Guttentag and Herring argue that rare disaster risks may be disregarded for decades without corrective losses, allowing competition to displace prudent creditors; short-horizon performance assessment and officer mobility can reinforce disaster myopia.

Evidence 2 passages

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  of the distribution that governs whether Nature draws from the disastrous distribution nor do they have sufficient evidence to infer the parameters of the distribution from the historical record. This degree of ignorance approaches what Keynes and Knight termed "uncertainty." Under such circumstances there can be no presumption that the subjective probabilities of market participants will converge to the objective probabilities. The argument that market discipline will ensure that decision-makers form expectations correctly has little force since the hazard may occur so infrequently that it may be disregarded with impunity for decades.6 Indeed, under such circumstances, competition may drive prudent creditors from the market because a creditor who attempts to charge an appro- priate default premium for a low probability hazard is likely to lose business to creditors who are willing to disregard the hazard. I Since the distribution of project-specific returns may vary from project to project, there is some scope for diversification across projects. 6 Arrow [1, p. 7] offers two additional reasons that rational behavior may not be the effective norm. Arbitrage possibilities may be inadequate and other market participants may prevent market prices from accurately reflecting future market values. Credit Rationing and Financial Disorder 1363 How are expectations formulated in circumstances characterized by uncer-

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  This cognitive bias may be reinforced by institutional factors. The performance of loan officers is usually evaluated over short periods on the basis of current income without adjustment for the uncertainty of future revenues or the front- loading of revenue streams. Concern for the future consequences of current 7 The threshold heuristic is based on the work of Herbert Simon concerning procedural rationality (see Simon [20a] for a recent overview). Slovic et al. [21] introduced the term in an explanation of why people may refuse to buy insurance against low-probability hazards. Kunreuther et al. [16] find evidence supporting the threshold heuristic in their field survey of the insurance decisions of 3000 households. 1364 The Journal of Finance Probability of a Disaster, ff 1 'i\t Subjective Sublecive .. ,\ I \~~~~~~~Kbjctv iTt+fl NX \)Actual N I~~ K I \ I 0~ l II t t+n t+n' Time Figure 2. The Disaster Myopia Hypothesis lending decisions may be further undercut by high job mobility among lending officers. Low frequency events are especially likely to be disregarded if the lending officer will not be personally identified with the outcome. In Appendix B, we show that this decline in the subjective probability of a disaster is also consistent with the Bayesian approach to decision-making when the time elapsed since the last occurrence of a disaster becomes very long. II. The Capacity to Withstand Shocks

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