Lending Booms and Lending Standards

This paper examines how the informational structure of loan markets interacts with banks’ strategic behavior 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 a vis other banks are low, such as when the proportion of borrowers with unknown projects in the market increases. In equilibrium this 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 maximize aggregate surplus, they 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. Finally, we examine the effects of information sharing and bank market structure in this context. JEL: D82, G21