European Business Schools Librarian's Group
ESSEC Working Papers,
ESSEC Research Center, ESSEC Business School
No DR 09007: Banks’ risk race: a signaling explanation
Damien Besancenot () and Radu Vranceanu ()
Additional contact information
Damien Besancenot: University Paris 13 and CEPN (Centre d'Economie de l'université Paris Nord), Postal: 99, Avenue Jean-Baptiste Clément, 93430 VILLETANEUSE, FRANCE
Radu Vranceanu: ESSEC Business School, Department of Economics, Postal: Avenue Bernard Hirsch - BP 50105, 95021 CERGY-PONTOISE Cedex, FRANCE
Abstract: Many observers argue that the abnormal accumulation of risk by banks has been one of the major causes of the 2007-2009 financial turmoil. But what could have pushed banks to engage in such a risk race? The answer brought by this paper builds on the classical signaling model by Spence. If banks’ returns can be observed while risk cannot, less efficient banks can hide their type by taking more risks and paying the same returns as the efficient 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.
Keywords: Banking Sector; Imperfect Information; Risk Strategy; Risk/return Tradeoff; Signaling
12 pages, October 2009
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