Bankruptcy

Why Do Banks Lend More?

By Christian E. Weller

Why has household debt grown so much? One rather convincing argument is that income growth has not kept pace with the cost of basic consumption. To maintain consumption, many families first increasingly relied 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.

Full post as published by Credit Slips on February 21, 2008 (boomark / email).