Collateral Scarcity and Bad Credit Booms

What distinguishes good credit booms from bad ones? We propose a new mechanism: collateral scarcity. When shocks raise investment demand but collateral values fail to keep pace, banks can no longer screen borrowers effectively using collateral. Banks optimally respond by relaxing lending standards, funding negative-NPV projects to sustain lending to positive-NPV ones. This is a bad credit boom. We show that bad booms are constrained inefficient because banks do not internalize the equilibrium effects on collateral supply of forming new credit relationships. Optimal policy dampens credit growth during booms and captures one-fifth of the welfare gains from eliminating asymmetric information. We find support for the theoretical prediction that collateral requirements fall disproportionately for low-productivity borrowers during bad booms in firm-level data. Exploiting regional variation in house prices, we find that this effect is stronger where collateral supply is less responsive, distinguishing our mechanism from theories based on collateral supply.