Curbing the credit cycle
David Aikman Andrew G Haldane Benjamin Nelson
17 March 2011, VOX.EU
Credit booms sow the seeds of subsequent credit crunches. This column argues that these have
their source in cross-bank externalities. To internalise these cross-sectional spillovers, policy
should operate “across the system”. It adds that this is the essence of macro-prudential policy,
which, for the first time is about to be undertaken internationally.
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 (See e.g. Minsky 1986, Kindleberger
1978, and Reinhart and Rogoff 2009). It was a lesson painfully re-taught to policymakers during
the most recent financial crisis.
In response, there have been widespread calls for remedial policy action. 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.
One source of credit market friction arises from coordination failures among lenders (see for
example Gorton and He 2008). In these models, banks are heterogeneous and their behaviour
strategic. The individually rational actions of heterogeneous lenders can generate collectively
sub-optimal credit provision in both the upswing (a credit boom) and the downswing (a credit
crunch). This is a collective action, or co-ordination, problem among banks.
In credit markets, these co-ordination failures are far from new. Keynes memorably noted:
“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is
ruined, is ruined in a conventional and orthodox way with his fellows, so that no one can really
blame him” (Keynes 1931).
Eighty years later, Chuck Prince, then-CEO of Citibank, captured the collective action problem
thus:
“As long as the music is playing, you’ve got to get up and dance. We’re still dancing”
As Prince’s quote attests, these incentives were a key driver of risk-taking behaviour in the run-up
to the crisis. In the face of stiffening competition, banks were increasingly required to keep pace
with the returns on equity offered by their rivals – a case not so much of “keeping up with the
Joneses” as “keeping up with the Goldmans”. To achieve these higher returns, it was individually
rational for banks to increase their risk profiles in various ways (Alessandri and Haldane 2009).
Keeping up with the Goldmans
In recent research (Aikman et al. 2011), we develop a simple model, building on Rajan (1994)
and Morris and Shin (2002), in which risk taking is driven by reputational concerns in a world of
imperfect information. Bankers care about their future job prospects, which depend in part on
their current reputations as assessed by the market. But the market has incomplete information
about a banker’s underlying ability. Instead, ability is inferred by the market through announced
returns.
As fundamentals improve, high-ability banks are more likely to achieve high returns than lowability banks. So posting low returns in the boom is particularly damaging to reputation as this
constitutes a clearer signal of low ability. This strongly incentivises excessive risk taking to boost
short term returns as fundamentals improve. This dynamic sows the seeds for procyclical
variation in risk taking and contributes to the generation of a credit cycle. The medium-term
implications of short-term excessive risk taking are an eventual crystallisation of large scale
losses together with widespread financial distress.
What are the empirical implications of our model?

First, strategic complementarities incentivise banks to adopt risky strategies in a
coordinated fashion during the boom. So the dynamics of the model predict that we should
observe cycles in financial activity at a macroeconomic level. Initial productivity improvements are
amplified into lending booms, which are followed by credit busts and, potentially, crises.

Second, at a microeconomic level, the coordination of risky strategies during the boom
should compress the dispersion of bank earnings, as low ability banks masquerade as high ability
banks during good times. But during the bust, when the macro state turns bad, the dispersion of
banks’ earnings should increase as low ability types crystallise losses while high ability types do
not.
At the macro level, we document the existence of strong cyclical variation in real credit for a
sample of 12 developed countries collected by Schularick and Taylor (2009). These cyclical
fluctuations over the medium term (with a duration of 8-20 years) are not only statistically
significant, but also strongly associated with the incidence of financial stress. The cycle we
identify for the UK is shown in Figure 1. Not only is the duration of the cycle in real credit different
from the business cycle, so too is its amplitude – around twice that of GDP in the medium term
and roughly five times that of GDP at conventional business cycle frequencies. Cycles in asset
prices are even greater in amplitude.
