Abstract

http://ssrn.com/abstract=1360974
 
 

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The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking Over the Business Cycle


Viral V. Acharya


New York University - Leonard N. Stern School of Business; Centre for International Finance and Regulation (CIFR); Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Hassan Naqvi


SKK Graduate School of Business

April 12, 2012

Journal of Financial Economics (JFE), Volume 106, Issue 2, November 2012, Pages 349-366
AFA 2011 Denver Meetings Paper

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.

Number of Pages in PDF File: 60

Keywords: Bubbles, Flight to quality, Moral hazard

JEL Classification: E32, G21

Accepted Paper Series


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Date posted: March 17, 2009 ; Last revised: October 1, 2012

Suggested Citation

Acharya, Viral V. and Naqvi, Hassan, The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking Over the Business Cycle (April 12, 2012). Journal of Financial Economics (JFE), Volume 106, Issue 2, November 2012, Pages 349-366; AFA 2011 Denver Meetings Paper. Available at SSRN: http://ssrn.com/abstract=1360974 or http://dx.doi.org/10.2139/ssrn.1360974

Contact Information

Viral V. Acharya
New York University - Leonard N. Stern School of Business ( email )
44 West 4th Street
New York, NY NY 10012
United States
HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm
Centre for International Finance and Regulation (CIFR) ( email )
Level 7, UNSW CBD Campus
1 O'Connell Street
Sydney, NSW 2000
Australia

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
New York University (NYU) - Department of Finance
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
Hassan Naqvi (Contact Author)
SKK Graduate School of Business ( email )
206 International Hall
Seoul, 110-745
Korea
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