Adrian Penalver (Banque de France) – Banks and the rational credit cycle

This paper considers how credit standards, loan interest rates, loan default rates and the allocation of capital vary over the business cycle. In popular commentary, banks are portrayed as myopic or forgetful, lowering credit standards during booms as memories of past crises fade and then overreacting by tightening credit standards when defaults rise. The purpose of this paper is to challenge this narrative by providing a theoretical model which replicates these stylised facts of the credit cycle but in which all the agents make rational forward-looking decisions. The paper builds a model of credit risk management for a bank making long term loans under asymmetric information and costly state verification. Heterogeneous firms face persistent idiosyncratic and aggregate shocks and make endogenous entry and exit decisions, including the possibility of default. These individual decisions are made conditional on the policy rules followed by the bank. The bank chooses Markov policy rules for its monitoring intensity, loan interest rate and deposit interest rate to maximise its expected profit subject to maintaining equality between aggregate savings and loans in every period. The model shows that cycles in credit standards and default can be completely rational responses to persistent but stochastic aggregate shocks. This result suggests that central banks and financial regulators should be wary of using credit standards as a sign of imprudent behaviour in the banking sector.