Relationship Banking, Monetary Policy, and Consumer Credit Reform
36 Pages Posted: 28 Nov 2007
Date Written: November 20, 2007
The increasing dependence of American households on debt financing and the rising rates of personal bankruptcy raise several welfare considerations that we analyze in this paper. We pose a theoretical model of relationship banking to first evaluate how strategic actions between banks and borrowers yield interest rates for various credit types and drive credit rationing in the market. Based on these results, we evaluate several policies that the government may implement to influence lending policies in consumer credit markets. We derive conditions under which the government optimally wishes to induce credit rationing and show that under some conditions, it is welfare enhancing to encourage banks to have a liberal lending policy, even if it means that interest rates are exceedingly high for low credit quality borrowers. Finally, we analyze the effects that a credit rating agency has on the dynamics of this market. Our theoretical analysis is consistent with empirical observations from these markets, and has significant importance especially given the recent subprime mortgage financial crisis.
Keywords: Banking, Credit, Monetary Policy
JEL Classification: E58, E51, D11
Suggested Citation: Suggested Citation