Skill, Luck, and Financial Crises
46 Pages Posted: 17 May 2013 Last revised: 20 Nov 2013
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: Suggested Citation