Basso, Henrique S. (2011) Awareness, persistent beliefs and credit cycles. Working Paper. Coventry: Department of Economics, University of Warwick. (Unpublished)

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Abstract

Starting from a standard RBC model with credit frictions, and augmenting it with an optimal awareness decision, we are able to generate a framework where bankers display persistent beliefs, hanging onto the view that economic conditions are benign. Persistent beliefs of prosperity generate low credit spreads and high asset prices; an economic boom is ensued. This initial process is characterized by the mispricing of default risk.
Subsequently, banks are unprotected, unable to absorb defaults, banking capital is depleted and output decreases sharply due to credit supply shortages. The behavior bias
introduced is crucial in amplifying the movements in economic fundamentals, helping the model in generating dynamic patterns closer to the ones observed during financial crises. We also show that these biases are more likely to occur the greater the sensitivity of banking
profits and leverage to the business cycle. Finally, using optimal incentive contracts we link the preference structure underlying the awareness decision to the composition of banking sector compensation; payoffs heavily skewed towards short-term gains induce the occurrence of persistent beliefs.

Item Type:	Working or Discussion Paper (Working Paper)
Subjects:	H Social Sciences > HB Economic Theory
Divisions:	Faculty of Social Sciences > Economics
Publisher:	Department of Economics, University of Warwick
Place of Publication:	Coventry
Official Date:	December 2011
Dates:	Date Event December 2011 ["eprint_fieldopt_dates_date_type_available" not defined]
Number of Pages:	41
Status:	Not Peer Reviewed
Publication Status:	Unpublished
Access rights to Published version:	Open Access

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