Purpose – This paper aims to examine the informational efficiency in retail credit markets to test whether behavioral biases (excessive optimism) by some participants in the banking industry might explain how credit booms are fueled by the banking sector. Design/methodology/approach – This paper analyzes the conditions for the efficient market hypothesis approach to be extended to bank-based systems. A simple model of herding and limits of arbitrage that follows a three-step behavioral approach is presented (Shleifer, 2000). The model is based on duopolistic Cournot competition, where one bank is unbiased and the other is boundedly rational in terms of excessive optimism. Findings – The paper shows why solely behavioral biases by participants in the banking industry explain how it feeds a credit bubble. According to the presented model, optimistic banks would lead the industry, while it would be rational for unbiased banks to herd under conditions that the authors derive. An important finding is the role of limits of arbitrage in the banking sector: there would be no incentives for rational banks to correct the misallocations of their biased competitors. Practical implications – It might be a valid contribution to the current debate on macroprudential regulation. Should tests of rationality and correlated behavior provide evidence on the pervasiveness of behavioral biases in the banking industry suggested by our model, then banking regulation should account for it. Originality/value – This paper introduces an alternative approach to analyze informational efficiency in the banking industry that, to the best of our knowledge, had not been raised so far. The model shows how behavioral biases might guide retail credit markets and why limits of arbitrage would be more pervasive in bank-based financial systems than in market-based ones.

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Purpose The efficient market hypothesis (EMH) states that asset prices in financial markets always reflect all available information about economic fundamentals. The purpose of this paper is to provide a guide as to which predictions of the EMH seem to be borne out by empirical evidence. Design/methodology/approach Rather than following the classic three groups of tests for the different forms of EMH that are common in the literature, the authors consider how the two alternative definitions of the EMH and the joint hypothesis problem impact on the tests and leave the controversy unsolved. The authors briefly report the antecedents, the main theoretical and empirical contributions and recent literature on each type of tests. Findings Eventually, as a summary for each type of tests, the authors provide a critical view on the main sources of acrimony between the alternative schools of thought in understanding asset price formation. Originality/value The paper may be seen as an up-to-date introductory review for researchers on the different tests of the EMH performed, and for newcomers to understand the key sources of acrimony between rationalists and behaviorists.

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.

2008 world financial meltdown highlighted significant shortcomings on procedures used by the banking sector to provide credit to the real economy. A long period of indulgence granting personal loans and mortgages that boosted a credit bubble all over the world has been followed by an era of suspicion within the banking sector, precipitating the liquidity crunch and the credit squeeze to private agents. Behavioral Finance has emerged as an alternative approach to analyze efficiency on financial markets, revealing a world with less than fully rational investors and arbitrageurs limited by risk aversion, short time horizons and agency problems. In this paper we consider the possibility to extend Behavioral Finance topics such as investor sentiment, overconfidence, heuristics or herd instinct to analyze banks behavior when providing credit to private agents, and how the absence of arbitrageurs in the credit market could justify the role of public banking as a countercyclical policy maker.