Bank Credit Cycles

Abstract

A bank determines whether potential borrowers are credit-worthy, that is, whether they meet the bank's credit or lending standards. In making this determination, each bank is in competition with other banks, but without knowing the competitor banks' credit standards. The resulting unique form of competition leads to endogenous credit cycles, periodic "credit crunches." Empirical tests of this repeated bank lending game are constructed based on parameterizing public information about relative bank performance that is at the root of banks' beliefs about rival banks' lending standards. The relative performance of rival banks has predictive power for subsequent lending in the credit card market, where we can identify the main competitors. At the macroeconomic level, the relative bank performance of commercial and industrial loans is an autonomous source of macroeconomic fluctuations. In an asset pricing context, the relative bank performance is a priced risk factor for both banks and nonfinancial firms. The factor-coefficients for non-financial firms are decreasing with size, consistent with smaller firms being more bank-dependent.

Keywords: credit cycles, credit crunches

JEL Classification: E32, E44, G21