Regulators have been concerned about the quality of lending, and have been increasing their supervision, conscious of the potential impact on financial stability. However, a paper from the Bank for International Settlements – Bank Competition and Credit Booms highlight that especially when interest rates are low, and competition intense, banks will naturally and logically drop underwriting standards. This observation is highly relevant to the Australian context, where competition for home loans in particular is leading to heavy discounting from already low rates, and potential lax underwriting. It suggests that lowering rates further will exacerbate the effect.
Greater bank competition and a lower risk-free rate raise the screening costs of lending, which can result in sharp increases in credit supply and deteriorations in average loan quality, which are inefficient for banks. Banks’ incentives to make risky loans can vary despite unchanged capital structure, thus highlighting the role of a risk-taking mechanism. This approach helps explain the existing mixed empirical results on the relationship between bank competition and financial stability. The model can be used to define a neutral interest rate in the context of financial cycles.
There is a growing recognition that the relationship between finance and growth may be unstable in practice. Past financial crises serve as painful reminders that increasing financial access by too much too fast is subject to diminishing returns at best, and can even lead to severe output losses when the financial sector is in disarray. Despite ample evidence for this perverse nonlinearity, there is less understanding about the exact mechanism by which excessive finance that is harmful for stability can arise as an equilibrium phenomenon. Similarly, the role of policy in navigating the trade-o between growth and financial stability, unlike that between growth and inflation, remains a relatively uncharted territory.
This paper proposes a simple model of bank lending decision, where a`credit boom’ could emerge as an equilibrium phenomenon. Two key forces interact to determine the equilibrium. First, banks have an incentive to screen out bad clients by restricting the amount of lending per contract, as riskier firms are known to seek larger loans despite a lower chance of success. Such screening entails costs to both banks and good firms, given that credits are being rationed to meet incentive compatibility conditions. This feature is essentially classic credit rationing.
The second force comes into play when banks enjoy some monopolistic power over their loan market, but can attempt to poach clients from another bank by offering cheaper loan contracts. Lowering prices of loans raises the screening costs, because it necessitates even greater credit rationing if banks were to screen out risky fi rms. When the degree of bank competition for borrowers is suciently intense, it becomes optimal for banks to stop screening and rush to dominate the market by off ering contracts with larger loans to all firms. This new pooling equilibrium is characterised by a low lending interest rate (relative to the average productivity of underlying projects), a larger loan size, and a higher probability of loan defaults.
A lower risk-free rate increases the banks’ incentives to lend by lowering the opportunity cost of funds. But how the credit market equilibrium responds to changes in the risk-free rate also depends on the market structure in which banks operate. In particular, when a bank can gain more market share for a given cut in lending rate, the degree of competiton tends to be higher in equilibrium for any level of risk-free rate. Credit booms are therefore more likely to occur when banks compete more aggressively and/or the risk-free rate is low. In this context, the notion of `fi nancial stability neutral’ monetary policy can be given an explicit de nition, namely that which will prevent a pooling equilibrium from occuring. At the same time, the presence of intense bank competition can limit the effectiveness of monetary policy in containing a credit boom and achieving the financial stability objective.
