Must-Read: Viral V. Acharya and Hassan Naqvi: On Reaching for Yield and the Coexistence of Bubbles and Negative Bubble

Must-Read: Viral V. Acharya and Hassan Naqvi: On Reaching for Yield and the Coexistence of Bubbles and Negative Bubbles: “We develop a model of financial intermediation characterized by an inside agency problem…

…such that managers ‘reach for yield’ by overinvesting in risky assets and concurrently underinvesting in safer assets when they have access to high enough liquidity. The investment preferences of managers follow a certain pecking order whereby their first preference is to invest in risky assets; their second preference is to hoard on to liquid assets (i.e. cash and cash equivalents) so as to provide a buffer against runs; and their last preference is to invest in medium-risk assets. The reaching-for-yield behavior of managers is conducive to the formation of bubbles in the market for risky assets and concurrently ‘negative bubbles’ in the market for safer (i.e. medium-risk) assets. We show that loose monetary policy reduces the cost of covering any liquidity shortfalls suffered by the intermediary which induces further ‘reaching for yield’ culminating in the coexistence of bubbles and negative bubbles in risky and safer assets respectively.