Lending Booms, Smart Bankers and Financial Crises

This paper develops a theory of financial crises that explains why crises should be expected to follow periods of sustained lending booms and high banking profitability. When the behavior of agents is affected by the availability heuristic and there is a long period of sustained banking profitability, all agents—banks as well as those who fund banks and those who regulate them—end up in an “availability cascade” in which they overestimate the skills of bankers in managing risks and underestimate the probability that the observed good outcomes are simply due to luck. All agents consequently become more tolerant of bank risk-taking, and banks invest in increasingly riskier assets. Further, as the number of banks entering this market grows, the liquidity of highly risky assets improves, making it more attractive for others to enter the market. The economy thus ends up with a large number of financial institutions investing in very risky assets that are traded in highly liquid markets. Subsequently, if some salient public signal reveals in some period that loan repayment probabilities are exogenous rather than skill-dependent, investors rush to withdraw funds, market liquidity dries up, and a crisis ensues. The model also explains why the economy may not recover even after the friction that precipitated the crisis has dissipated. Empirical predictions and policy implications of the analysis are discussed. The analysis suggests that the majority of regulations put in place in response to the crises of the last few decades, including the recent financial crisis, may do little to prevent future crises.