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
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
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, G21Accepted Paper Series
Date posted: March 17, 2009 ; Last revised: October 1, 2012
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