Viral Acharya and Hassan Naqvi
The seeds of a crisis: A theory of bank liquidity and risk taking over the business cycle
Journal of Financial Economics | Volume 106, Issue 2 (Nov 2012), 349–366

The global economy experienced interesting times after the bursting of the NASDAQ bubble in 2002. The Federal Reserve ran a loose monetary policy subsequent to the burst of this bubble. More specifically the Fed Funds rate dropped from 5.98% in January 2001 to 1.73% in January 2002 and stayed in this region till the end of 2005. Easy availability of credit fuelled U.S. asset prices. The ratio of debt to national income in the U.S. went up from 3.75-to-1, to 4.75-to-1 in the five-year period from 2002 to 2007. During this time house prices increased at a rate of 11% per year. As shown in Figure 1, during this period the house price to rent ratio increased at an alarming rate. The increase in house prices continued until mid-2006, after which there was a steep decline in housing prices.

1: Price-to-rent ratio, loan performance HPI, and BLS owners' equivalent rent
House prices had increased to unusually high price levels by 2008.

In our JFE paper, we argue that the influx of liquidity in the banking system sowed the seeds of the financial crisis. Traditionally liquidity has been thought of as a panacea whereby an influx of liquidity into banks is tantamount to a healthier banking system. However, as Lord Turner, Chairman of the Financial Services Authority, aptly put it, “We need a new philosophical approach... which recognizes that market liquidity is beneficial up to a point but not beyond that point...” (Financial Times, 2010)

Liquidity shields banks from failure, but managers push more loans

We show in our paper that excessive bank liquidity distorts managerial incentives and perpetuates an agency problem inside banks. In practice, bank managers have an incentive to give out excessive loans because their compensation is increasing in the volume of loans advanced. The Bureau of Labor Statistics finds that “most (loan officers) are paid a commission based on a number of loans they originate.” (BLS, Occupational Outlook Handbook, 2008–2009). Since the compensation of bank managers is tied to loan volume rather than long run profitability bank managers usually have an incentive to engage in excessive lending.

A study by the Office of Comptroller of Currency (OCC) found that “management driven weaknesses played a significant role in the decline of 90% of the failed and problem banks the OCC evaluated. ... Directors' or managements' overly aggressive behavior resulted in imprudent lending practices and excessive loan growth.” (OCC, 1988). More starkly the OCC found that 73% of the failed banks had indulged in excessive lending. Similar evidence came to the fore after the financial crisis of 2007–2009 when it was revealed that in the period preceding the crisis mortgage lenders, traders and risk centers in most of the financial institutions had been receiving substantial bonuses based on the size of their risky positions, rather than their long-run profitability.

We setup a model whereby the bank hires a risk-averse manager. The manager needs to exert effort in order to sell loans but nevertheless the bank can also punish the manager if he acts over-aggressively by issuing too many loans.

The bank depositors experience liquidity shocks and can thus withdraw their money from the bank early. If too many depositors run and withdraw early and the bank has insufficient reserves to service the withdrawals then the bank faces a penalty cost proportional to the liquidity shortage that it suffers. The penalty cost can be interpreted as a fire-sales cost of having to prematurely liquidate its assets to service withdrawals or alternatively it can simply be that the bank needs to get emergency funding from the central bank from its discount window at penal rates.

Subsequent to any early withdrawals by the depositors the bank can decide whether or not to conduct an audit in order to infer if the manager had acted over-aggressively by indulging in excessive lending. However, such audits are costly and thus the bank will not have an incentive to audit in all states of the world. If an audit is carried out and in the event that it is inferred that the manager had acted over-aggressively then the bank can punish the manager by imposing a penalty.

In this setup we show that the optimal contract offered to the manager is such that it maximizes the expected net profits of the bank subject to the participation constraint (which ensures that the manager accepts the contract) and the incentive constraint (which ensures that the manager has an incentive to exert effort in order to sell loans) and a limited liability constraint (which imposes an upper limit to any penalties imposed on the manager).

It can then be shown that the managerial compensation contract is such that bonuses are increasing in loan volume. Furthermore, the principal conducts an audit only if the liquidity shortfall suffered by the bank is sufficiently large. Intuitively, the managerial bonuses are increasing in loan volume so that the manager is incentivized to exert effort. Also, if the liquidity shortfalls are substantial then that sends a signal to the principal that the manager had most likely acted over-aggressively and given out too many loans. Thus the bank has an incentive to conduct an audit if the liquidity shortfalls are high enough. On the other hand, for insignificant or no liquidity shortfalls the bank avoids conducting a costly audit given that the likelihood of the manager having acted over-aggressively is low.

Aggressive lending can lead to asset price bubbles

The bank manager clearly faces a trade-off. If he acts over-aggressively he can potentially earn higher bonuses. However, if he acts over-aggressively and gets caught in the process then he is punished in which case he is worse off. The manager resolves this trade-off by acting over-aggressively only if the bank has sufficiently high liquidity (in the form of higher deposits) to begin with. This is because if ex ante bank liquidity is high then the likelihood of a liquidity shortfall is lower and hence the bank manager is more likely to get away from issuing excessive loans. On the other hand, if bank liquidity is already low to begin with and on top of that the manager issues excessive loans then the bank is more likely to conduct an audit in which case the manager will get caught. Given these results it can then be showed that an asset price bubble is created for high enough bank liquidity.

Bubbles are more likely when investors sense increased risk...

We argue that asset price bubbles are more likely to be formed when macroeconomic risk is high enough. Intuitively, if the macroeconomic risk is sufficiently high then investors prefer to deposit their endowments in banks rather than making direct entrepreneurial investments. This is because bank deposits are perceived to be safer investments vis-á-vis direct entrepreneurial investments especially in the presence of deposit insurance. Even in the absence of deposit insurance entrepreneurial moral hazard is likely to be high in bad times and hence it is more efficient for the investors to invest in banks during these times rather than face duplication of monitoring costs. Empirical evidence supports our hypothesis. Gatev-Strahan (JF 2006) find that as spreads in the commercial paper market increase, bank deposits increase because investors are more apprehensive of the risk in the corporate sector when macroeconomic risk is high.

...and when central banks inject liquidity

Bubbles are also more likely to be formed when the central bank injects liquidity into the banking sector by adopting a loose monetary policy. Historical evidence supports this. For instance, in the late 1980s a property bubble was formed in Finland and Sweden when the monetary authorities steadily expanded credit in the economy. In Japan a real estate was bubble subsequent to a loose monetary policy adopted by the Bank of Japan in 1986. In the United States, the housing bubble was formed after the Fed reduced the federal funds rate to 1% in 2003. Our model suggests that a central bank pursue a "leaning against liquidity" approach, i.e. expand credit during times of a liquidity crunch (in order to boost investment) but to adopt a contractionary monetary policy when banks are awash with liquidity so as to draw out their excess reserves.

Anak Agung Gde Anom Sukawati: Photo of the Painting `Mask Dancer'. Bali, 1966.. Our final piece is a painting from Bali. Balinese paintings have had international patronage since the 1930s, even before the movie Eat, Pray, and Love. Past patrons included famous visitors such as Charlie Chaplin and Margaret Mead. Bali became an enclave for Western artists, who brought secular themes, individual expression, better paper, and better techniques to the traditional Balinese intricate, dramatic, and busy painting style. Balinese paintings from this amalgamation are now called “Modern Traditional Balinese Paintings”. Even today, Bali has a thriving visual art scene that produces such paintings for the Western tourists—sometimes mass-produced in China.