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

Author(s): Viral V Acharya, Hassan Naqvi

CEPR Discussion Paper Number 8851
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Programme Area(s): Financial Economics (FE), International Macroeconomics (IM)

Date of Publication: 23/02/2012

Keyword(s): bubbles, flight to quality, moral hazard

JEL(s): E32, G21

Abstract: We examine how the banking sector may 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. Volumebased 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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