We examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, given lack of observability of effort, loan officers (or risk takers) are compensated based on the volume of loans but are penalized if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This 'flight to quality' leaves banks flush with liquidity, lowering the sensitivity of bankers' payoffs to downside risks of loans and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown. We show that the optimal monetary policy involves a "leaning against liquidity" approach: A Central Bank should adopt a contractionary monetary policy in times of excessive bank liquidity in order to curb risk-taking incentives at banks, and conversely, follow an expansionary monetary policy in times of scarce liquidity so as to boost investment.JEL Classifications: E32, E52, E58, G21

We examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, given lack of observability of effort, loan officers (or risk takers) are compensated based on the volume of loans but are penalized if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This 'flight to quality' leaves banks flush with liquidity, lowering the sensitivity of bankers' payoffs to downside risks of loans and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown. We show that the optimal monetary policy involves a "leaning against liquidity" approach: A Central Bank should adopt a contractionary monetary policy in times of excessive bank liquidity in order to curb risk-taking incentives at banks, and conversely, follow an expansionary monetary policy in times of scarce liquidity so as to boost investment.JEL Classifications: E32, E52, E58, G21

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