1. Financial Cycles & Macroeconomics
Borio JBF (2014)

2. Borio:
“…We do not necessarily know more today than we did yesterday … so-called ‘lessons’ are learnt, forgotten, re-learnt and forgotten again. Concepts rise to prominence and fall into oblivion … because the discipline is not immune to fashions and fads.”
“The notion of financial booms and busts actually predates … the more common and influential one of the business cycle”

3. The Financial Cycle Definition
Self-reinforcing interactions between perceptions of value & risk [prevailing riskiness of the economy], attitudes towards risk [risk aversion], & financing constraints translating into booms followed by busts amplifying output fluctuations
Thanks Stancho !

4. Financial Cycle 1st of 5 Stylized Facts
Variables proxying financial cycle:
Credit/GDP vs. historical norm (a rough measure of leverage)
Property prices vs. historical norm (a rough measure of steep return to norm)
Co-vary: credit finances construction & purchase of housing
Must focus on small set of variables to replicate the mutually reinforcing interaction between financing constraints and perceptions of value & risks

5. Financial Cycle 2nd of 5 Stylized Facts
Financial cycle has lower frequency than business cycle (ca. 16 years in industrialized nations)
Business cycle: 1 – 8 years

6. Financial Cycle 3rd of 5 Stylized Facts
Financial Cycle Peaks linked to Financial Crises (crises away from peaks are due to foreign cycles)
Black vertical lines
Show bank crisis
start dates

7. Financial Cycle 4th of 5 Stylized Facts
Predicts financial distress with good lead time

8. Financial Cycle 4B of 5 Stylized Facts
Levels
Growth
Rates
Cross-border credit outgrows domestic credit in finance cycle booms
Direct: foreign bank loans to domestic non-financial borrowers
Indirect: foreign loans to domestic banks which lend to domestic non-financial borrowers

9. Financial Cycle 5th of 5 Stylized Facts
Length & amplitude of financial cycle depends on policy regime
Financial : liberalization eases financing constraints
Monetary: inflation targeting regime => low inflation gives BNB no reason to fight financial cycle boom
Real-economy : low inflation, credit & asset P booms more frequent with globalization
Financial cycle longer
& higher amplitude
may be due to
financial deregulation

10. Borio: Need New Macro Models
Financial boom precedes crisis but does it cause it ?
Include debt and capital stock overhang
In boom, debt allows increased spending on assets
In bust, debt forces agents to cut spending
Rethink concept of potential output (economy at YFE will stay there absent shocks without inflation)
But recently output on too-high path while inflation stable

11. Borio: How to Modify Models ??
Jettison model-consistent (rational) expectations: agents can’t understand model of economy
“heterogeneous & fundamentally incomplete knowledge is a core characteristic of economic processes”
Allow risk attitudes to vary with economy’s SON to naturally amplify financial booms & busts
Capture the monetary nature of the economy

12. What’s a Monetary Economy ?
1. Banking system doesn’t only transfer real resources, but also generates nominal purchasing power
If deposits produced loans little problem in allocating resources
But loans creating deposits (may) create an excess (part of MS)
2. Dilute discipline’s heavy focus on eqbm

13. Monetary Economy
Borio: saving is same as funding only in non-monetary economies
Saving IS unspent income while financing is the access to (also borrowed) funds
E.g. in economy without investment, saving = 0 but firms still need to fund gap (buying input to revenue receipt)
Gross (not net) capital flows finance credit booms;
US boom funded domestically and from EU (nations with CA < 0 )
Net inflows are gross inflows less gross outflows

14. US BOP Accounts 2011 ($ Billions)

15. where’s Bernanke ?
murky link between
CA surplus &
interest rates
He doesn’t buy Bernanke’s savings glut: CA surplus nations (e.g. China) funded U.S. credit boom, cutting world interest rates
Saving & Investment affect “natural interest rate” not market interest rates
Natural interest rate: non-observable eqbm determined by real factors
Market rates (influenced by policy rates & yield curve) may deviate from natural rates for long periods
Borio: Natural rate an unlikely cause for imbalances leading to 2008 crisis

