Lending relationships and boom–bust cycles

Most of the macroeconomics and finance literature has focussed on sentiments, learning or news shocks to explain boom–bust cycles, while ramifications of widely-documented bank-firm credit ties have not been examined for these economic fluctuations. In this paper, I build a macroeconomic model in which banks have lending relationships with their borrowers and a credit expansion – defined as an increase in loans relative to deposits or a jump in loan-to-deposit (LTD) ratio which I call a credit shock – generates boom–bust patterns in key macroeconomic aggregates. These effects are increasing in the intensity and persistence of lending relationships and are larger at higher LTD ratios and increased persistence of the credit shock. This paper highlights how lending ties interact with an expansion in credit to generate boom–bust cycles without relying on behavioral biases (such as optimism or pessimism) and how the initial expansion sows the seeds of the subsequent recession, even in the absence of any additional shocks.