BANKSRISK RACE: A SIGNALING EXPLANATION

Abstract

Many observers argue that one of the major causes of the 2007-2009 recession was the abnormal accu-mulation of risk by banks. This paper provides a signaling explanation for this race for risk. If banks returns can be observed while risk cannot, the less e ¢ cient banks can hide their type by taking more risks and paying the same returns as the more e ¢ cient banks. The latter can signal themselves by taking even higher risks and delivering bigger returns. The game presents several equilibria that are all characterized by excessive risk taking as compared to the perfect information case

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