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The Credit Crunch: A Forced Outcome, an Overreaction, or a Rational Response?

To infer whether banks really over-tighten lending standards during a credit crunch, this paper examines how future loan performance was related to loan growth and capital ratios during the credit crunch of the early 1990s. The main finding is poorer future loan performance for banks that reduced lending significantly and those that had insufficient regulatory capital. Based on this finding, there doesn’t appear to have been much over-tightening either voluntary or forced. If banks’ overreaction were a main cause of loan contraction, future loan performance would have been negatively related with loan growth. Since regulatory pressure applied largely to low-capital banks, excessive regulatory pressure should have resulted in better future loan performance for low-capital banks. The key results of this paper are more consistent with moral hazard hypotheses and reduced loan demand accompanied by deterioration of overall credit quality.