The seeds of a crisis: A theory of bank liquidity and risk taking over the business cycle

Journal of Financial Economics, 2012, vol. 106, issue 2, 349-366

Abstract: We examine how the banking sector could ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, to induce effort, loan officers are compensated based on the volume of loans. Volume-based compensation also induces greater risk taking; however, due to lack of commitment, loan officers are penalized ex post only if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This ‘flight to quality’ leaves banks flush with liquidity, lowering the sensitivity of bankers’ payoffs to downside risks and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown.

Keywords: Bubbles; Flight to quality; Moral hazard (search for similar items in EconPapers)
JEL-codes: E32 G21 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (264)

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Working Paper: The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking over the Business Cycle (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:106:y:2012:i:2:p:349-366

DOI: 10.1016/j.jfineco.2012.05.014

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