23. maj 2016

Søren Hove Ravn publishes in the Journal of Economic Dynamics and Control

Endogenous Credit Standards and Aggregate Fluctuations

A frequent claim during economic downturns is that banks are unwilling to extend loans even to financially sound households and firms. Likewise, economic booms are often associated with examples of loans being granted to less creditworthy applicants. This type of anecdotal evidence suggests that credit standards applied by banks and other financial institutions change systematically over the business cycle, and more so than what can be explained by mechanical shifts in the quality of the pool of loan applications. This notion is supported by empirical evidence from a range of econometric studies, which has established the presence of countercyclical changes in lending standards: These are relaxed when the economy is booming, and vice versa.

While many theoretical explanations for this phenomenon have been proposed, few attempts have been made to incorporate these theories into macroeconomic models in order to quantify their impact on the size and shape of business cycle fluctuations.

In this paper, Søren Hove Ravn devises a general equilibrium model of the macroeconomy in which countercyclical movements in lending standards emerge as an equilibrium outcome. In other words, these movements are the result of optimizing behavior by each individual bank. In the model, banks compete on lending rates as well as collateral requirements. This competition is affected by the existence of lending relationships between individual firms and banks, in line with the literature on relationship banking: Once a firm has established a relationship with a bank, the firm will be tempted to stay with this bank in the future, so as to avoid the switching costs associated with changing banks, e.g., building a solid credit score, obtaining a good valuation of its collateral, etc. This induces banks to loosen their credit standards during economic booms in order to expand their current and future market share and tie in potential borrowers for the future, whereas in a recession, banks instead choose to extract profits from their current customer base by tightening their lending standards or increasing their lending rate margins.

Once incorporated into a properly calibrated general equilibrium model of the macroeconomy, fluctuations in lending standards turn out to be an important amplifier of business cycle fluctuations. The author finds that endogenous credit standards increase the volatility of GDP by around 25% over the course of the business cycle. This highlights the quantitative relevance of accounting for such fluctuations in macroeconomic models. Finally, the author demonstrates that in order to combat the effects of endogenous credit standards on macroeconomic volatility, a countercyclical loan-to-value ratio is an effective macroprudential policy tool.

You can read the full length journal article at Science Direct or as a pre-print at Søren Hove Ravn's website.