Overlending
Overlending
Overlending describes the behavior of creditors that extend loans to borrowers that are unable or unwilling to repay the debt on its original terms. The borrowers may be individuals, firms, or sovereign countries. Creditors span the range of public and private-sector institutions, although much of the analysis of overlending focuses on the lending patterns of banks. Overlending can lead to unsustainable debt burdens for the borrower and financial losses, both for the lenders and the broader economy, particularly in cases where disruptions of debt service lead to financial crisis.
Theoretical explanations for overlending often cite imperfect information and moral hazard as factors contributing to unsustainable lending booms. Imperfect information about the borrower or economic conditions contributes to uncertainty in assessing credit risk. Moral hazard, where the existence of insurance or guarantees encourages greater risk taking, may also contribute to overlending. Overlending can also take place when excess liquidity and competitive pressures between lending institutions contribute to loosening of credit standards. Obvious profligacy, including loans to insiders, corrupt businesspersons, or relatives where the loan may be made with no expectation of repayment, may also take place in the absence of strict credit standards.
In the United States, the government has crafted policies to inhibit overlending. Bank supervision aims to contain the moral hazard associated with deposit insurance and prudential standards prohibit the most egregious lending practices. Nevertheless, the savings and loan crisis, which lasted from the late 1970s through the 1990s, included elements of overlending. While structural problems related to restrictions on lending rates and the resulting interest-rate mismatch were underlying causes of the crisis, some thrift institutions had large loan losses attributed to insider loans or to lending in riskier markets. The policy solution to the savings and loan crisis therefore involved an enhanced supervisory structure as well as an infusion of funds to recapitalize troubled thrifts institutions.
By the early 1980s, the Latin American debt crisis was vying with the savings and loan crisis as the most significant financial calamity. In a paper presented at a World Bank symposium, Jack M. Guttentag and Richard J. Herring argued that competitive pressures on banks and overoptimistic assessments of borrower capacity contributed to unsustainable levels of lending. In their book The Loan Pushers (1988), William A. Darity and Bobbie L. Horn pointed out that while competitive pressures can lead to overlending, moral hazard might also have played a role since commercial bankers may have viewed the International Monetary Fund (IMF) and other publicsector actors as guarantors that would orchestrate a bailout. Darity and Horn also detailed factors that might have contributed to imprudent borrowing, but recognized that policies to prevent future financial turmoil must be based on a clear understanding of the roles that creditors as well as borrowers played. Institutional weaknesses would require institutional reform.
Despite efforts at such reform, international debt service problems reemerged in the mid-1990s. These problems involved bond holders as well as banks, and came after a rapid expansion of credits to firms and sovereign borrowers in Latin America and Asia. International financial institutions also increased their lending to the least developed countries, and by the end of the 1990s many poor countries, especially in Africa, were carrying unsustainable debt burdens. There has been a concerted policy response to the events of the 1990s: debt relief, a greater share of aid in grants, and promoting compliance with international financial standards and codes. All of these policy interventions are aimed at preventing the reemergence of overlending.
SEE ALSO Economics; Financial Instability Hypothesis; Financial Markets; Hedging; Leverage; Liquidity; Loans; Moral Hazard; Ponzi Scheme; Wealth
BIBLIOGRAPHY
Darity, William, Jr., and Bobbie L. Horn. 1988. The Loan Pushers: The Role of Commercial Banks in the International Debt Crisis. Cambridge, MA: Ballinger Publishing.
Guttentag, Jack M., and Richard J. Herring. 1985. Commercial Bank Lending to Developing Countries: From Overlending to Underlending to Structural Reform. In International Debt and the Developing Countries, ed. G. Smith and J. Cuddington. Washington, DC: World Bank.
Willene A. Johnson