Survey_ABG_2014

Abstract

In this paper we introduce a stylized two-period model of a financial sector. There are a finite number of banks. Each bank is owned by a shareholder and operated by a manager. In each of the two time periods, each manager choses between a risky and a safe investment. The shareholder cannot control the manager’s choice directly but may pay the manager depending on the return achieved on the investment. Due to limited liability, the risky investment leads to a higher expected return for the shareholder but to social losses in the event of a crisis. Such a crisis will occur if more than a critical number of managers chose the risky investment in a given period. If a crisis occurs in the second period, then the managers lose a percentage of the income they have previously earned in the banking sector. Additionally, managers have job opportunities outside the banking sector. In this model, the optimal outcome from a social welfare point of view is that a limited subcritical number of banks invest in risky high-return assets.