The Financial Cycle The global financial crisis was a painful reminder that the business cycle is not the only source of imbalances. Indeed, imbalances at the heart of the financial cycle have been the best predictors of downturns in recent decades. The financial cycle tracks the rise and fall in leverage and financial conditions around their sustainable levels. Compared to the business cycle, the financial cycle is greater in amplitude, slower moving and longer lasting, sometimes taking up to 20 years between peaks. As an economy expands, risk taking increases and lending constraints are relaxed. Debt and asset prices rise, reinforcing each other. Towards the top of the cycle balance sheets appear strong but are increasingly fragile. Equity and asset valuations are flattered by mark-to-market profits. Debt sustainability is vulnerable to shocks. At the very top irrationality sets in. Current conditions are assumed to continue forever. “House prices can only go up.” “Financial innovation reduces risk.” “Markets always clear.” People fall for the old lies and unknowingly take great risks secure in the belief that this time is different. To find a silver lining in the storm clouds of the financial crisis, there has been an explosion of work into how best to track the financial cycle and avoid its damaging extremes. 8  All speeches are available online at www.bankofengland.co.uk/speeches  8  A range of indicators are now monitored routinely by bodies, such as the Financial Policy Committee (FPC), tasked with maintaining financial stability.
That’s why the FPC has acted to limit the share of high loan-to-income mortgages UK banks can originate, the PRA has tightened standards on consumer credit and the Bank is monitoring closely the growth in leveraged lending. 13  All speeches are available online at www.bankofengland.co.uk/speeches  13  The second reason for caution is the possibility of a more material slowdown in China. China is the one major economy in which all major financial imbalances have materially worsened. It may be the exception that proves the rule that financial imbalances cause recessions. While China’s economic miracle over the past three decades has been extraordinary, its post-crisis performance has relied increasingly on one of the largest and longest running credit booms ever, with an associated explosion of shadow banking. Total Social Financing has increased from 120% to 223% of GDP since 2008. In parallel, the non-bank financial sector has increased from around 20% of GDP to over 70% today, with developments echoing those in the pre-crisis US including off-balance sheet vehicles with large maturity mismatches, sharp increases in repo financing, and large contingent liabilities of both borrowers and banks. Chinese authorities have begun taking measures to manage these risks. Growth in Total Social Financing is now in line with that of nominal GDP (Chart 10). The shadow banking sector is being restructured. But there is a tension between reducing the risks from high debt and supporting the economy.