For banks, there is an important trade-off here. A stricter standard can help them identify more reliable borrowers, but it requires more resources. It is expensive, for example, for banks to spend time researching a candidate applying for a loan. Looser standards are cheaper but carry the risk of lending to lower-quality borrowers who might default on a loan.
In addition, the decisions a bank makes about its lending standards also affect the decisions other lenders may make down the line. “Tight lending standards actually impose a negative externality on other lenders,” he says Michael Fishmanprofessor of economics at the Kellogg School of Management. “Banks with strict standards systematically fund good borrowers and remove them from the pool, leaving fewer creditworthy borrowers and reducing the quality of the overall borrower pool.”
Together with Jonathan Parker of MIT and Ludwig Straub of Harvard, Fishman demonstrates how the push for tighter standards creates a self-reinforcing feedback loop in which a bank that tightens its standards leads other banks to tighten theirs.
This pattern, economists say, leads to an overly restrictive and inefficient lending environment that may ultimately prolong the recession. In short, although strict lending standards offer banks the immediate benefit of controlling low-quality requests, they can create long-term problems for the broader lending ecosystem.
A model of lending standards
These findings are based on an economic model created by Fishman, Parker, and Straub to examine the dynamic relationship between bank lending patterns and borrower quality.
The model assumes that there are two types of borrowers: “high-quality” borrowers who have a high probability of repaying the loan and “low-quality” borrowers who have a lower probability of doing so.
When banks rely on strict lending standards, the model shows that the quality of available borrowers deteriorates over time, which gives banks a stronger incentive to tighten their standards even more. Conversely, a looser lending standard allows banks to finance a wider pool of borrowers, which improves the quality of available borrowers over time and, in turn, helps ease standards further.
These results are similar to the process a life insurance company might follow when deciding whether to conduct physical exams that assess the health of potential customers, Fishman says. A physical exam costs insurance companies a lot upfront, but it sets a high (or strict) standard that allows them to find the healthiest customers and likely save money down the line. This leaves behind a pool of less healthy—and possibly more costly—customers for companies that don’t have physical performance. “If I take medical tests and you don’t, then you’re systematically choosing the ‘bad’ risks of life,” he says.
Under normal economic conditions, the model finds, banks tend to favor loose standards, which create a pool of high-quality borrowers that is self-reinforcing—at least to a point. Thus, the pool of borrowers remains healthy until the economy is hit by a major economic event. The US subprime mortgage crisis, for example, suddenly caused banks to tighten their standards, which sank the health of the borrower pool. This ultimately led to higher interest rates and lower loan volumes, a situation that persisted for some time.
“The quality of a pool can go up to a certain point, or down and down, but eventually it stops improving or degrades,” says Fishman. “But if the pool gets bad enough, then no bank can make a profit and lending stops. You need something to pull you out of that bad pool.”
The guardrails of government policy
Because borrowers are a common resource for banks, maintaining a healthy pool of borrowers is important for all of them. However, banks are not always ready to take the risk required to do so, particularly when conditions begin to slide towards tight lending standards. This is where the game of government intervention can come into play.
For example, during the subprime crisis, mortgage lending had ground to a halt. The Treasury Department and the Federal Reserve “stepped in to provide additional lending because the banks weren’t making loans,” says Fishman. To start this and other lending markets, the government bought many bad assets to “increase the quality of the borrower pool and bring back other non-government lenders.”
The researchers demonstrate that there is a “window of opportunity” during which action must be taken to prevent the loan market from moving from a healthy state to a bad one.
As lending standards tighten and the pool of borrowers deteriorates, the more expensive it becomes to return to good lending conditions. There is a threshold beyond which intervention becomes so costly as to be impractical. “If you wait too long, then it’s just not worth it,” says Fishman.
Simple tips for lenders and regulators
These findings suggest that lenders considering how much due diligence to conduct should pay close attention not only to the creditworthiness of individual borrowers, but also to the quality of the overall pool of borrowers.
Regulators, for their part, should pay close attention to banks’ lending practices as an indicator of the overall health of the lending ecosystem. As lending volumes decline and standards tighten, the government may need to step in to support the market and prevent it from slipping irrevocably into negative territory.
“Unfortunately we don’t have a set of statistics to say that when the credit spreads are here and the lending volume is there, then intervention is necessary,” says Fishman. “But if a negative shock hits a market, then regulators should start paying attention … and the sooner the better.”
