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

We examine how the banking sector may ignite the formation of assetprice bubbles when there is access to abundant liquidity. Inside banks,given lack of observability of effort, loan officers (or risk takers)are compensated based on the volume of loans but are penalized if bankssuffer a high enough liquidity shortfall. Outside banks, when there isheightened macroeconomic risk, investors reduce direct investment andhold more bank deposits. This ‘flight to quality’ leavesbanks flush with liquidity, lowering the sensitivity of bankers’payoffs to downside risks of loans and inducing excessive credit volumeand asset price bubbles. The seeds of a crisis are thus sown. We showthat the optimal monetary policy involves a “leaning againstliquidity” approach: A Central Bank should adopt a contractionarymonetary policy in times of excessive bank liquidity in order to curbrisk-taking incentives at banks, and conversely, follow an expansionarymonetary policy in times of scarce liquidity so as to boost investment.