The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking over the Business Cycle

We examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, given limited liability and lack of observability of effort, loan officers (or risk takers) are compensated based on the volume of loans. 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 managerial payoffs to the downside risk of loans and inducing excessive credit growth and asset price bubbles. The seeds of a crisis are thus sown. A Central Bank, that can detect the macroeconomic risk or the ∗New York University Stern School of Business, NBER, CEPR and ECGI. e-mail: [email protected] †National University of Singapore and NUS Risk Management Institute. e-mail: [email protected] ‡We would like to acknowledge Hanh Le and Michelle Zemel for research assistance. Comments by seminar participants at National University of Singapore, CEMFI, and Lancaster University Management School are also appreciated.