Abstract
We examine informational efficiency in retail credit markets to test whether behavioral biases by participants in the banking industry might explain credit cycles. We offer a simple model of herding and limits of arbitrage in retail credit markets that follows the behavioral approach of Shleifer (2000). We show why solely behavioral biases by participants in the industry could explain how a credit bubble might be feeded by the banking sector. According to our model, optimistic banks would lead the industry while it would be rational for unbiased banks to herd under conditions we derive. An important finding is the role of limits of arbitrage in the industry: there would be no incentives for rational banks to correct the misallocations of their biased competitors. Informational efficiency, therefore, would rely solely on authorities.
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