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Risk Shifting, Asset Bubbles, and Self-fulfilling Crises

  • Challe, Edouard
  • Ragot, Xavier

Financial crisis are often associated with an endogenous credit reversal fol- lowed by a fall in asset prices and failures of financial institutions. To account for this sequence of events, this paper constructs a model where the excess risk-taking of portfolio investors leads to a bubble in asset prices (in the spirit of Allen and Gale, Economic Journal, 2000), and where the supply of credit to these investors is endogenous. First, we show that changes in the composition and riskiness of investors' portfolio as total lending varies may cause the ex ante return on loans to increase with the amount of total lending, thereby creating the potential for multiple (Pareto-ranked) equilibria associated with different levels of lending, asset prices, and output. We then embed this mechanism into a 3-period model where the low-lending equilibrium is selected with positive probability at the intermediate date. This event is associated with a inefficient liquidity dry-up, a market crash, and widespread failures of borrowers.

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Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/2712.

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Date of creation: Dec 2005
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Handle: RePEc:dau:papers:123456789/2712
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  1. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
  2. Graciela L. Kaminsky, 1998. "Currency and banking crises: the early warnings of distress," International Finance Discussion Papers 629, Board of Governors of the Federal Reserve System (U.S.).
  3. V.V. Chari & Patrick J. Kehoe, 2003. "Hot money," Staff Report 228, Federal Reserve Bank of Minneapolis.
  4. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
  5. Paul Povel & Michael Raith, 2004. "Optimal Debt with Unobservabable Investments," RAND Journal of Economics, The RAND Corporation, vol. 35(3), pages 599-616, Autumn.
  6. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  7. Reinhart, Carmen & Kaminsky, Graciela, 1998. "Financial crises in Asia and Latin America: Then and now," MPRA Paper 13877, University Library of Munich, Germany.
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