Tight Lending Standards Slow the Economy

Changes in lending standards by banks, undertaken to reduce their risk and preserve capital, have huge, macroeconomic effects on the economy. Not are not only restricting credit, they simultaneously reduce the demand for credit by businesses homeowners, even creating credit shocks that impact GDP. However, banks loosen standards to create a competitive advantage in the marketplace according to a new study by economists at the Federal Reserve.

Tightening credit creates shocks to the credit supply and leads to a substantial decline in output and the capacity of businesses and households to borrow from banks, as well as to a widening of credit spreads and an easing of monetary policy.

Shifts in the supply of bank loans to businesses and households corresponds to changes in lending standards that-using an econometric model-have been adjusted for the bank-specific and macroeconomic factors that, in addition to affecting banks’ credit policies, can also have a simultaneous effect on the demand for credit.

The economists, William F. Bassett, Mary Beth Chosak, John C. Driscoll, and Egon Zakrajsek, used the Fed’s quarter Senior Loan Officer Survey as a way to measure and track banks’ lending standards and credit policies from the bottom up, using bank-level responses on changes in lending standards for businesses.

“This analysis shows that credit supply disturbances have economically large and statistically significant effects on output and core lending capacity of U.S. commercial banks. Specifically, an adverse credit supply shock of one standard deviation is associated with a decline in the level of real GDP of about 0.75 percent two years after the shock, while the capacity of businesses and households to borrow from the banking sector falls more than 4 percent over the same period, the economists found. Such disruptions in the credit-intermediation process also lead to a substantial rise,” they found.

Economic factors influencing banks’ business credit policies include a projected increase in the unemployment rate as does a deterioration in the current labor market conditions. Expected changes in longer-term interest rates again exert a significant influence-in both economic and statistical terms-on the probability that banks will modify their current lending standards: An expected increase of 100 basis points in the 10-year Treasury yield over the next four quarters is estimated to lower the probability of tightening in the current quarter about 6.5 percentage points and boost the likelihood of easing by nearly the same amount.

The capacity of businesses and households to borrow from the banking sector begins to decline within two quarters after the initial credit disruption, and the resulting reduction in this broad measure of credit inter-mediation is very persistent and protracted, they said.