When Banks Get Picky about Lending, the Economy May Suffer

For banks, there is an important trade-off at play here. A tighter 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 who applies for a loan. Looser standards are cheaper, but they come with the risk of lending to lower-quality borrowers who might default on a loan.

What’s more, the decisions that one bank makes about its lending standards also affect the decisions that other lenders might make down the line. “Tight lending standards actually impose a negative externality on other lenders,” says Michael Fishman, a professor of finance at the Kellogg School of Management. “Banks with tight standards systematically fund good borrowers and remove them from the pool, leaving less creditworthy borrowers and diminishing 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 one bank tightening its standards leads to other banks tightening their standards.

This pattern, the economists say, results in an overly restrictive and inefficient lending environment that can ultimately prolong economic downturns. In short, though tight lending standards offer banks the immediate benefit of screening out low-quality requests, they can create long-term problems for the broader lending ecosystem.

A model of lending standards

These findings hinge on an economic model that Fishman, Parker, and Straub created to examine the dynamic relationship between banks’ lending standards and the quality of borrowers.

The model assumes that there are two types of borrowers: “high-quality” borrowers who have a high likelihood of paying back the loan and “low-quality” borrowers who have a lower likelihood of doing so.

When banks rely on a tight lending standard, the model shows that the quality of available borrowers deteriorates over time, which gives banks a stronger incentive to tighten their standard even more. Conversely, a looser lending standard allows banks to fund a wider pool of borrowers, which improves the quality of available borrowers over time and, in turn, helps loosen standards further.

These outcomes are similar to the process that a life insurance company might follow when deciding whether to conduct physical exams that assess the health of their potential customers, Fishman says. A physical exam costs the insurance companies a lot up front, but it sets a high (or tight) standard that enables them to find the healthiest customers and likely save money down the line. This leaves behind a pool of less healthy—and likely more costly—customers for the companies that don’t perform physicals. “If I’m doing medical exams and you’re not, then you’re systematically picking the ‘bad’ life risks,” he says.

Under normal economic circumstances, the model finds, banks tend to favor loose standards, which establishes a pool of high-quality borrowers that is self-reinforcing—at least to a point. The pool of borrowers thus remains healthy until the economy is hit by a major economic event. The American subprime mortgage crisis, for instance, caused banks to suddenly tighten their standards, which plunged the health of the borrower pool. This ultimately led to higher rates and lower lending volume, a condition that persisted for quite some time.

“The quality of a pool can go up and up to a certain point, or down and down, but eventually it stops improving or deteriorating,” Fishman says. “But if the pool gets bad enough, then no bank can make a profit and lending will stop. You need something to get 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 to all of them. Yet banks are not always prepared to take on the risk required to do so, particularly when conditions start slipping toward tight lending standards. This is where government intervention may come into play.

For example, during the subprime mortgage crisis, mortgage lending had ground to a halt. The Treasury and the Federal Reserve “stepped up to provide additional lending because banks weren’t lending,” Fishman says. To kickstart this and other lending markets, the government bought lots of bad assets to “raise the quality of the borrower pool and bring back lenders other than the government.”

The researchers demonstrate that there is a “window of opportunity” during which action must be taken to prevent the lending market from shifting from a healthy state to a bad one.

The more lending standards tighten and the pool of borrowers worsens, the more expensive it becomes to return to good lending conditions. There is a threshold beyond which intervention becomes so costly that it becomes impractical. “If you wait too long, then it simply isn’t worth it,” Fishman says.

Simple advice for lenders and regulators

These findings suggest that lenders who are thinking about how much due diligence to exercise should pay close attention not only to the creditworthiness of individual borrowers, but also to the quality of the overall borrower pool.

Regulators, for their part, should pay careful attention to the lending practices of banks as a proxy for the overall health of the lending ecosystem. As lending volumes dip and standards tighten, the government may need to step in to support the market and prevent it from slipping irreversibly into a negative state.

“We don’t, unfortunately, have a set of statistics to say that when credit spreads are here and lending volume is there, then intervention is necessary,” Fishman says. “But if some negative shock hits a market, then regulators ought to start paying attention … and the sooner the better.”