Do Banks Pass Through Credit Expansions to Consumers Who Want to Borrow?
We propose a new approach to studying the pass-through of credit expansion policies that focuses on frictions, such as asymmetric information, that arise in the interaction between banks and borrowers. We decompose the effect of changes in banks' cost of funds on aggregate borrowing into the product of banks' marginal propensity to lend (MPL) to borrowers and those borrowers' marginal propensity to borrow (MPB), aggregated over all borrowers in the economy. We apply our framework by estimating
... work by estimating heterogeneous MPBs and MPLs in the U.S. credit card market. Using panel data on 8.5 million credit cards and 743 credit limit regression discontinuities, we find that the MPB is declining in credit score, falling from 59% for consumers with FICO scores below 660 to essentially zero for consumers with FICO scores above 740. We use a simple model of optimal credit limits to show that a bank's MPL depends on a small number of "sufficient statistics" that capture forces such as asymmetric information, and that can be estimated using our credit limit discontinuities. For the lowest FICO score consumers, higher credit limits sharply reduce profits from lending, limiting banks' optimal MPL to these consumers. The negative correlation between MPB and MPL reduces the impact of changes in banks' cost of funds on aggregate household borrowing, and highlights the importance of frictions in bank-borrower interactions for understanding the pass-through of credit expansions. Note: Figure shows marginal profits for lending to observationally identical borrowers. A reduction in the cost of funds shifts the marginal profit curve outward, and raises equilibrium credit limits (CL* → CL**). Panel A considers a case with a relatively flat marginal profit curve; Panel B considers a case with a steeper marginal profit curve. The vertical axis is divided by the MPB because a given decrease in the cost of funds induces a larger shift in marginal profits when credit card holders borrow more on the margin. See Section 5 for more details. In our model, banks set credit limits at the level where the marginal profit from a further increase in credit limits is zero. A decrease in banks' cost of funds reduces the cost of extending a given unit of credit and corresponds to an outward shift in the marginal profit curve. As shown in Figure 1 , a reduction in the cost of funds has a larger effect on optimal credit limits when the marginal profit curve is relatively flat (Panel A) than when it is relatively steep (Panel B). What are the economic forces that determine the slope of marginal profits? One important factor is the degree of adverse selection. With adverse selection, higher credit limits are disproportionately taken up by consumers with higher probabilities of default. These higher default rates lower the marginal profit of lending, thereby generating more steeply downward-sloping marginal profits. Higher credit limits can also lower marginal profits holding the distribution of marginal borrowers fixed. For example, if higher debt levels have a causal effect on the probability of default -as they do, for example, in the strategic bankruptcy model of Fay, Hurst and White (2002) -then higher credit limits, which increase debt levels, will also raise default rates. As before, this lowers the marginal profit of lending, generating more steeply downward sloping marginal profits. 2 7 According to the 2010 Survey of Consumer Finances, 68% of households had a credit card versus 10.3% for a home equity line of credit and 4.1% for other lines of credit. Moreover, credit cards were particularly important during the Great Recession when many homeowners were underwater and unable to borrow against home equity. In our sample, credit cards issued to consumers with FICO scores above 740 had, on average, $1,294 of interest-bearing debt at one year after origination, indicating that credit cards were a key source of credit even in the upper range of the FICO distribution.