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New Research Indicates that Reducing the Cost of Lending Leads to Little Stimulus

NYU Stern Professor Johannes Stroebel and co-authors show that banks are reluctant to lend to credit-restrained households because it’s not profitable.

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As the US, the European Central Bank and the Bank of England are looking for ways to spur economic activity, they should be aware of the limitations of credit expansion policies.

In a new study, Professor Johannes Stroebel of the NYU Stern School of Business, Sumit Agarwal of the National University of Singapore, Souphala Chomsisengphet of the Office of the Comptroller of Currency and Neale Mahoney of the University of Chicago Booth School of Business find that government policies aimed at stimulating the economy by reducing banks’ cost of funds, so that they will extend more credit to households, are relatively ineffective.  In fact, banks are reluctant to lend to those households with the greatest interest in borrowing because it is not profitable.
 
The authors used data on 8.5 million US credit card accounts during the Great Recession, when policymakers pursued credit expansion policies to encourage banks to lend more to households and firms, with the expectation that this would increase spending and investment.
 
Key findings include:
  • Households with the lowest FICO scores had the highest willingness to borrow.
  • Despite lower-cost capital, banks were reluctant to lend to these potential borrowers.
  • The authors estimate that a one percentage point reduction in the costs of funds for banks raises optimal credit limits by only $127 for consumers with low FICO scores.
  • A bank’s propensity to lend is negatively correlated with a household’s propensity to borrow (i.e., the more likely a household is to borrow, the less likely a bank is to grant additional credit).
  • During the Great Recession, banks conducted credit card lending at a profit-maximizing level. 
“As the US, the European Central Bank and the Bank of England are looking for ways to spur economic activity, they should be aware of the limitations of credit expansion policies,” says Professor Stroebel. “Based on our research, these measures are severely limited in their effectiveness.”
 
The article, “Do Banks Pass Through Credit Expansions? The Marginal Profitability of Consumer Lending During the Great Recession,” is currently a National Bureau of Economic Research (NBER) working paper.

To speak with Professor Stroebel, please contact him directly at jstroebe@stern.nyu.edu; or contact Jessica Neville, 416-516-7677, jneville@stern.nyu.edu; or Carolyn Ritter, 212-998-0624, critter@stern.nyu.edu, in NYU Stern’s Office of Public Affairs.

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