The Fed – Banks, Non Banks, & Lending Standards

October 2020

Banks, Non Banks, & Lending Standards

R. Matthew Darst, Ehraz Refayet, Alexandros Vardoulakis

Abstract:

We study how competition between banks & non-banks affects lending standards. Banks have private information about some borrowers & are subject to capital requirements to mitigate risk-taking incentives from deposit insurance. Non-banks are uninformed & market forces determine their capital structure. We show that lending standards monotonically increase in bank capital requirements. Intuitively, higher capital requirements raise banks’ skin in the game & screening out bad projects assures positive expected lending returns. Non-banks enter the market when capital requirements are sufficiently high, but do not cause a deterioration in lending standards. Optimal capital requirements trade-off inefficient lending to bad projects under loose standards with inefficient collateral liquidation under tight standards.

Keywords: Lending standards, credit cycles, asymmetric information, non-banks, regulation

DOI: https://doi.org/10.17016/FEDS.2020.086

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