 Rational overoptimism and limited liabilityJournal of Monetary Economics, 2024, vol. 143, issue C Abstract: Is excessive risk-taking in credit cycles driven by incentives or biased beliefs? I propose a framework suggesting that the two are actually related and, specifically, that procyclical overoptimism can arise rationally from risk-taking incentives. I show that when firms and banks have a limited liability payoff structure, they have lower incentives to pay attention to the aggregate conditions that generate risk. This leads to systematic underestimation of the accumulation of risk during economic booms and overoptimistic beliefs. As a result, agents lend and borrow excessively, further increasing downside risk. Credit cycles driven by this new “uninformed” risk-taking are consistent with existing evidence such as high credit and low-risk premia predicting a higher probability of crises and negative returns for banks. My model suggests that regulating incentives can decrease overoptimistic beliefs and thus mitigate boom-and-bust cycles. Keywords: Overoptimism; Expectations; Information; Limited liability; Credit cycles (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:moneco:v:143:y:2024:i:c:s0304393223001344 DOI: 10.1016/j.jmoneco.2023.11.002 Access Statistics for this article Journal of Monetary Economics is currently edited by R. G. King and C. I. Plosser More articles in Journal of Monetary Economics from Elsevier |
Is your work missing from RePEc? Here is how to contribute.
Questions or problems? Check the EconPapers FAQ or send mail to .
EconPapers is hosted by the
School of Business at Örebro University.