Rational Cycles and Endogenous Lending Standards

Abstract

We study the equilibrium and welfare in a rational model of endogenous cycles generated by the two-way interaction between investors’ choice of lending standards and real outcomes. When lenders optimally choose lax lending standards it leads to low interest rates, high output growth, but also to the deterioration of future credit application quality. When the quality is sufficiently low, lenders endogenously switch to tight standards. This implies high credit spreads and low output, but a gradual improvement in the quality of applications, which eventually triggers a shift back to lax lending standards and the cycle continues. The equilibrium cycle might feature a long boom, a lengthy recovery, or a double-dip recession. It is generically different from the constrained efficient cycle as atomistic lenders ignore their effect on the composition of the pool of borrowers. Carefully chosen macro-prudential or counter-cyclical monetary policy often improves the decentralized equilibrium cycle. J

EL codes: D82, E32, E44, G01, G10

Keywords: lending standards; endogenous cycles; adverse selection; information choice