A country experiencing a lending boom
goes through a period of unusually fast growth in credit. This paper proposes a
theory of lending booms that incorporates two distortions which are prevalent in
emerging markets: the imperfect enforceability of contracts and government
bailout guarantees. The
first of distortion implies that there may be an underinvestment problem and that shocks are propagated through their effect on borrower wealth. The second distortion amplifies shocks since it encourages excessive risk taking and overinvestment. Although they appear to affect borrowing in opposite ways, the tow distortions do not neutralize each other. They combine to rationalize the gradual buildup of lending booms, the excess volatility of credit and asset prices and the slow recovery if a lending boom ends in a financial crisis. The interaction also introduces a nonlinearity in the response to shocks. This explains why most lending booms do not require a large negative shock to end, but rather come to a ’soft landing’. In addition to accounting for the main characteristics of a typical lending boom episode the model also surprising policy implications.