Success-Driven Skill Inferences and Financial Crises

This paper explains why crises follow periods of sustained banking profitability. When there is a “down” macroeconomic state in which outcomes are exogenous and an “up” state in which they depend on agents’ risk-management skills, periods of up macro states and banking profitability cause all agents to elevate their estimates of these skills. Everybody consequently become sanguine about bank risk, and banks choose increasingly riskier assets. The consequent increased liquidity attracts additional institutions to invest. Subsequently, the occurrence of the down macro state leads to fund withdrawals, vanishing liquidity, and a crisis. Regulatory implications of the analysis are extracted.

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