The Highs and the Lows: A Theory of Credit Risk Assessment and Pricing through the Business Cycle

44 Pages Posted: 16 Feb 2015

See all articles by Anjan V. Thakor

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

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Date Written: February 15, 2015

Abstract

This paper develops a theory of how risk is assessed and priced through the business cycle by developing an intuitive model in which there is uncertainty about whether outcomes depend on the risk-management skills of banks or are just based on luck, in the spirit of Piketty’s (1995) model of “left-wing” and “right-wing” dynasties. Periods of sustained banking profitability cause all agents to rationally elevate their estimates of bankers’ skills, despite the uncertainty about what is driving outcomes. Everybody consequently becomes sanguine about bank risk, credit spreads decline, and banks choose increasingly risky assets. Conditional on subsequently observing unexpectedly high defaults, beliefs can endogenously shift to put more weight on outcomes being luck-driven, and this causes credit spreads to widen and may be enough to trigger a crisis. Regulatory implications of the analysis are extracted.

Keywords: financial crisis, learning, skill, luck

JEL Classification: G02, E32, D83

Suggested Citation

Thakor, Anjan V., The Highs and the Lows: A Theory of Credit Risk Assessment and Pricing through the Business Cycle (February 15, 2015). Available at SSRN: https://ssrn.com/abstract=2565499 or http://dx.doi.org/10.2139/ssrn.2565499

Anjan V. Thakor (Contact Author)

Washington University, Saint Louis - John M. Olin School of Business ( email )

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St. Louis, MO 63130-4899
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European Corporate Governance Institute (ECGI) ( email )

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Belgium

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