Figure 1. Medium-term fluctuations in real credit and real GDP, UK, 1880-2008.
Source: authors’ calculations
At the micro level, Figure 2 plots a time series of the cross-sectional dispersion of equity returns
for major UK banks, alongside dispersion for the top 100 Private Non-Financial Companies
(PNFCs). Measures of return dispersion are consistently and statistically significantly lower for
banks than for non-banks. And dispersion tended to fall over the long credit boom during this
century. Measures of equity return dispersion hit all-time lows at the height of the recent credit
boom in 2006-2007, before exploding in 2008.
Figure 2. Cross sectional dispersion of equity returns of major UK banks and top 100 UK Private
Non-Financial Companies (by market cap)
Source: CapitalIQ and authors’ calculations.
We also examined return patterns among the largest global banking and non-financial firms. The
pattern is the same. We observe a compression of returns during credit booms and a dispersion
in busts, with the cyclicality becoming more marked through time. This suggests an increase in
the degree of coordination of global banks’ activities after the financial liberalisation of the 1980s,
indicating that credit cycles may have become increasingly synchronous globally.
Pair-wise correlations between 12 advanced countries’ medium-term credit cycles for two postwar sub-samples, 1945-79 and 1980-2008, confirm that impression (Figure 3). A shift to the right
of the cumulative distribution indicates an increase in the degree of cross-country correlation.
Figure 3. Cumulative distribution function of cross-country correlations of credit cycles
Source: authors’ calculations
Policy implications
Individual banks may fail to internalise the reputational externalities their lending actions impose
on others. The result is a periodic tidal wave of credit during the boom followed by protracted
credit drought during the crunch. Chuck Prince’s disco inferno causes murder on the dance floor.
These credit cycle externalities provide justification for state intervention to help coordinate
lending expectations and actions by banks.
One means of curbing credit cycle frictions might be through monetary policy – either by ensuring
it moderates appropriately the business cycle (Taylor 2010) or, more ambitiously, by having it
play a wider role in curtailing financial imbalances (Borio and White 2004). The evidence we
present is not especially encouraging on that front. The frequency and amplitude of the business
and credit cycles is quite different. Monetary policy may be an inefficient tool for calming the
credit cycle, if at the same time it is to moderate the business cycle.
Micro-prudential policy, aimed at tackling financial imbalances in individual financial institutions,
may also be ineffective for dealing with aggregate credit cycles. That is because bank-specific
actions will not, by themselves, internalise the spillovers that arise across banks over the credit
cycle. They may even worsen them if they allow individual banks to steal a reputational march
over their competitors.
This coordination problem suggests systematic, across-the-system actions are needed to curtail
effectively credit booms and busts. This is one dimension of macro-prudential policy. To be
effective, these policies need to increase the long-term cost of credit extension to banks during
booms and, as importantly, to lower these costs during busts. These actions would help smooth
out credit supply over the cycle. There are a variety of macro-prudential tools which could have
this effect, including pro-cyclical capital and liquidity requirements, or remuneration packages that
tie individual earnings more closely to long term performance (Bank of England 2009, Kashyap et
al. 2010, G30 2010).
Credit spillovers occur across borders as well as across banks. This suggests macro-prudential
policies need also to have an international dimension if they are to tackle credit externalities. This
is recognised in the macro-prudential policy framework currently being discussed by the
international regulatory community (BIS 2010). For example, judgements on local credit
conditions determine the amounts of capital to be held by international banks on their exposures
in those countries. This reciprocity feature should help to reduce the arbitrage risks posed by the
internationalisation of the credit cycle.
The state of macro-prudential policy today has many similarities with the state of monetary policy
just after the Second World War. Data is incomplete, theory patchy, policy experience negligible.
Monetary policy then was conducted by trial and error. The same will be true of macro-prudential
policy now. Mistakes will be made. But as experience with the other arms of macroeconomic
policy, as well as during the credit crunch, has taught us, the biggest mistake would be not to try.
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