We analyze a dynamic credit market where banks choose lending standards,
modeled as costly effort to screen out bad borrowers. Tighter standards worsen
the borrower pool, increasing banks’ incentives to employ tight standards in the
future. This dynamic complementarity in lending standards can amplify and
prolong downturns, decreasing lending and increasing credit spreads. Because
lending standards have negative externalities, the market can converge to a
steady state with inefficiently tight lending standards. We discuss the role of
optimal policy to avoid this outcome as well as the impact of balance sheet
costs on lending standards.