A Dynamic Behavioral Model of the Credit Boom

Abstract

[Abstract] In this paper we provide a dynamic model of banking competition where bounded rationality of some competitors explains how the credit cycle is amplified. We model the economic cycle following Rötheli (2012b) where boundedly rational banks, in their Bayesian learning, overestimate probabilities of success during booms and underestimate them during recessions. The main results obtained are three. First, the model suggests pessimism/underconfidence is not a powerful driver of credit cycles. Instead, it supports it is euphoria during large upswings what seeds the next crunch. Second, the dynamization of the model provides further insight on how boundedly rational competition amplifies the credit cycle. Finally, an additional prediction is that the effects of behavioral biases are expected to be more pervasive the lower the quality of the niche markets