recent

4 ways the US election could impact 2025 climate policy

This Walmart executive runs on people power and consistent routines

An AI chatbot can reduce belief in conspiracy theories

Credit: stavklem / Shutterstock

Ideas Made to Matter

Financial Markets

Lending standards can be too tight for too long, research finds

By

The economy plays a huge role in lending trends, which is why it’s harder to get a loan in a recession than it is during a boom time.

Lending standards were loose during the lending boom of the mid-2000s, for example, when credit spreads and default rates were low. And standards were relatively tight during the credit crunch in 2008 – 2009, when default rates were high, and they continued to be tight even during the recovery that followed, so credit spreads also remained high.

What was notable was that lending standards were notably slow to loosen up — even after the turmoil began to ease in 2009 and into 2010, said finance professor a co-director of the MIT Golub Center for Finance and Policy and the MIT Consumer Finance Initiative.

New research from Parker and his co-authors suggests that some of the persistence of tightness after a shock is self-inflicted. When banks try to protect themselves by increasing their due diligence in evaluating potential borrowers, they set off a chain reaction whereby other banks do the same and worsen the credit crunch. 

Parker, Michael J. Fishman of Northwestern University, and Ludwig Straub of Harvard unpack this ripple effect in “A Dynamic Theory of Lending Standards,” examining the effort banks take to screen out bad borrowers. The researchers created a model that examines the effects of tight lending standards versus loose lending standards and shows what can happen when banks go the extra mile to acquire a plethora of information on borrowers and condition their lending on that information. Here’s what they found:

  • By not funding people who are less creditworthy, tighter standards worsen the pool of potential borrowers who are looking for loans, which in turn creates an even bigger incentive for banks to employ tight standards in the future.
  • Tighter standards in a good market are inefficient. They amplify and prolong downturns, decrease overall lending, and increase credit spreads.

The following insights led the researchers to those conclusions.

Lending standards are inefficient when they’re too tight

When the economy is good, banks rely less on consumers’ private information to make loans, Parker said. They rely more on publicly available information, which is an efficient and low-cost way to acquire data to assess loan applicants.

But when there’s a financial shock to credit markets, or when banks have to be selective about the loans they make because of balance sheet constraints or management concerns about leverage, banks put in more work to evaluate potential borrowers.

The researchers found that this can lead to a domino effect that causes banks to keep up their tough due diligence persistently, even after economic conditions improve. This makes loans more costly to make and means that credit markets get stuck with high interest rates that borrowers end up having to pay. 

If the market is in good shape, less due diligence makes more sense. Over-diligence slows down the process, costs the banks more money — an expense they pass on to borrowers — and reduces their ability to lend to worthy borrowers.

Counterintuitively, in credit markets where most potential borrowers are creditworthy, “less checking would make the loans actually cheaper for those good borrowers who would’ve gotten through the tight lending standards, who would have gotten loans either way,” Parker said.

This is especially relevant right now because there are a lot of commercial real estate losses on bank balance sheets and there is lingering concern about the fiscal health of banks following the year-ago collapse of Silicon Valley Bank and two other large regional lenders.

“There’s a bunch of regulatory concern about the loans that banks are making right now,” Parker said. And that concern is causing banks to put in more effort than necessary when checking a borrower’s history. 

The real estate market is another sore spot. Lending standards are currently tight, especially in commercial real estate.

“When you have people with reasonably good credit scores who are putting a down payment down on a house that’s a good piece of collateral, it doesn’t make sense for banks to be doing a lot of evaluation of whether that loan is going to pay off or not,” Parker said.

“The chances that [a loan] will fail are very small. Some of them will default and lose a little bit of money, but that will be a rare event,” he said.

The government should intervene when lending standards are too tight

Parker said that it can be beneficial to have the government relax lending standards when they’re too tight for too long. Lending standards, for example, were too tight for too long following the 2008 – 2009 financial crisis, Parker said.

In a high interest rate environment, the government could temporarily support the lending market with a temporary loan guarantee program funded by a tax on loan payments. In 2009, the government purchased mortgage-backed securities, which pool borrowers, and took over Fannie Mae and Freddie Mac so they could continue to insure mortgages.

Fintechs are adding additional pressure 

Financial technology startups are now lending like banks, approving loans with just a few taps on a cellphone — but without the same degree of regulation. For example, short-term point-of-sale lending, known as “buy now, pay later,” is carving some safe loans out of the credit card space and stealing market share. These companies make loans with a soft credit check based on “what is being purchased, where it’s being bought, and maybe even when,” Parker said.

Related Articles

Categorical thinking can lead to investing errors
Can generative AI provide trusted financial advice?
Couples miss out when they fail to coordinate retirement benefits

Buy now, pay later loans — which allow consumers to break up payment into four installments — began to soar in popularity during the online spending boom spurred by the pandemic. Amid high credit card interest rates, these loans remain popular with people who want to keep a low credit card balance.

Parker said that might push credit card interest rates higher: As some of the better credit risks are carved out of banks’ lending pool, credit card companies might tighten lending standards and reduce credit to marginal borrowers.

“This is a very active place in the economy today, where there are lots of fintech lenders that are working on developing new lending models,” Parker said. For example, SoFi, an online finance company that specializes in student loan refinancing, connects borrowers with investors who want to lend them money.

Parker said that traditional banks should be aware that their borrower pool is being influenced by the arrival of these companies, perhaps more than they realize.

The arrival of buy now, pay later “changes how competitive credit cards are,” Parker said, because the “loans that they’re making are effectively different and separate” from the ones the banks are making.

If buy now, pay later works, “some safe loans would presumably be carved out of the credit card space and satisfied by buy now, pay later,” Parker said. “There are still a bunch of questions about exactly how this is going. But credit card interest rates might end up a little bit higher because some of the better credit risks are being removed from their lending pool.”

Read next: How target date funds impact investment behavior

For more info Tracy Mayor Senior Associate Director, Editorial (617) 253-0065