Boundedly rational banks’ contribution to the credit cycle

We investigate how banks’ boundedly rational learning influences their views about default risks over the business cycle. Our analysis details the direction and the magnitude of these effects assuming that banks update probability in a Bayesian way. With a limited experience span lenders are liable to overestimate (underestimate) losses from defaulting loans early (late) in the boom. Depending on their experience span, banks turn over-optimistic and underprice default risk 3–5 years into the boom. During recessions an overpricing of risk begins just quarters into the recession. Our simulations are calibrated with U.S. data and provide evidence for the view that banks contribute to excessive lending during the upswing and to credit crunches in recessions.

► This study is a contribution to the behavioral economics of the credit cycle.
► Learning with a limited experience span leads to a cycle in banks expected loan losses.
► The study anchors banks’ experience span in empirical observations.
► During recessions banks become overly pessimistic regarding expected loan losses and hence overprice credit risk.
► The overpricing of default risk dissolves over the boom and is followed by risk underpricing as the boom ages.