On informational efficiency of the banking sector: a behavioral model of the credit boom
Abstract
Purpose
This paper aims to examine the informational efficiency in retail credit markets to test whether behavioral biases (excessive optimism) by some participants in the banking industry might explain how credit booms are fueled by the banking sector.
Design/methodology/approach
This paper analyzes the conditions for the efficient market hypothesis approach to be extended to bank-based systems. A simple model of herding and limits of arbitrage that follows a three-step behavioral approach is presented (Shleifer, 2000). The model is based on duopolistic Cournot competition, where one bank is unbiased and the other is boundedly rational in terms of excessive optimism.
Findings
The paper shows why solely behavioral biases by participants in the banking industry explain how it feeds a credit bubble. According to the presented model, optimistic banks would lead the industry, while it would be rational for unbiased banks to herd under conditions that the authors derive. An important finding is the role of limits of arbitrage in the banking sector: there would be no incentives for rational banks to correct the misallocations of their biased competitors.
Practical implications
It might be a valid contribution to the current debate on macroprudential regulation. Should tests of rationality and correlated behavior provide evidence on the pervasiveness of behavioral biases in the banking industry suggested by our model, then banking regulation should account for it.
Originality/value
This paper introduces an alternative approach to analyze informational efficiency in the banking industry that, to the best of our knowledge, had not been raised so far. The model shows how behavioral biases might guide retail credit markets and why limits of arbitrage would be more pervasive in bank-based financial systems than in market-based ones.
Keywords
Acknowledgements
The authors are indebted to Professor Hamid Uddin and to two anonymous reviewers for valuable comments and suggestions. The authors also acknowledge Tomasz Michalski (HEC Paris) for his suggestions in the 19th MFS Conference, Krakow, June 2012, and Enrico Cervellati (Università di Bologna) for valuable insights in the area of behavioral finance. Thanks are also due to Manuel Gómez, Paulino Martínez, José A. Seijas and Marcos Vizcaino for technical assistance. Manel Antelo acknowledges financial aid received from the Galician regional government (Xunta de Galicia) and FEDER through project “Consolidación e estruturación GPC2013-045/GI2060 Análise económica dos mercados e institucións (AEMI)”. A former draft of the model in this paper was released as a working paper by IDEGA.
Citation
Peon, D., Calvo, A. and Antelo, M. (2015), "On informational efficiency of the banking sector: a behavioral model of the credit boom", Studies in Economics and Finance, Vol. 32 No. 2, pp. 158-180. https://doi.org/10.1108/SEF-04-2013-0050
Publisher
:Emerald Group Publishing Limited
Copyright © 2015, Emerald Group Publishing Limited