The Seeds Of A Crisis: A Theory Of Bank Liquidity And Risk-Taking Over The Business Cycle
The authors examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, given lack of observability of effort, loan officers (or risk takers) are compensated based on the volume of loans but are penalized 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 of loans and inducing excessive credit volume and asset price bubbles.