

[...] There was a view that being very clever was a justification for making money out of people who were less clever. This attitude encouraged the arrogance of the traders who rigged and fixed prices in what were thought to be competitive markets. [...]

Financial engineering allows banks and shadow banks to manufacture additional assets almost without limit. This has had two consequences. First, the new instruments created are traded largely among big financial institutions and so the financial system has become enormously more interconnected. [...] Second, although many of these positions even out when the financial system is seen as a whole, gross balance sheets are not restricted by the scale of the real economy [...]

[...] There are three reasons to believe that, before the crisis, the banking sector as a whole became too large. [...] The belief that when in trouble banks will be bailed out by the state because they are too important to fail leads to an implicit subsidy, which means a larger banking system than is justified by the underlying economics.

Second, many of the examples of high personal renumeration, especially in the form of bonuses, in the financial sector reflect not high productivity but what economists call rent-seeking behaviour. In other words, the renumeration is far higher than is necessary to persuade people to work in the industry. [...] Many of the transactions in complex financial instruments are zero-sum--a clever trader makes money out of a less clever one. Such activity diverts talent from professions where the social returns are high, such as teaching, to those, such as finance, where the private return exceeds, often substantially, the social return.

Third, financial capital is attracted into the industry by the appearance that there are high profits to be made. [...] a common way of exploiting normal accounting conventions for derivative and other complex transactions was to report as current income the present value of expected future cash flows, even though they had not yet been received. [...]