Lending Cycles

We investigate the lending behavior of banks by exploiting a rich panel dataset on the contract terms of approximately two million commercial and industrial loans granted by 580 banks between 1977-1993. Using a Markov switching panel model we demonstrate that banks change their lending standards from tightness to laxity systematically over the cycle. We then use an efficient minimum chi-square estimator to examine the relationship between the cyclical component of aggregate unemployment and bank lending standards when both variables are jointly endogenously determined in a system of simultaneous equations with mixed, continuous/discrete dependent variables. The patterns we uncover suggest that lax lending standards that tend to occur during expansions exert considerable influence on the dynamics of aggregate fluctuations.