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When banks lend money to people who can’t pay it back, bad things happen. It’s called “reckless lending” for a reason. And on a large enough scale, reckless lending can be a strong catalyst for systemic financial crisis.
So what encourages banks to practice reckless lending in the first place?
Well, there are two main incentives for banks to lend recklessly:
Increasing competition from other banks, and…
Decreasing demand for credit.
In the case of our last crisis, both of those incentives came into play.
The mortgage lending sector transformed from a duopoly into a tightly competitive market of various lenders, which drove lenders to loosen standards in an attempt to woo borrowers. On top of that, credit demand from high quality borrowers was sparse, further encouraging lenders to approve loans for risky borrowers.
Today, the same thing is happening again.
