A behavioral model of the credit boom

After more than 2 years working on my PhD., trying to come out with a theoretical and empirical approach to analyze whether behavioral biases (particularly ‘prospect theory’, and bank managers’ optimism and overconfidence) might explain the recent credit bubble in Spain (and elsewhere!), work begins to bear fruit.

 

Here it follows the abstract of the paper with tentative title ‘Informational efficiency of the banking sector. A behavioral model of the credit boom’ that we are about to yield. An empirical research is also now underway: “We examine informational efficiency in retail credit markets to test whether behavioral biases by participants in the banking industry might explain credit cycles. We offer a simple model of herding and limits of arbitrage in retail credit markets that follows the three-step approach of Shleifer (2000). We show why solely behavioral biases by participants in the industry could explain how a credit bubble might be feeded by the banking sector. According to our model, optimistic banks would lead the industry while it would be rational for unbiased banks to herd. We derive the conditions for rational banks to herd, and show the resulting credit boom of loans of low quality is welfare reducing for high quality borrowers and welfare increasing for low quality borrowers. An important finding is the role of limits of arbitrage in the industry: there would be no incentives for rational banks to correct the misallocations of their biased competitors. Informational efficiency, therefore, would rely solely on authorities.”

 

Open access to the original data in the paper and the possibility to try with alternative scenarios (Excel Solver would be required) is readily available at http://www.dpeon.com/documentos.html

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