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 nancial 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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Date of creation: 14 Apr 2011
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Banking sector; Risk strategy; Risk/return tradeoff; Signaling; Imperfect information.;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-10-31 (All new papers)
- NEP-BAN-2009-10-31 (Banking)
- NEP-CTA-2009-10-31 (Contract Theory & Applications)
- NEP-FMK-2009-10-31 (Financial Markets)
- NEP-RMG-2009-10-31 (Risk Management)
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