Limited liability and bank herding

Finance

IFA Working Paper

2005

We show that limited liability can induce profit-maximizing bank owners to herd with other banks. 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. Bank owners herd ex ante and undertake correlated investments to increase the likelihood of joint survival: given limited liability, bank owners are not concerned about the associated increase in the likelihood of joint failure. 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.

Institute of Finance and Accounting

FIN 445

IFA Working Paper

No