It reflects the tendency to take on excessive risk during economic upswings – too much punch from the punchbowl, if you will – and to become overly risk averse during the downturns. Procyclicality makes the financial system and the economy more vulnerable to shocks, and increases the likelihood of financial distress. Risk concentrations and interconnections are the key issues in the cross-sectional dimension.
Financial institutions can have similar exposures to shocks or be linked through balance sheets. As a result, losses in one institution can lead to fears of contagion that amplify the adverse effects of the initial shock.