Comments on “Procyclicality and Volatility in the Financial System”

Stefan Gerlach, and Paul Gruenwald
Published Date:
July 2006
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In these comments on the chapter by Ashley Taylor and Charles Goodhart, I will try to step back and take a broader view of procyclicality from the perspective of a common- or garden-variety macroeconomist. From that viewpoint, I will attempt to identify the key issues that may be important in the Asian context, as well as areas for further research.

Basic concepts

Procyclicality can be defined most broadly as the co-movement of key financial sector variables (especially credit, but also spreads, maturities, provisioning, etc.) with real variables over the economic cycle.1 There is little question that financial systems are procyclical in this general sense. I agree with José Viñals, however, that to some extent such co-movement, especially of credit growth, is normal, and even healthy, and would be a feature of well-run banks - especially when faced with asymmetric information and agency problems - in sound financial systems. Some degree of procyclicality in credit is needed to support growth, which would have a tendency to be cyclical even if financial systems were not a factor causing cycles.

The concern of course is that procyclicality is “excessive” in the sense that it amplifies the business cycle, and may even cause financial instability. There is certainly evidence that in many countries credit-to-GDP ratios tend to rise in upswings and fall in downswings.2 There is also evidence that suggests that risk tends to be underestimated in upswings and overestimated in downswings. Moreover, such procyclicality seems to be more pronounced during downturns than upswings. Nevertheless, the practical problem for policy-makers is how to know ex ante when procyclicality is “excessive.” This remains hard to assess, except in extreme cases. This judgement is difficult in part because, as already noted, a degree of procyclicality is probably desirable, and because of the evolving nature of the business cycle, including in Asia - an issue to which I will return.

Factors contributing to excessive procyclicality

The academic literature identifies a number of factors that can cause excessive procyclicality.3 Since these causes are well covered in other contributions to this book, I will mention just three general ones briefly.

Inadequate risk management has clearly been one source of excessive procyclicality, with ample evidence that provisioning and spreads are quite strongly procyclical in many cases. Estimates of risk are often based on time horizons that are too short, with the experience of earlier downturns too easily forgotten. Also, in upswings banks’ risk assessment capabilities become stretched, leading to an underpricing of risk and a deterioration in asset quality that does not come to light until later in the cycle. Another feature of inadequate risk management is heavy reliance on collateral rather than on assessments of capacity to repay, which can exacerbate procyclicality by linking lending too closely to the behavior of property prices.

Weak supervisory capabilities can also contribute to excessive procyclicality through a build-up in risks that can threaten the stability of the financial system. This could be compounded by forbearance following an adverse shock. Such forbearance might limit procyclicality in the short run as banks continue to lend, but would exacerbate it in the longer run as non-performing loans accumulate.

Regulatory frameworks themselves can contribute to procyclicality. As Ashley Taylor and Charles Goodhart argue so clearly in Chapter 2, even initiatives that improve bank risk management, such as Basel II, may contribute to procyclicality.

Issues relating to Asian financial systems

Let me turn now to some issues that are either specific to Asia or of particular importance to the region that I believe are worth highlighting.4

First, the role of foreign banks. Since the Asian crisis, there has been a sharp increase in the presence of foreign banks in the region. Potential benefits of this development are the upgrading of risk assessment capabilities and better pricing of risk, which have had positive spillover effects on domestic banks. This has most likely helped to reduce procyclicality in financial systems in the region. On the other hand, foreign banks may react more negatively than domestic banks to, and therefore amplify, serious adverse domestic or external shocks - as Joseph Yam said in a recent speech, they may turn out to be fair-weather friends.5 Foreign banks may also transmit spillovers from events in other markets, as they seek to adjust their global balance sheets.

Second, capital inflows. Both foreign direct investment and portfolio flows continue to play an important role in the region, helping to finance investment and growth. But they can also give rise to difficulties that contribute to procyclicality. Surges in inflows can fuel excess liquidity, lower interest rates, and encourage excessive risk taking. And the sudden reversal of inflows can exacerbate down-turns and even cause financial instability, as Asia knows all too well. The behavior of credit rating agencies can exacerbate the procyclicality of capital flows if ratings are adjusted too slowly in response to the emergence of risks and to improvements in the outlook and policy environment. Figure 2.1 illustrates the role played by capital inflows during the Asia crisis, and shows that rating agencies were behind the curve both before the crisis and as economies began to recover. An important question, therefore, is whether rating agencies have improved the quality and timeliness of their assessments since the Asian crisis.

Figure 2.1:Capital inflows, real GDP growth and credit rating in Indonesia, Korea, Malaysia, the Philippines, Taiwan POC, China and Thailand

Third, the evolving business cycle in Asia. Understanding the nature of the business cycle in Asia is important for making sensible estimates of risk through the cycle, not least under implementation of Basel II, as we have heard from Ashley Taylor and Charles Goodhart. Asia still relies heavily on exports, especially of electronics, to countries outside the region, particularly the United States. But the region is starting to move towards a more domestic demand-led growth model, while intra-regional trade has grown rapidly over the last few years. The resulting changes in the business cycle need to be understood for proper estimation of risk through the cycle in Asia.

Fourth, the development of regional bond markets. While banking systems remain dominant in the region, bond markets have grown quite rapidly since the Asian crisis, and various initiatives are underway to facilitate their further development at the national and regional levels. These markets provide a financing alternative to bank loans, and financing made available through them may prove to be more stable than that intermediated through mature financial centers. At the same time, there is some evidence that the availability of bond financing is closely linked to the willingness of banks to lend, as banks monitor borrowers more closely. This would tend to exacerbate procyclicality. How these two forces balance out is an open question worthy of further study.

Policy issues

Finally, let me make a few observations about the implications of procyclicality for policy.6

The basis for policy action - or at least for policies that are explicitly counter-cyclical in intent - rests to a considerable degree on whether financial system procyclicality is judged to be excessive in Asia, i.e. that it has adverse effects on macroeconomic stability and welfare. As noted above, in most cases this is difficult to judge ex ante. Most economic policy, of course, is made in the face of considerable uncertainty about the state of the economy and the effects of the actions contemplated. A reasonable way to approach this issue is to consider the risks of intervening to smooth procyclicality when it is not necessary, versus the risks of not intervening when procyclicality is likely to cause problems, or even serious financial instability.7

Other issues that need to be considered and seem far from settled include:

  • Over what part of the cycle should policies be undertaken? One view is that policy-makers have better information and a longer time horizon than market participants, suggesting that policies should aim to improve outcomes over the entire cycle. An alternative view is that policy-makers can only hope to solve the collective action problems, which seem more acute in downturns.

  • What form should the policy intervention take? Should it be through prudential mechanisms, more general monetary policy instruments, or even actions to limit capital inflows?

  • Should policy interventions be rule-based or discretionary? This issue seems to have been settled for now in the case of monetary policy in favor of discretion, but remains an open question in the case of prudential policies aimed at limiting procyclicality.


Craig, Davis and Pascual (2004) use this broad definition.

See Borio, Furfine and Lowe (2001) for evidence on this and other indicators of excessive procyclicality.

These factors are reviewed in Borio, Furfine and Lowe (2001), and also in Craig, Davis and Pascual (2004), among others.

Some of these issues are raised in Craig, Davis and Pascual (2004).

The policy implications of procyclicality are discussed in more detail by Lowe and Stevens in Chapter 4, this volume.

See Greenspan (2004) for a discussion of the approach as applied to monetary policy.


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