The credit cycle
Lending standards loosen in good times and tighten in bad ones, which amplifies both. It is more reliably cyclical than the economy it drives.
Economic downturns arrive for many reasons. A surprising share of the severe ones share a mechanism: credit expanded faster than income for several years, and then it stopped.
The loop
- Conditions improve. Defaults fall, collateral values rise, lenders' loss experience looks excellent.
- Competition pushes standards down. Loans are made to weaker borrowers at thinner spreads, because the recent record says the risk is low.
- Credit funds spending and asset purchases. Asset prices rise, which raises the value of collateral, which supports more lending.
- Something interrupts it — rates rise, a large borrower fails, a valuation is questioned.
- Lenders tighten simultaneously. Borrowers who assumed refinancing discover it is unavailable.
- Forced selling lowers asset prices, which lowers collateral values, which tightens credit further.
Loss models are calibrated on recent experience. During an expansion, recent experience contains almost no defaults, so models conclude lending is safe — at precisely the moment when accumulated leverage is making it least safe. The measurement is honest and the conclusion is backwards, and this happens repeatedly because there is no obvious alternative data to use.
The financial accelerator
Collateral links asset prices to credit availability in both directions. Rising asset prices increase borrowing capacity, which increases demand for assets. Falling prices reduce borrowing capacity, which forces sales. A modest shock to fundamentals becomes a large move in credit and therefore in the real economy.
Why it outruns the business cycle
Credit conditions typically turn before output does. Lenders respond to their own balance sheets and to forward-looking risk assessment; firms cut investment when financing becomes unavailable, and cut employment after that.
- Senior loan officer surveys — central banks ask banks directly whether they are tightening or loosening standards. Among the more useful leading indicators, and free.
- Credit spreads — the extra yield on corporate over government debt. Widening spreads price a rising probability of default before defaults occur.
- Private credit growth versus nominal GDP — persistent gaps between the two are the standard warning signal in the financial stability literature.
- The yield curve — partly a credit signal, since an inverted curve compresses the margin banks earn on lending. See Treasury yields and the curve.
Why policy struggles with it
Interest rates are a blunt instrument: raising them to restrain credit restrains everything else at the same time. This is the case for macroprudential tools — loan-to-value limits, capital buffers that rise in booms, lending caps — which target credit directly. Their record is real and mixed, and they are politically difficult to impose while a boom is popular.
Borrowing brings consumption forward. Repayment pushes it back. A period of rapid credit growth is followed by a period in which income goes to servicing debt rather than to spending, which is why recoveries from credit-driven downturns are typically slower than recoveries from other kinds. See how banks create money.