Nonbank lenders and mortgage supply: A theoretical basis and policy implications

There is a rich literature on the response of the demand for mortgage to market interest rate variations. However, the literature on the response of the supply side is rather sparse. Nonbanks have now taken a substantial portion of lending in the mortgage market from traditional banks. Recent empirical literature shows that bank and nonbank mortgage lenders respond in rather contradictory ways to a sustained interest rate hike; while banks shrink their lending in response to a rate hike, nonbanks grow and expand their lending. This study offers a theoretical foundation for those empirical observations. It constructs a contract model of mortgage lending and shows that the observed seemingly contradictory responses by banks and nonbanks to rate hikes are optimal responses by the two groups of lenders. The results identify three interest rate sensitivities that play crucial roles in determining how banks and nonbanks respond to a policy rate hike. In highlighting the complexities of monetary policy transmission, the study identifies certain parametric conditions under which not only nonbanks but traditional banks could partially neutralize the transmission of monetary policy.