Endogenous screening, credit crunches, and competition in laxity

• Author: Scott Hoover,Sherrill Shaffer
• DOI: http://doi.org/10.1016/j.rfe.2007.09.001
• Published date: 01 December 2008
• Date: 01 December 2008

Endogenous screening, credit crunches, and competition in laxity

Sherrill Shaffer

a,

⁎

,1

, Scott Hoover

b

a

Department of Economics and Finance (Department 3985), University of Wyoming, 1000 East University Ave., Laramie,

WY 82071, United States

b

Washington and Lee University, United States

Received 25 July 2006; received in revised form 29 May 2007; accepted 5 September 2007

Available online 29 September 2007

Abstract

A simple model of lending with endogenous screening predicts that risk-neutral banks tend to adopt tighter

lending standards under several conditions commonly seen in recessions: lower interest rates (or spreads), higher

default rates, or a smaller fraction of good borrowers. Historical data support these predictions. In addition, better

information about borrower types encourages tighter lending standards, and competition in laxity can arise with

multiple banks. Within the class of symmetric screening decisions, endogenizing the interest rates disrupts the

existence of equilibrium in pure strategies, just as when screening decisions are assumed to be exogenous.

© 2007 Elsevier Inc. All rights reserved.

JEL codes: G21; D81

Keywords: Lending; Screening; Credit crunches; Prisoner's dilemma

1. Introduction

Economic downturns typicallywitness a decreased volume ofbank lending, often with nonpricerationing

of credit—ap henomenon termed “credit crunches”(Schreft,1990; Schreft & Owens,1995; Weinberg,1995;

Yuan & Zimmermann, 2004)or“financial crises”(Chan-Lau & Chen, 2002; Schneider & Tornell, 2004).

Conversely, banks often expand their lending during macroeconomic growth phases by relaxing terms and

standards (English and Reid (1994),p.485;Weinberg (1995)).Such systematic switching between tight and

Review of Financial Economics 17 (2008) 296–314

www.elsevier.com/locate/rfe

⁎Corresponding author. Tel.: +1 307 766 2173, fax: +1 307 766 5090.

E-mail address: shaffer@uwyo.edu (S. Shaffer).

1

The authors are grateful for suggestions from Ken Kopecky, Fred Sterbenz, and a referee.

1058-3300/$ - see front matter © 2007 Elsevier Inc. All rights reserved.

doi:10.1016/j.rfe.2007.09.001

lax lending standards over the business cycle has been observed in the U.S. (Asea & Blomberg, 1998),

Scandinavia (Holmstrom & Tirole, 1997), Germany (Nehls & Schmidt, 2004), Mexico (Torne ll ,

Westermann, & Martinez, 2004), Namibia (Ikhide (2003)), and Asia (Agenor, Aizenman, & Hoffmaister,

2004; Chan-Lau & Chen, 2002).

The causes of this regime switching have been widely debated. Guttentag and Herring (1984) show

how cognitive bias by lenders, including overweighting current information on the value of collateral, can

lead to regimes of credit rationing, depending on prevailing financial conditions. Rajan (1994) shows that

managerial myopia can generate cyclical herd behavior as a type of market failure. Azariadis and Smith

(1998) show that heterogeneity and private information in an overlapping generations economy can

induce repeated switching between Walrasian regimes and regimes of credit rationing. Shaffer (1999)

suggests that cyclical fluctuations in banks' use of the discount window may contribute to credit crunches.

Heterogeneity in households' occupational choice (Yuan & Zimmermann, 2004) or between tradable and

nontradable sectors with bailout guarantees (Schneider & Tornell, 2004) has also been suggested to

trigger such fluctuations. Chan-Lau and Chen (2002) show that costly loan monitoring with capital inflow

inertia can yield credit crunches. There is substantial empirical evidence that regulatory capital

requirements played a role in the 1990–91 U.S. credit crunch (Bernanke & Lown, 1991; Hancock &

Wilcox, 1994, 1998; Peek & Rosengren, 1995a,b; Shrieves & Dahl, 1995), and Holmstrom and Tirole

(1997) show how capital constraints on both banks and borrowers can contribute to a credit crunch.

This paper contributes to our understanding of regime switching in lending by showing its rationality in

a simple model that abstracts from three features previously used in such derivations, thus establishing

that those complications are not necessary to generate the observed behavior. First, unlike Holmstrom and

Tirole (1997) and Shaffer (1999), our model has no capital constraints. Previous empirical studies have

sharply debated the extent to which capital regulations contributed to the U.S. credit crunch of the early

1990s. Our model lends theoretical support to the plausibility of studies such as Berger and Udell (1994)

and Sharpe (1995), who conclude that the empirical evidence does not convincingly demonstrate that

capital regulations were a dominant cause of the credit crunch. As a corollary, our model further

demonstrates that credit crunches cannot necessarily be eliminated by relaxing such capital regulations.

Second, in contrast to Rajan (1994), our model does not assume myopic banks, thereby establishing a

more fully rational basis for regime switching. Unlike Guttentag and Herring (1984), we do not rely on

cognitive bias by lenders. Our model's staticstructure shows regime switchingdoes not require overlapping

generations, infinite horizons, or other dynamic interactions.

As in Azariadis and Smith (1998), our model incorporates adverse selection of borrowers in the face of

imperfect screening. However, unlike their model—and more realistically—we do not require borrowers

to know their own type, so self-selecting contracts are not feasible. No additional market failures,

frictions, or regulatory distortions are required for our results.

1

Three main results emerge. First, banks may adopttighter lending standards under conditions commonly

seen in recessions: lower interest rates, higher loan default rates, or a smaller fraction of good borrowers.

2

1

Lang and Nakarama (1989) provide a theoretical basis for the cyclical pattern of pricing found by Petersen and Rajan (1995),

given asymmetric information. Our analysis, unlike theirs, shows regime switching need not require dynamic interactions, nor

that borrowers know their own type.

2

The relation between interest rates and the business cycle is less straightforward. Asea and Blomberg (1998, p. 101) show

that the risk-free rate tends to rise going into a recession but falls during recessions, while interest rate spreads display more

mixed results over the cycle (Holmstrom & Tirole, 1997 p. 664). In our model, the interest rate on loans also reflects the spread

over the cost of funds; in Section 4, we provide empirical evidence that spreads decline during recessions.

297S. Shaffer, S. Hoover / Review of Financial Economics 17 (2008) 296–314