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Discussion Paper Details

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

Author(s): Viral V. Acharya and Hassan Naqvi

Publication Date: February 2012

Keyword(s): bubbles, flight to quality and moral hazard

Programme Area(s): Financial Economics and International Macroeconomics

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.

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Bibliographic Reference

Acharya, V and Naqvi, H. 2012. 'The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking over the Business Cycle'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8851