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The seeds of a crisis: A theory of bank liquidity and risk taking over the business cycle

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  • Acharya, Viral
  • Naqvi, Hassan
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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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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 106 (2012)
    Issue (Month): 2 ()
    Pages: 349-366

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    Handle: RePEc:eee:jfinec:v:106:y:2012:i:2:p:349-366

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Bubbles; Flight to quality; Moral hazard;

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    Cited by:
    1. Imbierowicz, Björn & Rauch, Christian, 2014. "The relationship between liquidity risk and credit risk in banks," Journal of Banking & Finance, Elsevier, vol. 40(C), pages 242-256.
    2. Thorsten Beck & Andrea Colciago & Damjan Pfajfar, 2014. "The role of financial intermediaries in monetary policy transmission," DNB Working Papers 420, Netherlands Central Bank, Research Department.
    3. Marco Pagano, 2013. "Finance - Economic Lifeblood or Toxin?," EIEF Working Papers Series 1309, Einaudi Institute for Economics and Finance (EIEF), revised Apr 2013.

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