Procyclicality, collateral values and financial stability

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 04 August 2006

Working Paper No. 304
By Prasanna Gai, Peter Kondor and Nicholas Vause

This paper analyses how the risk-sharing capacity of the financial system varies over the business cycle, leading to procyclical fragility. We show how financial imperfections contribute to underinsurance by entrepreneurs, generating an externality that leads to the build-up of systematic risk during upturns. Increased asset price uncertainty emerges as a symptom of the sectoral concentration that builds up during booms. The liquidity of the collateral asset is shown to play a key role in amplifying the financial cycle. The welfare costs of financial stability, in terms of the efficiency costs due to financial frictions and the volatility costs due to amplification, are also illustrated.

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