A theory of procyclical bank herding

Finance

IFA Working Paper

2004

When bank loan returns have a systematic factor, the failure of one bank conveys adverse information about this systematic factor and increases the cost of borrowing for the surviving banks relative to the situation of no bank failures. Such information spillover is costly to profit-maximizing bank owners. Given their limited liability, bank owners herd ex-ante and undertake correlated investments to increase the likelihood of joint survival. Competitive effects such as superior margins from lending to different industries and migration of depositors of a failed bank to the surviving bank mitigate herding incentives. When expected returns on loans are low (economic booms), the herding incentives dominate, whereas when expected returns are high (economic downturns), the competitive effects dominate. This gives rise to a pro-cyclical pattern in the industry based concentration of aggregate bank lending.

Institute of Finance and Accounting

FIN 408

IFA Working Paper

No