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A Dynamic Theory of Lending Standards

From Michael J. Fishman, Jonathan A. Parker and Ludwig Straub

We analyze a dynamic credit market where banks choose lending standards, modeled as costly effort to screen out bad borrowers. Tighter standards worsen the borrower pool, increasing banks’ incentives to employ tight standards in the future. This dynamic complementarity in lending standards can amplify and prolong downturns, decreasing lending and increasing credit spreads. Because lending standards have negative externalities, the market can converge to a steady state with inefficiently tight lending standards. We discuss the role of optimal policy to avoid this outcome as well as the impact of balance sheet costs on lending standards.

Featured Publication

"A Dynamic Theory of Lending Standards."

Fishman, Michael J., Jonathan A. Parker, and Ludwig Straub. The Review of Financial Studies Vol. 37, No. 8 (2024): 2355-2402. Preprint. Appendix.

Learn More about Lending Markets

Current Lending Markets projects from the Consumer Finance Initiative cover topics including mortgage refinancing, lending standards and shadow debt and bankruptcy. Find more Lending Markets research here.