Banks Risk Race: A Signaling Explanation (Besancenot D., Vranceanu R.)

Information Asymmetry and Transparency Risk-taking and Risk Management

Abstract Many observers argue that one of the major causes of the 2007-2009 financial turmoil was the abnormal accumulation of risk by banks. This paper provides a signaling explanation for this "risk race." 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.
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Libref/ Besancenot D., Vranceanu R. (2010) “Banks Risk Race: A Signaling Explanation”, pp. 1-14
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