Lending Standards, Productivity, and Credit Crunches

Abstract: We propose a macroeconomic model in which adverse selection in investment amplifies macroeconomic fluctuations, in line with the prominent role played by the credit crunch during the financial crisis. Endogenous lending standards emerge due to an informational asymmetry between borrowers and lenders about the riskiness of borrowers. By using loan approval probability as a screening device, banks ration credit following increases in lending risk, generating large endogenous movements in TFP, explaining why productivity often falls during crises. Furthermore, the mechanism implies that financial instability is heightened when interest rates are low.