Bubbles Tomorrow, Yesterday, but Never Today?

John C. Williams at the Federal Reserve Bank San Francisco discussed bubbles and takes a thorough look at asset price bubbles and sets through the assessment of bubble conditions as well as the explanation for mis-pricing.

 "Many researchers are probing why people have the procyclical pattern of optimism seen in these surveys. One key element in the theories coming out of this research is that people do not possess the full set of information assumed in the standard asset price model with rational expectations. Instead, they must make do with the limited information at hand when judging likely future discounted dividend payments and the future price of the asset. Indeed, a growing body of evidence in behavioral economics and finance shows that people’s expectations of future asset returns depend on their past experiences (Vissing-Jorgensen 2003 and Malmendier and Nagel 2011). This process of forecasting with limited information has been shown to cause forecast errors that can drive a wedge between asset prices and the values implied by economic fundamentals (Cutler, Poterba, and Summers 1991 and Barsky and DeLong 1993)."

There is more here about momentum in expectations and how this explains asset price swings.  This looks particularly at 'extrapolative expectations'.  This could be a very useful way to start building a banking model.  There are more references in the item.