The seeds of a crisis: A theory of bank liquidity and risk taking over the business cycle |
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Authors: | Viral Acharya Hassan Naqvi |
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Institution: | 1. Department of Finance, Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012, United States;2. CEPR, United States;3. NBER, United States;4. Graduate School of Business - Sungkyunkwan University, 53 Myungryun-dong 3-ga, Jongro-gu, Seoul 110-745, Republic of Korea |
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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. |
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Keywords: | Bubbles Flight to quality Moral hazard |
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