WHY BANK CREDIT POLICIES FLUCTUATE - A THEORY AND SOME EVIDENCE

In a rational profit-maximizing world, banks should maintain a credit policy of lending if and only if borrowers have positive net present v alue projects. Why then are changes in credit policy seemingly correla ted with changes in the condition of those demanding credit? This pape r argues that rational bank managers with short horizons will set cred it policies that influence and are influenced by other banks and deman d side conditions. This leads to a theory of low frequency business cy cles driven by bank credit policies. Evidence from the banking crisis in New England in the early 1990s is consistent with the assumptions a nd predictions of the theory.