Question

How does an unanticipated decline in the price level cause a drop in lending?

Answer 1

Banks or financial institutions typically do asset-based lending. In asset-based lending, they take assets as the collateral and lend money against it (loan to value ratio). The larger the value of the asset, the more will be the loan sanctioned against it. Banks keep collateral to safeguard their interests. If a loan becomes nonperforming, the banks will take hold of that asset & will sell it in the market to recover their dues. By taking collateral, banks feel safer and can lend a larger amount of money at lower interest rates as compared to unsecured loans.

An unanticipated decline in the price level increases the risk profile of the assets of the bank, ie loans they have given become riskier as the value of collateral taken by them sharply falls. This makes banks risk-averse to further lending which results in a drop in lending.