Disaster Myopia is a special form of financial vulnerability, when banks undervalue default probabilities if failures do not arise for a long period of time. And even if a bank uses superior credit risk models that indicate higher risk pricing, it may lose in competition to other banks, which disregard this risk and therefore may choose herding behavior.

Increased competition from credit markets forces banks to narrow spreads and at the same time relaxed lending standards worsen the pool of borrowers.

Strong competition with disaster myopia, short terms and herding may therefore increase financial vulnerability of banks.

The disaster-myopia theory is that if potential shocks that can cause major losses to lenders occur occasionally, they will not be fully reflected in loan prices and conditions. If the market is aggressive and some lenders are willing to discount the probability of a shock altogether, other lenders who might be prone to be more cautious are forced to go along or lose market share.

In the mortgage market, disaster myopia meant basing mortgage prices and underwriting rules on the hypothesis that because house prices had risen for a long period, they would continue to rise. The termination of price increases was thus a shock for which lenders were no better prepared than borrowers.

Disaster myopia was especially widespread among aggressive sub prime lenders, who could make a lot of money in a very short time as long as house prices kept rising. Other sub prime lenders who might not be disaster-myopic were required to operate as if they were, to remain competitive.