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

60 Pages Posted: 17 Mar 2009 Last revised: 1 Oct 2012

Viral V. Acharya

New York University - Leonard N. Stern School of Business; 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

Multiple version iconThere are 3 versions of this paper

Date Written: April 12, 2012

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

JEL Classification: E32, G21

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: https://ssrn.com/abstract=1360974 or http://dx.doi.org/10.2139/ssrn.1360974

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 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, Republic of (South Korea)

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