CURBING THE CREDIT CYCLE THAT LEADS TO FINANCIAL CRISIS: New evidence to underpin macroprudential policy

Credit cycles are distinct from the business cycle in their frequency and amplitude. One of their central features is a tendency for banks collectively to take on more risk, which can ultimately lead to a financial crisis.

These are among the findings of research by David Aikman, Andrew Haldane and Benjamin Nelson, published in the June 2015 Economic Journal. Their study explains the importance of public policy that targets bank balance sheets directly by looking across the whole financial system – a key dimension of the so-called ''macroprudential'' policy-making that has been widely adopted since the latest crisis.

Credit lies at the heart of crises. Credit booms sow the seeds of subsequent credit crunches. This is a key lesson of past financial crashes, manias and panics. It was a lesson re-taught painfully to policy-makers during the most recent financial crisis. This time, the credit cycle has been particularly severe and synchronous.

In response, there have been widespread calls for remedial policy action. These proposals come in various stripes. Some have proposed a more active role for monetary policy in addressing financial imbalances. Others have suggested using new macroprudential tools to rein in credit excesses. Others still have proposed a radical root-and-branch reform of the structure of banking.

Evaluating the merits of these proposals requires a conceptual understanding of the causes of the credit cycle and an empirical quantification of its dynamic behaviour.

What is the underlying friction generating credit booms and busts? Are credit cycles distinct from cycles in the real economy? And how have they evolved, both over time and across countries?

Answers to these questions should help frame public policy choices for curbing the credit cycle. The first contribution of the new study is to present some empirical evidence on the credit cycle.

The researchers show that across countries and across a sweep of history, credit cycles (measured by variation in the ratio of bank lending to GDP) are both clearly identifiable and regular. Typically, they presage banking crises.

Importantly, however, credit cycles are distinct from the business cycle in their frequency and amplitude. It is fluctuations in credit relative to output operating over the medium term – that is, beyond business cycle frequency, with peak-to-trough cycles completed over the course of a decade or more – that, over the last century, have been so damaging.

Second, the researchers present a simple theoretical framework within which to understand how large fluctuations in credit relative to real activity can occur.

They show that a number of frictions studied in previous research can each be understood to generate strategic complementarity between banks – including systemic risk shifting, reputational concerns and so-called ''moral hazard''. Each of these generates a tendency for banks collectively to take on more risk. The authors argue that this is a central feature of the credit cycles that have operated for over a century across the industrialised world.

Drawing on this analysis, they offer some implications for the design of public policy. In particular, new policy apparatus may be needed that targets bank balance sheets directly but, unlike microprudential policy, does so by looking across the system systematically. This is one key dimension of macroprudential policy.

Various international macroprudential policy committees are now in place – in the United States, the Financial Stability Oversight Committee; in the euro area, the European Systemic Risk Board; and in the UK, the Financial Policy Committee. These provide elements of a macroprudential policy framework.

Others remain to be put in place. Knowledge of the sources and dynamics of the credit cycle will be important in assembling those missing pieces. This study is intended to be a contribution towards that goal.


''Curbing the Credit Cycle'' by David Aikman, Andrew Haldane and Benjamin Nelson'' is published in the June 2015 issue of the Economic Journal. Some of the analysis draws on a speech by the authors published in November 2010 (http://www.bankofengland.co.uk/archive/Documents/historicpubs/speeches/2010/speech463.pdf). The authors are at the Bank of England.