How Lending Standards Change across the Business Cycle

In this blog post, we employ the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices to describe how lending conditions change over the course of the business cycle. The survey is conducted quarterly, and senior loan officers are asked to report changes in lending practices relative to the previous quarter.

Lending standards characterize banks’ policies for approving loan applications, whereas lending terms refer to details (e.g., interest rate) specified in loan contracts conditional on application approval. The survey provides information about both.

The FRED chart below shows the net percentage of U.S. banks reporting a tightening of lending standards for commercial and industrial loans to large and middle-market firms (which make up the largest share of lending).“Net fraction” (or “net percentage”) refers to the share of surveyed banks that reported having tightened (“tightened considerably” or “tightened somewhat”) lending standards or terms minus the share of surveyed banks that reported having eased (“eased considerably” or “eased somewhat”) them. It is clear from the chart that banks tighten lending standards during recessions (the gray-shaded areas) and ease them during economic expansions. Note that tightening of lending standards begins prior to recessions and rises sharply once the recessions hit. The latest data point available is from July 2024. It describes the change in lending standards over the second quarter of 2024 and suggests the tightening period that began in 2022 may be drawing to a close.

The next FRED chart shows that conditions for lending terms exhibit a similar pattern. The two components of lending terms on which we chose to focus are:

• Credit lines: The net percentage of U.S. banks reducing the maximum size of the credit lines they extend to large and middle-market businesses
• Loan rate spreads: The net percentage of U.S. banks increasing the spread of loan rates over their cost of funds to large and middle-market businessesThe survey also provides information on the maximum maturity of loans or credit lines, cost of credit lines, premiums charged on riskier loans, loan covenants, collateralization requirements and use of interest rate floors.

It is clear that lending standards and lending terms fluctuate over the business cycle in response to changes in the economic outlook. In times of high productivity and a favorable economic outlook, banks anticipate higher success rates for the projects they finance and therefore higher loan repayment rates, which may lead to laxer lending standards. One seminal paper in this area focuses on the moral hazard friction.See Ben Bernanke and Mark Gertler’s March 1989 American Economic Review article, “Agency Costs, Net Worth, and Business Fluctuations.” Borrowers with higher net worth brought about by economic expansions have more skin in the game, which mitigates concerns about excessive risk-taking and therefore reduces lending costs and increases lending activity. Another seminal paper focuses on contract enforcement frictions, which give rise to collateralized lending.See Nobuhiro Kiyotaki and John Moore’s April 1997 Journal of Political Economy article, “Credit Cycles.” Lending activity increases during economic expansions in response to rising collateral values. In my own work, the focus is on the adverse selection problem.See my October 2015 article with Nicolás Figueroa in the Journal of Economic Dynamics and Control, “Lending Terms and Aggregate Productivity,” and my February 2018 article, also with Nicolás Figueroa, in the Journal of Banking and Finance, “Cash Flows and Credit Cycles.” Banks do not observe entrepreneurs’ productivity and can only screen them via loan contract offers. Productive entrepreneurs can effectively signal their ability to repay the loan by selecting a suboptimally low credit line. In economic expansions, such signaling gets costlier and competitive pressures may result in lenders abandoning screening altogether.

Interestingly, when the loan officers surveyed were asked to state the reason for easing of lending terms during economic expansions, the most common explanation pointed to the “more aggressive competition from other banks and nonbank lenders.”Again, see the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices.

Thus, the easing of lending standards and lending terms observed during economic expansions can amplify and propagate positive productivity shocks—such as, for example, new technology—by increasing investment and extending more credit to creditworthy entrepreneurs.For example, see Bernanke and Gertler (1989) and Kiyotaki and Moore (1997).

At the same time, lending conditions themselves determine the mix of projects realized in the economy, thereby steering the future course of aggregate productivity. Several studies, including my own cited above, have suggested that, after a long period of easing lending standards, the pool of projects that get financed may deteriorate, increasing the likelihood of a recession. As such, lending terms may also play a role in reversing the course of economic activity.

Policymakers have also expressed concerns about the risks created by easing lending standards and have increased supervisory attention to this area since 1998—the year the Federal Reserve undertook an intensive study of loan underwriting practices across the country. Summarizing its findings, the Board of Governors Supervision and Regulation Letter SR 98-18 points out that “formal projections of a borrower’s future performance were present in only 20 to 30 percent of the loan approval documents reviewed.” Evidence from the financial press and bankers’ opinions also indicates that projects of negative present value are increasingly funded during economic expansions, according to a 1994 study.See Raghuram G. Rajan’s May 1994 Quarterly Journal of Economics article, “Why Bank Credit Policies Fluctuate: A Theory and Some Evidence.”

The following FRED chart uses data collected by the Federal Reserve Board to show delinquency ratesDelinquent loans and leases are those 30 days or more past due and still accruing interest, as well as those in nonaccrual status. on business loans over the business cycle.

In general, the delinquency rate on business loans made by U.S. commercial banks falls during expansions as economic conditions improve and production projects succeed, and it rises during recessions. Notably, the delinquency rate begins to rise while the economy is still expanding, providing some support to the hypothesis that poor-quality projects manage to obtain financing when economic times are good.

Notes

1. “Net fraction” (or “net percentage”) refers to the share of surveyed banks that reported having tightened (“tightened considerably” or “tightened somewhat”) lending standards or terms minus the share of surveyed banks that reported having eased (“eased considerably” or “eased somewhat”) them.
2. The survey also provides information on the maximum maturity of loans or credit lines, cost of credit lines, premiums charged on riskier loans, loan covenants, collateralization requirements and use of interest rate floors.
3. See Ben Bernanke and Mark Gertler’s March 1989 American Economic Review article, “Agency Costs, Net Worth, and Business Fluctuations.”
4. See Nobuhiro Kiyotaki and John Moore’s April 1997 Journal of Political Economy article, “Credit Cycles.”
5. See my October 2015 article with Nicolás Figueroa in the Journal of Economic Dynamics and Control, “Lending Terms and Aggregate Productivity,” and my February 2018 article, also with Nicolás Figueroa, in the Journal of Banking and Finance, “Cash Flows and Credit Cycles.”
6. Again, see the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices.
7. For example, see Bernanke and Gertler (1989) and Kiyotaki and Moore (1997).
8. See Raghuram G. Rajan’s May 1994 Quarterly Journal of Economics article, “Why Bank Credit Policies Fluctuate: A Theory and Some Evidence.”
9. Delinquent loans and leases are those 30 days or more past due and still accruing interest, as well as those in nonaccrual status.