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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

Abstract

We examine how the banking sector may 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. Volumebased 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.

Suggested Citation

  • Acharya, Viral & Naqvi, Hassan, 2012. "The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking over the Business Cycle," CEPR Discussion Papers 8851, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:8851
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    More about this item

    Keywords

    Bubbles; Flight to quality; Moral hazard;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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