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Overlending and Macroprudential Tools

Author

Listed:
  • Natalie Tiernan

    (Office of the Comptroller of the Currency)

  • Pedro Gete

    (Georgetown University)

Abstract

This paper is a quantitative study of two frictions that generate banks' underinvestment in screening borrowers and, thus, overlending: 1) Limited liability, and 2) Banks failing to internalize that their credit decisions alter the pool of borrowers faced by other banks. The resulting lax lending standards overexpose banks to negative economic shocks and amplify the effects of economic fluctuations. They generate excessive volatility in credit, banks' capital and output. We study a calibrated model whose predictions concerning the quantity and quality of credit are in line with recent U.S. business cycles. Quantitatively, limited liability is the friction that generates laxer lending standards. It induces 27% excess volatility in output relative to 8% from the other friction. Then we study three policy tools: capital requirements and taxes on banks' lending and borrowings. The three tools encourage banks to screen more and should be state-contingent because the frictions vary with macroeconomic conditions. In quantitative terms, we find that taxes are better tools than capital requirements because they do not reduce credit going to the more productive agents.

Suggested Citation

  • Natalie Tiernan & Pedro Gete, 2014. "Overlending and Macroprudential Tools," 2014 Meeting Papers 379, Society for Economic Dynamics.
  • Handle: RePEc:red:sed014:379
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    References listed on IDEAS

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    1. Overlending and Macroprudential Tools
      by Christian Zimmermann in NEP-DGE blog on 2014-12-01 23:28:12

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