Banks’ risk race: a signaling explanation
AbstractMany observers argue that the abnormal accumulation of risk by banks has been one of the major causes of the 2007-2009 financial turmoil. But what could have pushed banks to engage in such a risk race? The answer brought by this paper builds on the classical signaling model by Spence. If banks’ returns can be observed while risk cannot, less efficient banks can hide their type by taking more risks and paying the same returns as the efficient banks. The latter can signal themselves by taking even higher risks and delivering bigger returns. The game presents several equilibria that are all characterized by excessive risk taking as compared to the perfect information case.
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Bibliographic InfoPaper provided by ESSEC Research Center, ESSEC Business School in its series ESSEC Working Papers with number DR 09007.
Length: 12 pages
Date of creation: Oct 2009
Date of revision:
Banking Sector; Imperfect Information; Risk Strategy; Risk/return Tradeoff; Signaling;
Other versions of this item:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-11-14 (All new papers)
- NEP-BAN-2009-11-14 (Banking)
- NEP-CTA-2009-11-14 (Contract Theory & Applications)
- NEP-FMK-2009-11-14 (Financial Markets)
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