Rational Inattention and Counter-Cyclical Lending Standards
42 Pages Posted: 15 Mar 2017 Last revised: 7 Dec 2017
Date Written: December 1, 2017
We develop a model of rational inattention to analyse the interaction between banks' lending standards and aggregate economic conditions. Banks are constrained in their capacity to assess borrower quality and trade off the number of processed loan applications with the precision of their loan review. As aggregate economic conditions improve, the marginal return to additional scrutiny decreases and banks investigate applicants less carefully. As a result, they approve loans that are riskier ex-ante and generate lower expected returns, which can explain excessively lenient lending standards during market booms.
Keywords: credit cycle, lending standards, loan officers, rational inattention, financial accelerators
JEL Classification: G20, G21, E51
Suggested Citation: Suggested Citation