Lending Booms, Smart Bankers and Financial Crises
8 Pages Posted: 1 Apr 2015
Date Written: January 19, 2015
This paper develops a theory that explains why financial crises follow profitable lending booms. When agents exhibit the "availability heuristic" and there is a long period of banking profitability, all agents — banks, their investors and regulators — end up in an “availability cascade,” overestimating bankers’ risk-management skills and underestimating the probability that observed outcomes are due to good luck. Consequently, banks profitably invest in riskier assets. Subsequently, if a public signal reveals that outcomes are luck-driven, investors withdraw funds, liquidity evaporates, and a crisis ensues. A loan resale market improves liquidity but increases the probability of a crisis.
Keywords: financial crises, availability heuristic, bankers' skills
JEL Classification: D81, E58, G21
Suggested Citation: Suggested Citation