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In this paper we show that periodic credit crunches, swings between high and low credit allocations, are an inherent part of banking due to the way banks compete for borrowers. The amount of information that banks produce about potential borrowers, and the amount of credit banks are willing to extend, varies through time due to strategic interaction between competing banks. Credit cycles can occur without any change in the macroeconomic environment. We investigate this amplification mechanism and provide empirical evidence that bank credit cycles are an important autonomous part of business cycle dynamics. Extensive empirical tests of the model are presented, based on parameterizing the public information that is the basis for banks’ beliefs about rivals’ strategies. These information measures concern rival banks’ relative performance, encapsulated in a Performance Difference Index (PDI). The empirical behavior of U.S. bank credit card lending, commercial and industrial lending, and bank profitability, are consistent with the model. Bank credit cycles are a systematic risk. We find that, consistent with this, the PDI is a priced factor in an asset pricing model of bank stock returns. Most importantly, the PDI is a priced factor for non-financial firms as well, and increasingly so as firm size declines.

Changes in bank credit allocation, sometimes called "credit crunches," appear to be an important part of macroeconomic dynamics. Bank lending is procyclical. Rather than change the price of loans, the interest rate, banks sometimes ration credit. A dramatic example in the U.S. is the period shortly after the Basel Accord was agreed in 1988, during which time the share of U.S. total bank assets composed of commercial and industrial loans fell from about 22.5 percent in 1989 to less than 16 percent in 1994. At the same time, the share of assets invested in government securities increased from just over 15 percent to almost 25 percent. More generally, it has been noted that banks vary their lending standards or credit standards. Bank “lending standards” or “credit standards” are the criteria by which banks determine and rank loan applicants’ risks of loss due to default, and according to which a bank then makes its lending decisions. While not observable, there is a variety of evidence showing that while lending rates are sticky, banks do, in fact, change their lending standards. The most direct evidence comes from the Federal Reserve System’s Senior Loan Officer Opinion Survey on Bank Lending Practices. Banks are asked whether their "credit standards" for approving loans (excluding merger and acquisition-related loans) have “tightened considerably, tightened somewhat, remained basically unchanged, eased somewhat, or eased considerably.” Lown and Morgan (2001) examine this survey evidence and note that, except for 1982, every recession was preceded by a sharp spike in the percentage of banks reporting a tightening of lending standards. Other evidence that bank lending standards change is econometric. Asea and Blomberg (1998) examined a large panel data set of bank loan terms over the period 1977 to 1993 and “demonstrate that banks change their lending standards - from tightness-to laxity-systematically over the cycle” (p. 89), and they conclude that cycles in bank lending standards are important in explaining aggregate economic activity.