Conversely, if increased competition and deregulation increase reputational concerns, this increases the propensity of the system to periodic credit booms and subsequent busts. 2.3  Dynamics  This model can generate credit cycles which amplify cycles in the real economy relative to a world without credit cycle frictions. 9 Without frictions, bad loans are liquidated immediately, allowing new assets to be originated next period to unencumbered borrowers. By contrast,  8  These expectation effects are necessarily intra-temporal in our model. The actual operation of macroprudential policy may well have effects through inter-temporal expectations as well. See Section 5 below. 9  The property that global games generate endogenous cycles in dynamic settings has been analysed in, inter alia, Steiner (2006) and Giannitsarou and Toxvaerd (2007). 6  BIS Review 168/2010  extending credit to bad risks eventually results in balance sheet impairment for both borrowers and lenders. We perform a simple simulation to illustrate these dynamics. Suppose the macro state moves stochastically around its trend as a result of a sequence of iid productivity shocks. The macro state is mean-reverting as long as banks set tight policies when they realise low asset returns. This occurs when reputational effects are switched off  . Next suppose reputational concerns are introduced, leading banks to risk up to signal high ability. Because of strategic complementarities, banks do this whenever . This leads to subsequent impairment of the borrowing sector.
There is also evidence of them arising from coordination failures, which generate spillover effects across banks and countries. 1  See IMF (2010). BIS Review 168/2010  1  Drawing on this evidence, Section 5 identifies some implications for the design of public policy. It suggests that neither monetary nor micro-prudential policy may be well-equipped to tackle the credit cycle. Instead, some new policy apparatus may be needed which (unlike monetary policy) targets bank balance sheets directly but which (unlike micro-prudential policy) does so systematically. This is one key dimension of so-called macro-prudential policy. 2 Various international macro-prudential policy committees are, or are about to be, put in place – in the US the Financial Stability Oversight Committee, in the euro-area the European Systemic Risk Board and in the UK the Financial Policy Committee. These provide one element of a macroprudential policy framework. Other elements remain to be put in place. Knowledge of the sources and dynamics of the credit cycle will be important in assembling those missing pieces. This paper is intended to be a contribution towards that goal. 2. A model of the credit cycle  We begin by sketching a model which captures some key features of past and in particular the present, credit cycle. There are a number of existing models of the credit, or leverage, cycle. In all of these models, cyclicality in financial variables is aggravated by various microeconomic frictions. These frictions typically then amplify fluctuations in the real economy.