Pre-crisis credit standards: Monetary policy or the savings glut?
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This paper presents a theoretical model of bank credit standards. It examines how a monopoly bank sets its monitoring intensity in order to manage credit risk when it makes long duration loans to borrowers who have private knowledge of their project’s stochastic profitability.
The model has a recursive structure and contains heterogeneous agents who can self-select to be depositors or borrowers at any point in time. The bank loan contract considered specifies the interest rate, the monitoring intensity and a profitability covenant.
Within this class of contract, he bank chooses the terms which maximise Markov stationary profits subject to the constraint that it must have as many deposits as loans. As an illustrative example, the model is used to consider whether the reduction in credit standards and credit spreads observed before the financial crisis could have been caused by low official interest rates or a positive deposit shock. The model rejects a risk-taking channel of monetary policy and endorses the savings glut hypothesis.
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