Accounting and Finance Seminar - Peter Kondor (LSE)
G.15, 15-19 Tyndalls Park Road
Rational Sentiments and Economic Cycles
We propose a rational model of endogenous credit cycles generated by the two-way interaction of credit market sentiments and real outcomes. Sentiments are high when most lenders optimally choose lax lending standards. This leads to low interest rates and high output growth, but also to the deterioration of future credit application quality. When the quality is suﬃciently low, lenders endogenously switch to tight standards, i.e. sentiments become low. This implies high credit spreads, low quantity of issued credit and a gradual improvement in the quality of applications, which eventually triggers a shift to lax lending standards. The equilibrium cycle might feature a long boom or a lengthy, possibly double-dip recession. It is generically diﬀerent from the optimal cycle as atomistic lenders ignore their aggregate eﬀect on the composition of borrowers. Carefully chosen risk-weighted capital requirements can often improve the decentralized equilibrium cycle.