Why Do Banks Lend More?

Why has household debt grown so much? One rather convincing argument, prominently developed by Elizaeth Warren, is that income growth has not kept pace with the cost of basic consumption. To maintain consumption, many families ultimately relied more and more on consumer debt. This argument, though, only explains why the demand for credit has increased.

For the supply side of the market, the opposite should have been true. The same income trends that translated into more demand for credit should have resulted in less supply. Greater income inequality and slower income growth meant less collateral for banks. Also, slower income growth and rising inequality occurred at a time of financial deregulation, which has a priori an ambiguous effect on the supply of credit. There may be more banks entering the market, which could raise the credit supply, but there is also more consolidation in the industry, which could reduce the credit supply, at least for low-income and moderate-income borrowers.

The puzzle that economists struggle with is that the greater demand for credit over the past few decades and especially after 2000 was actually met with an increased supply, even though income growth slowed and income inequality increased. Recent economic research sheds some light on this puzzle.

Stanford University economics professor Dirk Krueger and NYU economics professor Fabrizio Perri showed in a working paper published by the National Bureau of Economic Research in 2002 how greater income inequality could result in a larger credit supply, as long as higher income inequality went along with little income mobility. Their main argument is that banks have an increasing incentive to lend to low-income and moderate-income families in such a situation. Banks know that these families know that they can only maintain their consumption by going into debt over and over again. Because families will have to rely on credit to maintain their consumption, they will have a strong incentive to repay their loans. Consequently, high income inequality coupled with low income mobility actually reduces the repayment risk to banks and they expand their credit supply. A colleague of mine once pointed out that this is actually an argument made by payday lender as to why theirs is a growth industry: more people are stuck at the lower end of the income scale and thus have to rely regularly on consumer credit to pay for their consumption. This gives lenders new opportunities and could reduce repayment risk since borrowers will try to avoid default since they will have to rely on credit again in the future. 

The empirical evidence, though, is mixed. In an article that I co-authored with economist Heather Boushey from the Center for Economic and Policy Research in Washington, DC, and that was published in the winter 2008 issue of the Review of Political Economy we found that greater inequality does indeed lead to more credit. This phenomenon, though, only applies to credit card debt and not to mortgages. And contrary to the theoretical predicitons, we found that this greater credit card debt, following increasing inequality, is actually associated with higher credit card default. It seems that while banks intuitively get the point that there may be  more and more willing borrowers out there, they still incur more risk on their balance sheets when income growth is low, income inequality is high, and income mobility is low. It may just be the case that banks know that they will be bailed out if enough of them make a sufficiently large number of bad bets.

Comments

[Mike Dillon]

Applying this question from a mortgage perspective gets a much simpler answer from me. The industry's mantra is that lenders/note holders lose upwards of $50k on foreclosures. I have yet to see anyone actually break that figure down and if anyone does I'm going to be hard pressed to believe it. The reason is not a complicated one, at least when talking about securitized loans.

There are simply too many insurance policies in place where securitized loans are involved for lenders/note holders/investors to actually LOSE money - unless you are counting the future revenue streams. I've documented potential triple or quadruple dipping in my own case depending on how many claims have been made on policies.

It's going to be harder in this RE market, and margins are going to be much closer for years to come, but when a property goes to auction, it is usually purchased by the note holder for the remainder of the debt - outstanding principle, interest, legal fees, etc. I believe I outlined the process earlier in another topic with the $200k foreclosure selling for $150k.

By the time that a property actually gets to the auction block - assuming that the note has been securutized - the insurance claim has already been made and quite possibly paid off.

The claim that lenders/note holders "lose money" has been, to the best of my knowledge, largely unsupported. And when you talk about mortgage servicers, they actually profit throughout the entire default/foreclosure process.

[Christian E. Weller]

Response to Mike Dillon:

Your answer elaborates more eloquently what I hinted at in my last sentence. The incentive structure for lenders seems to have changed, so that they don't actually incur the rising losses. Consequently, the standard models for determining the supply of credit, which include a risk-return trade off consideration on the part of lenders, no longer apply. The return remains the same, but the risk goes down, and voila the supply goes up. Somebody other than the lender is left holding the bag and that is exactly what financial regulation needs to rectify: change the incentive structure, so that financial markets work properly again.

[Anon]

The idea that credit availablity should shrink as demand increases is simple minded and lazy and to suggest that the cost of credit card debt (interest rates and penalty fees) should be artificially depressed is not only incredibly myopic, but dangerous for all of its good intentions. We are in the middle of a credit crunch, cutting off the lender of last resort to consumers during a time of financial crisis is ridiculous. To suggest that the cost of that loan to the consumer should be regulated is dangerous. Credit cards are one of the most competitive undifferentiated markets in financial services with low switching costs for consumers. I agree that the terms should be simple and easy to understand for all applicants, but to suggest that someone without any direct skin in the game should have a say in the price of the product boggles the mind. The main problem with the subprime mortgage crisis was not the availability of credit, it was the poor underwriting standards. Said another way, the lenders were not compensated enough for the credit risk they were assuming. Now you are suggesting that the credit card issuers reduce their underwriting standards and if they don't the government should do it for them? How does this make any sense? Are you a think tank or a stooge with an agenda? Just asking...

[Roger, Charlotte NC]

The People of the beautiful land called The United States of America need to demand from our politicians to once and for all to start printing Government’s US NOTES and within 2 or 3 years eliminate our debt to the Federal Reserve and then abolish the Federal Reserve act once and for all.

As we all know Federal Reserve notes are an obligation to the US Government AKA the people but if the government start printing his own Legal tender Notes just as Abraham Lincoln did to finance the War (1861-1865) with what was called “Greenback”. Then they will be no obligation as such it is interest free.

Colonel Dick Taylor of Chicago was put in charge of solving the problem of how to finance the war. His solution is recorded as this. "Just get Congress to pass a bill authorizing the printing of full legal tender treasury notes... and pay your soldiers with them and go ahead and win your war with them also."
Colonel Dick Taylor When Lincoln asked if the people of America would accept the notes Taylor said. "The people or anyone else will not have any choice in the matter, if you make them full legal tender. They will have the full sanction of the government and be just as good as any money; as Congress is given that express right by the Constitution."
Eliminate the fractional reserve banking is a must as well.
So what is not to like about that? It is common sense and it is about time we do something about it.

In today’s economic uncertainty “for all common Americans” it is important that the minds this organization contains be put to great uses to all if somehow this topic is brought to a series of debates with historians and economists and public participation so to spark and greater interest on this important subject that for so many years has slaved us and with it bring an already overdue change for the better.

I believe we own it to our country and the future of our children.

Respectfully..

[Michael D. Fox]

It seems to me that the question now is no longer "Why Do the Banks Lend More?," but rather "Why DON'T the Banks Lend More?"

The current real estate crisis appears to me to be significantly a function of the banks refusing to extend credit, not the other way around. Even as the Federal Reserve continues to low interest rates in the hope that more money will find its way to homeowners, the lenders keep tightening credit.

The situation seems closer to the oil crisis than anything we've seen before in the real estate market. The lenders, like OPEC, are restricting supply, no matter what inducements the government provide.

What do you think it will take for the banks to open up the credit supply?

[SARPONG ANDREWS]

I am highly elevated by your inceptions on why do banks lend more.However I would be glad if you could elaborate by given me a detailed case study on a particular bank.This will help me do more research on the topic.