"...changes in lending standards have the greatest impact during expansions when banks sow the seeds of future recessions by lending to borrowers who are likely to default."
The popular press has been full of assertions lately that the business cycle is dead. The growth of the less cyclical service and government sectors, better inventory management by manufacturers, and the revolutionary effects of new information technologies all have been offered as reasons why recessions are a thing of the past.
But another major contributor to the boom and bust nature of the business cycle, and one that has shown no signs of fading into irrelevance, is the way that banks alter their lending standards over economic peaks and troughs. In Lending Cycles (NBER Working Paper No. 5951), Patrick Asea and S. Brock Blomberg document systematic patterns in lending standards, with banks tightening credit in recessions and easing it during expansions. Indeed, the authors argue that the loans extended on "easier" terms during expansions return to haunt the banks as problem loans during contractions.
One of the major difficulties economists have faced in determining the effect of bank lending on the aggregate economy is the lack of detailed data on the terms of individual loan contracts. Asea and Blomberg overcome this problem by constructing a new bank-level panel dataset using information on the contract terms of close to two million commercial loans. (The data come from the Federal Reserve System.) The authors use quarterly data from 1977 to 1993 to measure how the size of loans, the risk premiums that banks charge on loans, and the probability that banks require collateral on loans varies over time. They then compare this information to fluctuations in economic activity and unemployment.
Asea and Blomberg find that in contractionary phases of the business cycle, the risk premiums that banks charge increase, loan size is unaffected, and the probability of collateralization rises. In expansionary times, risk premiums decline, loan size increases, and the probability of collateralization declines. Unlike previous research that has failed to find a significant relationship between credit market behavior and the aggregate economy, the authors find that during recession the average interest rate doubles relative to the three-month Treasury bill rate resulting in approximately 50,000 layoffs.
An intriguing finding of this study is that changes in lending standards have the greatest impact during expansions when banks sow the seeds of future recessions by lending to borrowers who are likely to default. The authors argue that banks' propensity to over-lend during expansions is not a cause of irrational exuberance but appears to be an inherent feature of the banking business.