DP5095 | Lending Booms and Lending Standards

Publication Date

23/06/2005

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Abstract

This paper examines how the informational structure of loan markets interacts with banks? strategic behaviour in determining lending standards, lending volumes, and the aggregate allocation of credit. In a setting where banks obtain private information about their clients? creditworthiness, we show that banks may loosen lending standards when information asymmetries vis à vis other banks are low. In equilibrium this reduction in standards leads to a deterioration of banks? portfolios, a reduction in their profits, and an aggregate credit expansion. Furthermore, we show that although these low standards may increase aggregate surplus, they also increase the risk of financial instability. We therefore provide an explanation for the sequence of financial liberalization, lending booms, and banking crises that have occurred in many emerging markets.