A Theory of Procyclical Bank Herding

Viral V. Acharya, Tanju Yorulmazer
2003 Social Science Research Network  
We provide an explanation for the procyclical variation in the concentration of aggregate bank lending. 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. Such information contagion is thus costly to bank owners. Given their limited liability, profit-maximizing banks herd ex-ante and undertake correlated investments to increase the likelihood of joint
more » ... hood of joint survival. If the depositors of a failed bank can migrate to the surviving bank, then herding incentives are mitigated by such competitive effects. 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 correlation of bank loan returns. The localized nature of contagion and herding, and the efficiency properties of bank lending decisions, are also characterized. J.E.L. Classification: G21, G28, G38, E58, D62.
doi:10.2139/ssrn.442860 fatcat:xmdox4773rge3mjg6qxrqym76q