Skill, Luck, and Financial Crises

46 Pages Posted: 17 May 2013 Last revised: 20 Nov 2013

See all articles by Anjan V. Thakor

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School; Financial Theory Group; European Corporate Governance Institute (ECGI); Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

Date Written: April 22, 2013

Abstract

This paper explains why crises follow periods of sustained banking profitability in an environment in which there is uncertainty about whether outcomes depend on the risk management skills of banks, or are just based on luck, in the spirit of Piketty’s Model (1995) of “left-wing” and “right-wing” dynasties. Periods of sustained banking profitability cause all agents to elevate their estimates of bankers’ skills, despite the uncertainty about what is driving outcomes. Everyone consequently becomes sanguine about bank risk, and banks choose increasingly risky assets. The consequent increased liquidity attracts additional institutions to invest. Since banks fund themselves by borrowing from institutional investors who choose not to incur the cost to learn whether outcomes are skill-based or luck-based, the elevated perceptions of banking skills permit investment risk to continue to climb, and there are no financial crises.

However, the emergence of a credit default swap (CDS) market on the banks' debt leads to price discovery through the actions of traders who can profitably become informed about the macro state pertaining to whether outcomes are due to skill or luck. This may induce the banks' creditors to infer a high probability that outcomes are based only on luck. This leads them to refuse to roll over short-term debt, and there is a positive probability of this occurring to enough banks to precipitate a crisis. Regulatory implications of the analysis are extracted.

Keywords: financial crisis, learning, skill, luck

JEL Classification: G2, E32, D83

Suggested Citation

Thakor, Anjan V., Skill, Luck, and Financial Crises (April 22, 2013). Available at SSRN: https://ssrn.com/abstract=2265472 or http://dx.doi.org/10.2139/ssrn.2265472

Anjan V. Thakor (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

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Financial Theory Group ( email )

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European Corporate Governance Institute (ECGI) ( email )

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Belgium

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

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Cambridge, MA 02142
United States

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