Bank Credit Standards (Second Quarter 2009 Business Review)

*The views expressed here are those of the author and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. 1 Most observers view the expansion of high-risk mortgage loans between 2004 and 2006 as a particularly dramatic example of a widespread decline in lending standards. While the research on this episode is expanding rapidly, the evidence is too recent to interpret with confidence or to incorporate into this article. Nonetheless, the theories I discuss in this article will certainly be part of a full explanation for the recent financial crisis. Bankers and the business press often speak of cycles in bank credit standards, periods in which banks’ lending standards are too lax, followed by periods in which standards are too stringent. In this view, bank lending policies tend to amplify fluctuations in GDP; easy money during the upturn anks’ lending standards at times seem too stringent and at other times too lax. The pattern seems to indicate that banks lend more easily in good times but tighten credit standards in lean times. But such a lending pattern may also be attributable to changes in borrowers’ default risk over the business cycle or changes in the demand for loans, which rises and falls with GDP. Is there a systematic reason why banks might be too lax or too stringent in their lending? Economists have proposed a number of models to explain a bank lending cycle, including changes in bank capital, competition, or herding behavior. In this article, Mitchell Berlin discusses these models and the empirical evidence for each.