Working Paper: CEPR ID: DP8851
Authors: Viral V. Acharya; Hassan Naqvi
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.
Keywords: bubbles; flight to quality; moral hazard
JEL Codes: E32; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased bank liquidity (G21) | excessive risk-taking (G41) |
| Increased bank liquidity (G21) | asset price bubbles (G19) |
| Increased bank liquidity (G21) | reduced sensitivity of bankers' payoffs to downside risks (G40) |
| reduced sensitivity of bankers' payoffs to downside risks (G40) | excessive credit volume (E51) |
| Heightened macroeconomic risk (E66) | increase in bank deposits (G21) |
| increase in bank deposits (G21) | increased bank liquidity (G21) |
| increased bank liquidity (G21) | excessive lending (G21) |
| Agency problems (G34) | over-lending when liquidity is high (F65) |
| Managerial incentives (M52) | excessive risk-taking (G41) |