This paper examines the characteristics of the financial system that tend to accentuate the economy’s cyclical fluctuations and, on occasion, end up causing asset bubbles and financial crises, like the one that started in 2007 with the US subprime mortgages.

The paper discusses, first, some features of the economics of banking that make it inherently cyclical. In particular, competition for market share at times of expansion and the difficulty in assessing risk throughout the cycle.

However, the lion’s share of the analysis focuses on the procyclical factors that result from the imperfect functioning of financial markets. The serious problems of asymmetric information between the different agents in the industry – managers, borrowers, creditors and owners – result in a tendency towards excessive leverage during a boom and overly restrictive policies during downturns. The paper also examines how these problems of information, together with negative externalities between institutions, can lead to extreme situations of seriously unstable markets (bubbles and crises). It also discusses to what extent some of the current regulations help to exacerbate the sector’s procyclical nature instead of alleviating it.

The conclusion proposes principles that might be taken into account by a regulatory framework that helps to reduce the procyclical nature of the financial system.

Keywords: financial stability, banking regulation, credit cycle
JEL Codes: E32, G21, G28, G32

 

All documents are in Adobe Acrobat format (PDF).
To view a document in PDF format you need the Adobe Acrobat Reader. If you don’t have it already loaded on your computer, you can donwload it now.