16. Dealing with Credit Booms
Dell’ariccia et al FCCC 11

17. The Good & the Bad of Credit Booms
Good: Increases investment & consumption Good: Contributes to financial deepening Bad: May lead to crisis or sub-trend growth Credit booms arise out of financial reform capital inflow surges strong economic growth Bad are likely to be larger & last longer, but can’t really tell difference bad vs. good booms

18. When does Credit Boom End in Credit Bust?
Fast credit expansion brings vulnerability:
Lax lending standards
Excessive leverage
Asset price bubbles
Credit booms may go unnoticed:
Inflation targeting central banks ignore M aggregates (may overlook credit boom)
Regulators’ focus on individual banks may lead to ignore aggregate credit dynamics
Professional consensus: M Policy too blunt to correct asset P bubbles often coming with credit booms

19. Dell’arricia Study Details
Cross country with focus on bank credit (large share of overall credit) => ignore bond markets, trade credit, etc
Use data available to policymakers at the time, not revisions coming post-decision
Compare credit/GDP in each year and country to trend between years t – 10 and t. Define as boom if :
Deviation from trend > (1.5 x std dev) with annual credit/GDP growth rate > 10% OR
Annual credit/GDP growth > 20%
Sample 170 countries with 175 boom episodes

20. Typical Credit Boom
Median boom 3 years; Credit/GDP grows 13% p.a. (5 x all-year median growth)
Most booms in middle-income (also high-income) nations
More booms in undeveloped financial systems (median credit/gdp at start of boom is 19% vs. 30% for entire sample)

21. More countries suffer credit boom since deregulation of 1980s

22. Bernanke & Gertler’s Financial Accelerator
In upturn
Rising borrower creditworthiness & collateral values
Lenders supply more credit & may loosen lending standards
Greater credit allows greater investment and consumption with another round of collateral value rise
Downturn, the opposite happens

23. Performance In Credit Booms
Faster GDP growth
Fast-rising Asset P
Inflation subdued
Real exchange rate appreciates
CA deficit (=> KFA surplus due to foreign bank fund inflows)

24. Question 1 on Long Term
Research uses credit/GDP to measure financial development that helps GDP growth
1. Does credit boom bring permanent financial deepening ?
Some bring crises with sharp drop in credit/GDP
40% bring permanently higher credit/GDP level (eqbm?)
(FIG 3 : credit growth in boom positively related to long term financial deepening )

25. Question 2
Is financial deepening via a credit boom the same as through gradual growth?
Positive correlation between
# years nation’s been in credit boom
Real GDP per capita growth since 1970

26. The Bad Side
33% of booms followed within 3 years by banking crisis

27. Bad Side 2
States with greater booms during expansion also suffered larger delinquencies during bust

28. Bad Side 3
Credit booms preceded many of largest banking crises of last 30 years

29. Bad Side 4
60% of booms bring below-trend growth (by 2.2%) over next 6 years
Nations with bigger credit/GDP changes had deeper recessions
Credit boom predicts well “credit-less recovery” (1/3 lower average growth)

30. Find 3 factors linked to start of Credit Boom
33% of booms follow financial reform to increase financial deepening
Capital inflow surges (often due to liberalization) increase funds in banks
Booms start during or after strong economic growth
Many countries can be affected simultaneously
Financial liberalization occurs in several nations simultaneously
Capital inflows occur due to global liquidity conditions

31. Some Nations Are More Susceptible
Those pegging exchange rate (precludes M policy to deal with boom)
Those expanding M policy (low borrowing cost inflates asset P)
Those with poor bank supervision

32. Credit Boom Can Bring Deepening or Crisis
Define Bad if followed by banking crisis within 3 years or brings recession or below-trend growth
What’s there about boom to predict if it turns into crisis or long sub-par GDP growth? Find BAD booms:
Are larger and last longer
Usually start with high credit/GDP
Sometimes related to:
Higher inflation
larger CA deficits,
lower quality bank supervision
faster growing asset P