A Dynamic Theory of Lending Standards

We develop a tractable dynamic model of credit markets in which lending standards and the quality of potential borrowers are endogenous. Competitive banks privately choose their lending standards: whether to pay a cost to screen out some unprofitable borrowers. Lending standards have negative externalities and are dynamic strategic complements: tighter screening worsens the future pool of borrowers for all banks and increases their incentives to screen in the future. Lending standards can amplify and prolong temporary downturns, affecting lending volume, credit spreads, and default rates. We characterize constrained-optimal policy which can generally be implemented as a government loan insurance program. When markets recover, they may do so only slowly, a phenomenon we call “slow thawing.” Finally, we show that limits on lending such as from capital constraints naturally incentivize tight lending standards, further amplifying shocks to credit markets