1

Curbing the Credit Cycle

David Aikman

Andrew G Haldane

Ben Nelson

Bank of England

November 2010

Crisis Cycle

2

Credit growth (UK, US and Euro area)

-4

-2

0

2

4

6

8

10

12

14

16Q

1:2

00

0

Q3

:20

00

Q1

:20

01

Q3

:20

01

Q1

:20

02

Q3

:20

02

Q1

:20

03

Q3

:20

03

Q1

:20

04

Q3

:20

04

Q1

:20

05

Q3

:20

05

Q1

:20

06

Q3

:20

06

Q1

:20

07

Q3

:20

07

Q1

:20

08

Q3

:20

08

Q1

:20

09

Q3

:20

09

%

Max-Min Mean

Crisis Cycle

3

Price-to-Book ratios (UK, US and European banks)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

European LCFIs

US LCFIs

Major UK banks (b)

Ratio

Policy Questions

• Is there a credit cycle?

• What friction drives the cycle?

• Is it distinct from the business cycle?

• Is it domestic/international?

• What tools best curb it?

4

Policy Questions and Answers

5

• Is there a credit cycle? Yes

• What drives the cycle? Co-ordination failure

• Is it distinct from business cycles? Yes

• Is it international? Yes

• What tools best curb it? Macro-prudential

Co-ordination Failures – Past and Present

• Keynes’ sound banker:

“...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”

• Prince’s sound banker:

“...as long as the music is playing, you’ve got to

get up and dance. We’re still dancing”.

6

Credit Cycle Dynamics

• Model of banking co-ordination failure

• Information friction:

– Public can’t observe macro state (θ) or banker

ability (good/bad)

• Incentive friction:

– Banks value short-run reputation (ρ) as well as

long-run value

• Reputational dynamics

ρί >0: “Keynes constraint”

ρθ >0: “Prince constraint”

Strategic complementarity in lending decisions7

Credit Cycle Dynamics

• Dual/multiple equilibrium: “Credit boom/bust”

– Positive macro state

Reputational incentives to gamble/risk up (“risk illusion”)

Reputational incentives to herd

Credit boom

Aggregate risk realised

Credit crunch

• Unique equilibrium (θ*)

Expectational equilibrium

8

Credit Cycle Dynamics

9

Low reputational weight High reputational weight

-20

0

20

40

60

80

100

120

0 20 40 60 80 100 120

θ frictionless θ*

Credit Empirics

• Schularick and Taylor (2009) data base

– 12 countries

– > 100 years

– credit/bank asset growth

• Asset (housing and equity) prices

• Medium-term cyclical dynamics

– band-pass filter

– 8-20 year frequency10

Credit/GDP ratios

11

UK US

0

0.5

1

1.5

2

2.5

3

3.5

1860 1880 1900 1920 1940 1960 1980 2000 2020

Year

loans:GDP assets:GDP

0

0.2

0.4

0.6

0.8

1

1.2

1860 1880 1900 1920 1940 1960 1980 2000 2020

Year

loans:GDP assets:GDP

Credit and Business Cycles

12

UK US

Asset Price and Business Cycles

13

UK US

Credit Cycle and Crises

14

Crisis

Frequency (%)

Credit Boom

Frequency (%)

% Credit Booms

with Crisis Within 5

Years

US 22% 7% 67%

UK 16% 7% 78%

France 16% 8% 60%

Canada 12% 9% 55%

Spain 26% 10% 63%

Average 17% 7% 51%

Credit Cycle Spillovers

15

Dispersion of US bank/non-bank returns Dispersion of US bank/non-bank ROEs

International Credit Cycles

16

Credit GDP

Public Policy Implications

• Case for intervention? – Collective action problems in credit market

• Monetary policy? – Business and credit cycles distinct; monetary

policy ill-suited.

• Micro-prudential policy? Collective action problem; micro-prudential

policy ill-suited.

• Macro-prudential?

– Systematic (act on banks collectively)

– Signalling (importance of co-ordinating expectations)

– International (reciprocity rules between countries)

• FSOC/ESRB/FPC (nationally) and G20/FSB/BCBS (internationally)

guardians of framework

17

UK Credit Cycle and Monetary Regimes

18

(1) Gold Standard (6) Bretton Woods; Sterling full external convertibility

(2) Inter-war suspension (7) Monetary Targeting

(3) Resumption of Gold Standard (8) Exchange Rate Mechanism

(4) Sterling Area (9) Inflation Targeting

(5) Bank of England nationalised; Bretton Woods (10) Bank of England independence

US Credit Cycle and Monetary Regimes

19

(1) Gold Standard (6) Treasury-Federal Reserve Accord (1951)

(2) Inter-war suspension (7) End convertibility into gold (“Nixon Shock”) (1971)

(3) Resumption of Gold Standard (8) Volker era

(4) FDIC established; Federal Reserve reorganisation (9) Greenspan era

(5)Bretton Woods (10) Bernanke era