Foreseen Risks

Gomes, J F, Grotteria, M and Wachter, J A (2023) Foreseen Risks. Journal of Economic Theory, 212. p. 105706. ISSN 0022-0531

Abstract

Large crises tend to follow rapid credit expansions. Causality, however, is far from obvious. We show how this pattern arises naturally when financial intermediaries optimally exploit economic rents that drive their franchise value. As this franchise value fluctuates over the business cycle, so too do the incentives to engage in risky lending. The model leads to novel insights on the effects of unconventional monetary policies in developed economies. We argue that bank lending might have responded less than expected to these interventions because they enhanced franchise value, inadvertently encouraging banks to pursue safer investments in low-risk government securities.