4  Individuals might receive intrinsic utility from being thought of as high ability, or it might matter materially if future job prospects (including wages) depend on current reputation (see Scharfstein and Stein (1990)). The threat of corporate takeovers might also generate shortened managerial horizons, or agents might engage in hyperbolic discounting, which generates a short-term bias. 5  We assume no discounting, as in Rajan (1994). The qualitative results would not change were we to consider it. 6  is the probability assigned by the market of the bank being high ability, conditional on the bank setting a risky policy (unobserved by the market), the asset being bad, the macro state being and proportion other banks also setting risky policies. 4  BIS Review 168/2010  When the loan is bad, setting a tight (superscript ) policy yields  as the probability of a loss is unity under a tight policy and the bank obtains reputation . 7  The evolution of reputation is key for determining behavioural dynamics in the model. The marginal effect on reputation of banks adopting risky rather than tight policies is given by  improvements in the macro state increase the incentive banks face to We posit liberalise their risk management policies. When the macro state is good, any negative earnings are more likely to be attributed to low ability. This is the “Prince constraint”.
Andrew G Haldane: Curbing the credit cycle Speech presented by Andrew G Haldane, Executive Director, Financial Stability, Bank of England, at the Columbia University Center on Capitalism and Society Annual Conference, New York, 20 November 2010. *  *  *  The speech was prepared by Messrs David Aikman, Andrew G Haldane and Benjamin Nelson. The views are not necessarily those of the Bank of England. We are grateful to Piergiorgio Alessandri, Richard Barwell, Salina Ladha, Roland Meeks, Victoria Saporta and Alan Taylor for comments. Thanks to Vijay Balle and Clare Rogowski for excellent research assistance and to Moritz Schularick and Alan Taylor for making their data available to us. 1. Introduction  Credit lies at the heart of crises. Credit booms sow the seeds of subsequent credit crunches. This is a key lesson of past financial crashes, manias and panics (Minsky (1986), Kindleberger (1978), Rogoff and Reinhart (2009)). It was a lesson painfully re-taught to policymakers during the most recent financial crisis. This time’s credit cycle has been particularly severe and synchronous. In 2006, private sector credit across the UK, US and euro area rose by around 10%. During 2009, private credit in these countries fell by around 2%. 1 The knock-on consequences for real growth were equally severe and synchronous. Peak to trough, G7 real output fell by 3.6% during the Great Recession. In response, there have been widespread calls for remedial policy action. These proposals come in various stripes.