Aurora Borealis
1 February 2013 CFA Institute Journal Review

The Seeds of a Crisis: A Theory of Bank Liquidity and Risk Taking over the Business Cycle (Digest Summary)

  1. Lee M. Dunham

A theoretical model of bank lending can explain how abundant bank liquidity levels (as measured by bank deposits) lead to credit booms and asset price bubbles. The authors find that when banks experience surges in bank deposits during times of heightened macroeconomic risk, there is incentive to underprice loans, which leads to credit booms and asset price bubbles.

What’s Inside?

The authors present an interesting model of bank lending that may explain the precipitous rise of credit and asset prices leading into the 2007–09 financial crisis and their similarly precipitous fall during the crisis. A key driver of the authors’ model is the amount of deposits that become increasingly available to banks during periods of heightened macroeconomic risk.

How Is This Research Useful to Practitioners?

Bank deposits tend to rise during times of high macroeconomic risk, particularly as investors engage in a flight to quality and shift from riskier investments to safer bank deposits. Banks use these deposits to make loans, and loan officers tend to have incentive-based compensation contracts that are linked to loan volume rather than profitability. Such contracts induce lenders to opportunistically underprice loans to drive higher loan volume, despite the risk of a penalty if caught.

The authors’ model includes bank lenders’ adverse penalty if they are caught underpricing loans. But monitoring lenders is costly, and therefore, a bank will be audited only if it suffers a substantial liquidity shortfall. Lenders realize that when bank deposits are relatively high (abundant liquidity), the probability of an audit is low. The implication of the authors’ model is that lenders are likely to aggressively price loans during times of heightened macroeconomic risk, when banks are operating at high levels of bank deposits.

Next, the authors link the increase in loan volume to asset prices. Underpriced loans lead to excessive borrowing, which, in turn, leads to excessive demand for assets by borrowers. Consequently, asset prices rise above fundamental values, which leads to price bubbles. The implication is that asset price bubbles are most likely to form when banks have excessive liquidity, which is most likely to occur during times of heightened macroeconomic risk.

How Did the Authors Conduct This Research?

The model presented by the authors is a three-date model (Time 0, 1, 2) consisting of the banking sector, borrowers, and savers (households) as well as an entrepreneurial sector (corporations). At Time 0, the bank owner contracts with the loan officer to make the bank’s loan decisions, in which the officer’s compensation is linked to loan volume, with a penalty if the officer is caught underpricing loans. After contracting, the loan officer receives deposits from savers and makes decisions on how much to make available in loans, how much to hold in reserves, and how to price loans. Loans are classified as success or failure at Time 2.

In the model, banks face unknown withdrawals (treated as a random variable) at Time 1 and banks face a penalty if there is a liquidity shortfall (i.e., reserves are less than withdrawals). The bank owner would simply maximize expected profits net of any penalty as a result of a liquidity shortfall by setting optimal deposit and lending rates, which are a function of total deposits and loan portfolio risk. But the loan officer is making these decisions, and the contract incentivizes the officer to underprice loans. A key assumption of the model is asymmetrical information: The bank owner cannot observe the optimal lending and deposit rates that maximize expected profits in the absence of this agency problem. At Time 1, the bank owner may conduct a costly audit (too expensive to audit in all states) of the loan officer to determine whether the officer underpriced loans. An important implication of the authors’ model is that the loan officer will engage in loan underpricing only if bank deposits are relatively high.

Abstractor’s Viewpoint

The authors’ model is technical but very straightforward and offers insight into how credit booms and asset price bubbles can be formed when banks are flush with liquidity. The model has significant implications for expansionary monetary policies of central banks and how such policies can lead to the creation of asset price bubbles.

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