A Dynamic Theory of Bank Lending, Firm Entry, and Investment Fluctuations

Abstract

This paper offers a dynamic theory of bank lending standards with two features. First, bank screening takes time. Second, the borrower pool is determined endogenously by firm entry. I show that in booms, banks reduce standards by offering unscreened credit to any borrower, which results in many low-quality firms entering the pool. In busts, high-quality borrowers delay borrowing if the average quality of the pool is sufficiently low. If so, banks increase standards by offering credit only after screening. With that expectation, only high-quality firms enter the pool. The implied investment fluctuations can be related to macroeconomic recoveries.

Keywords: Bank Lending Standards, Dynamic Adverse Selection, Credit Cycle