Going the Extra Mile: Distant Lending and Credit Cycles

Abstract

The average distance of U.S. banks from their small corporate borrowers increased before the global financial crisis, especially for banks in competitive counties. Small distant loans are harder to make, so loan quality deteriorated. Surprisingly, such lending intensified as the Fed raised interest rates from 2004. Why? We show that banks' responses to higher rates led bank deposits to shift into competitive counties. Short-horizon bank management recycled these inflows into risky loans to distant uncompetitive counties. Thus, rate hikes, competition, and managerial short-termism explain why inflows “burned a hole” in banks' pockets and, more generally, increased risky lending.