2 Financial stability and macroeconomic developments

Cyclical fluctuations and the financial industry's behaviour

Economic developments are cyclical. Experience shows that banks' loan losses are greater during economic downturns than during upswings. Therefore, the risk involved in a project may seem to vary at different times in the business cycle.

One important cause of many financial crises has been that financial institutions and financial markets underestimate risk during cyclical upswings and overestimate risk during economic downturns.¹⁾ During upswings, credit growth is often strong, banks' results are solid (due in part to low loan loss provisions), the rise in the value of assets such as property and securities is considerable and the risk premium on high-risk projects as well as spreads in the bond market are low. In general, this will amplify the period of expansion. At the same time, a strong increase in debt makes households and enterprises more vulnerable to a rise in interest rates or a drop in income. When interest rates rise or the economic situation changes, a high debt burden may therefore amplify an economic downturn and, at worst, trigger a financial crisis.²⁾ A high debt burden may also prompt enterprises to take on greater risk than is desirable because owners with limited liability have less to lose on a high-risk project, but a great deal to gain if the project succeeds.

Whereas risk in the financial system often builds up over an extended period of high economic growth, a turnaround in the economy often comes much faster. The turnaround often results in a decline in earnings, more bankruptcies and increased loan losses. Financial institutions and financial markets may interpret this as an indication that risk, also in connection with new projects, has increased, even though the developments may reflect the surfacing of risk that has built up in the financial system over an extended period. Furthermore, empirical studies show that the likelihood of downgrading of credit ratings increases during a downturn and decreases during an upswing. Negative changes in future prospects often result in a decline in the value of securities and property, in part because market participants try to sell assets in order to secure their value. The reduced value of collateral makes it more difficult for enterprises and households to obtain loans and other financing. When dealing with groups of enterprises where there is particular uncertainty about future earnings, financial institutions and securities markets may find it so difficult to distinguish between low-risk and high-risk projects that the supply of capital to this group dries up. ³⁾ The result may be a credit crunch.

While internal risk systems and external ratings that measure the relative risk of projects at a given time may be well developed, it is far more difficult to measure absolute risk over time. This is one important reason why financial institutions may behave procyclically. Paradoxically, the development of sophisticated quantitative risk systems may intensify these problems, since data sources may be influenced by the economic situation at the time a project is evaluated and the trend extrapolated even though it cannot be maintained in the long term.

In addition, intense competition from new market participants who have little experience of financial crises and do not take adequate account of this risk may lead to these participants operating with artificially low risk premia in order to underbid their competitors. This behaviour may be especially pronounced during upswings. Such a situation may also arise without competition from new market participants if existing financial institutions are overoptimistic or behave as though the probability of financial crises will gradually decline over time. Moral hazard due to the fact that bank deposits are insured by special guarantee schemes and that the government may step in with support in the event of a banking crisis may intensify these problems. The consequence will be that banks do not build up the capital necessary to cope with periods of economic contraction.

If the required rate of return or the lending rate to projects reflects the risk over the entire economic cycle, capital will be built up during economic upswings when the rate of return and net interest income are high and losses are low. The most objective risk measurement possible will therefore contribute to stabilising economic developments and make the financial system more robust. However, this makes considerable demands on investment decisions in the risk management systems of financial markets and financial institutions. A cyclical downturn may, however, be deeper and more prolonged than earlier experience might indicate. The probability of a financial crisis would then be greater.

An important task for the authorities is to monitor developments in the financial industry, see them in relation to macroeconomic developments and, if necessary, consider taking action. A key task for central banks is to ensure monetary stability. A monetary policy that aims at stabilising economic developments and ensuring nominal stability will normally contribute to less risk in the financial sector during economic upswings and will in this way alleviate the situation during periods of economic decline.