A Dynamic Theory of Lending Standards

Citation:

Michael Fishman, Jonathan Parker, and Ludwig Straub. 2019. “A Dynamic Theory of Lending Standards”.
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Abstract:

We propose a dynamic model of credit markets, in which there is a novel two-way interaction between lending standards and the quality composition of the borrower pool. Borrowers can be of high or low types, and each lender privately decides on its lending standard, modeled as the option to screen out low types with some probability. Lending standards are dynamic strategic complements: Screening worsens the borrower pool, increasing the incentive to screen going forward. Despite the complementarity, the equilibrium is unique, but may exhibit two stable steady states, one with normal lending standards and one with tight lending standards. Thus, even temporary adverse shocks can have amplified and long-lasting effects on the health of credit markets. According to the model’s normative predictions, lending standards are inefficiently tight during such episodes, since screening banks do not internalize their effect on the quality of the borrower pool. We discuss several policies such as government support for lending that can help ameliorate this inefficiency, along with several pitfalls to avoid.
Last updated on 04/22/2020