Working Paper: NBER ID: w14943
Authors: Andrei Shleifer; Robert W. Vishny
Abstract: We propose a theory of financial intermediaries operating in markets influenced by investor sentiment. In our model, banks make loans, securitize these loans, trade in them, or hold cash. They can also borrow money, using their security holdings as collateral. We embed such banks in a stylized financial market, in which securitized loans may be mispriced, and investigate how banks allocate limited capital among the various activities, as well as how they choose their capital structure. Banks maximize profits, and there are no conflicts of interest between bank shareholders and creditors. The theory explains the cyclical behavior of credit and investment, but also accounts for the fundamental instability of banks operating in financial markets, especially when banks use leverage.
Keywords: financial intermediaries; investor sentiment; capital allocation; bank stability; credit cycles
JEL Codes: E32; G21; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| banks' capital allocation decisions (G21) | investor sentiment (G41) |
| investor sentiment (G41) | banks' capital allocation decisions (G21) |
| high asset prices (G19) | banks' risk-taking behavior (G21) |
| low asset prices (G19) | banks' asset liquidation (G33) |
| banks' risk-taking behavior (G21) | market instability (E32) |
| banks' asset liquidation (G33) | further destabilization of security prices (G19) |
| banks' capital allocation decisions (G21) | cyclical investment behavior (E32) |
| cyclical investment behavior (E32) | volatility in real economic activity (E32) |