Lending standards, productivity, and credit crunches

Abstract

We propose a macroeconomic model in which adverse selection in investment amplifies macroeconomic fluctuations, in line with the prominent role played by the credit crunch during the financial crisis. Endogenous lending standards emerge due to an informational asymmetry between borrowers and lenders about the riskiness of borrowers. By using loan approval probability as a screening device, banks ration credit following increases in lending risk, generating large endogenous movements in TFP, explaining why productivity often falls during crises. Furthermore, the mechanism implies that financial instability is heightened when interest rates are low.

Assessing the Impact of Basel III: Evidence from Structural Macroeconomic Models

“…A third mechanism is asymmetric information on credit risk between firms (which know the risk) and banks (which do not), leading to adverse selection and credit rationing. During a savings glut the risk of default increases to the point where banks decide not to lend all available funds and restrict credit to safe firms (Swarbrick, 2019). Lastly, intermediaries can differ with respect to their probability of default.…”