Lax Lending Standards and Capital Requirements

Banks generate excessive low-quality lending if they decide their optimal screening and lending intensities without internalizing that their behavior alters the pool of borrowers faced by other banks. Banks choose to spend too much time \u85nding new customers rather than screening them, leading to an ine ¢ ciently high level of credit. This paper conducts a quantitative study of this market failure and then shows how capital requirements remedy it. First, we present a calibrated model whose predictions concerning the quantity and quality of credit are in line with recent U.S. business cycles. Second, we show that the externality ampli\u85es the e¤ects of economic shocks, bankscapital and lending are too volatile. Capital requirements can reduce this excessive volatility if bankscapital is more expensive than external funds. Moreover, optimal capital requirements should be time-varying because the market failure varies with macroeconomic conditions. We appreciate the comments of Behzad Diba, Jean Stephane Mesonnier and seminar participant