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“Banks and the rational credit cycle”
Termin
Freitag, 11. Dezember 2015, 11:00 Uhr
Ort
Oesterreichische Nationalbank
Abstract
This paper considers how credit standards, loan interest rates, loan default rates and the allocation of capital vary over the business cycle. In popular commentary, banks are portrayed as myopic or forgetful, lowering credit standards
during booms as memories of past crises fade and then overreacting by tightening credit standards when defaults rise. The purpose of this paper is to challenge this narrative by providing a theoretical model which replicates these stylised facts of the credit
cycle but in which all the agents make rational forward-looking decisions. The paper builds a model of credit risk management for a bank making long term loans under asymmetric information and costly state verification. Heterogeneous firms face persistent
idiosyncratic and aggregate shocks and make endogenous entry and exit decisions, including the possibility of default. These individual decisions are made conditional on the policy rules followed by the bank. The bank chooses Markov policy rules for its monitoring
intensity, loan interest rate and deposit interest rate to maximise its expected profit subject to maintaining equality between aggregate savings and loans in every period. The model shows that cycles in credit standards and default can be completely rational
responses to persistent but stochastic aggregate shocks. This result suggests that central banks and financial regulators should be wary of using credit standards as a sign of imprudent behaviour in the banking sector.
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Eva Seidl
Oesterreichische Nationalbank
Abteilung für Öffentlichkeitsarbeit und Finanzbildung
Communications and Financial Literacy Division
Eva Seidl
Phone: +43-1-404 20-6620
Fax: +43-1-404 20-04 6620
E-mail: eva.seidl@oenb.at