Rational overoptimism and limited liability

• Published in: Journal of monetary economics 2024-04, Vol.143, p.103538, Article 103538
• Main Author: Gemmi, Luca
• Format: Article
• Language: English
• Subjects: Credit cycles; Expectations; Information; Limited liability; Overoptimism
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2023.11.002

Is excessive risk-taking in credit cycles driven by incentives or biased beliefs? I propose a framework suggesting that the two are actually related and, specifically, that procyclical overoptimism can arise rationally from risk-taking incentives. I show that when firms and banks have a limited liability payoff structure, they have lower incentives to pay attention to the aggregate conditions that generate risk. This leads to systematic underestimation of the accumulation of risk during economic booms and overoptimistic beliefs. As a result, agents lend and borrow excessively, further increasing downside risk. Credit cycles driven by this new “uninformed” risk-taking are consistent with existing evidence such as high credit and low-risk premia predicting a higher probability of crises and negative returns for banks. My model suggests that regulating incentives can decrease overoptimistic beliefs and thus mitigate boom-and-bust cycles. •Overoptimism in credit booms originates rationally from risk-taking incentives.•Payoff convexity leads to inattention to aggregate risk and “uninformed” risk-taking.•High credit growth and low risk premia predict a higher firm’s default risk.•Regulating incentives attenuates overoptimism and mitigates credit cycles.