Risk Shifting, Asset Bubbles, and Self-fulfilling Crises

Financial crisis are often associated with an endogenous credit reversal fol- lowed by a fall in asset prices and failures of financial institutions. To account for this sequence of events, this paper constructs a model where the excess risk-taking of portfolio investors leads to a bubble in asset prices (in the spirit of Allen and Gale, Economic Journal, 2000), and where the supply of credit to these investors is endogenous. First, we show that changes in the composition and riskiness of investors' portfolio as total lending varies may cause the ex ante return on loans to increase with the amount of total lending, thereby creating the potential for multiple (Pareto-ranked) equilibria associated with different levels of lending, asset prices, and output. We then embed this mechanism into a 3-period model where the low-lending equilibrium is selected with positive probability at the intermediate date. This event is associated with a inefficient liquidity dry-up, a market crash, and widespread failures of borrowers.