The good, the bad, and the missed boom

Some credit booms result in financial crises. While excessive risk taking is a plausible cause, many investors do not anticipate increasing risk. We show that credit booms may be misunderstood as productivity-driven, due to opaque bank assets which disguise risk incentives. Balanced funding relative to productive prospects can sustain prudent lending (good boom), while funding imbalances may induce high risk exposure and boost asset prices (bad boom), or lead to asset under-pricing and insufficient lending (missed boom). Rational agents drawing inference from prices make mistakes that can amplify the effect of funding imbalances and propagate risk.