The seeds of a crisis: a theory of bank liquidity and risk taking over the business cycle

Viral Acharya, Hassan Naqvi

Research output: Contribution to journalArticleResearchpeer-review

166 Citations (Scopus)

Abstract

We examine how the banking sector could 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. Volume-based 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.

Original languageEnglish
Pages (from-to)349-366
Number of pages18
JournalJournal of Financial Economics
Volume106
Issue number2
DOIs
Publication statusPublished - 1 Nov 2012
Externally publishedYes

Keywords

  • Bubbles
  • Flight to quality
  • Moral hazard

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