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Banks Risk Race: A Signaling Explanation

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Author Info

  • Damien Besancenot

    ()
    (CEPN - Centre d'Economie de l'Université Paris Nord - Université Paris 13 - CNRS : UMR7234)

  • Radu Vranceanu

    ()
    (Economics Department - ESSEC Business School)

Abstract

Many 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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Bibliographic Info

Paper provided by HAL in its series Working Papers with number halshs-00424214.

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Date of creation: 14 Apr 2011
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Handle: RePEc:hal:wpaper:halshs-00424214

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Related research

Keywords: Banking sector; Risk strategy; Risk/return tradeoff; Signaling; Imperfect information.;

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References

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  1. VanHoose, David, 2007. "Theories of bank behavior under capital regulation," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3680-3697, December.
  2. Spence, A. Michael, 2001. "Signaling in Retrospect and the Informational Structure of Markets," Nobel Prize in Economics documents 2001-6, Nobel Prize Committee.
  3. Allen N. Berger & Robert DeYoung, 1995. "Problem Loans and Cost Efficiency in Commercial Banks," Center for Financial Institutions Working Papers 96-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  4. Pomfret, Richard, 2010. "The financial sector and the future of capitalism," Economic Systems, Elsevier, vol. 34(1), pages 22-37, March.
  5. John G. Riley, 1974. "Competitive Signalling," UCLA Economics Working Papers 050, UCLA Department of Economics.
  6. Donald P. Morgan, 2002. "Rating Banks: Risk and Uncertainty in an Opaque Industry," American Economic Review, American Economic Association, vol. 92(4), pages 874-888, September.
  7. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
  8. Spence, A Michael, 1973. "Job Market Signaling," The Quarterly Journal of Economics, MIT Press, vol. 87(3), pages 355-74, August.
  9. Koehn, Michael & Santomero, Anthony M, 1980. " Regulation of Bank Capital and Portfolio Risk," Journal of Finance, American Finance Association, vol. 35(5), pages 1235-44, December.
  10. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  11. Kahane, Yehuda, 1977. "Capital adequacy and the regulation of financial intermediaries," Journal of Banking & Finance, Elsevier, vol. 1(2), pages 207-218, October.
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Citations

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Cited by:
  1. Damien Besancenot & Radu Vranceanu, 2011. "Experimental Evidence On The 'Insidious' Illiquidity Risk," Working Papers halshs-00602107, HAL.
  2. Damien Besancenot & Radu Vranceanu, 2011. "Experimental Evidence On The 'Insidious' Illiquidity Risk," CEPN Working Papers halshs-00602107, HAL.

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