14 A key variable here is the interest rate level: If current and anticipated rates are comparably low, loans tend to be taken out for projects which would not be profitable or not be financed at higher rates. Furthermore, lenders in such an  11  Uncertainty regarding the stability of individual banks can also result in banks no longer lending to one another, thereby mutually aggravating their difficulties and leading to even more restrictive lending practices. 12 Other aspects based on rational considerations that I did not examine further here and which can also lead to excessive borrowing or lending are (misplaced) incentives of an institutional, regulatory and fiscal nature, and the emergence of innovative financial products. 13 Cf. Kindleberger and Aliber (2005). 14 Cf. Jorda et al. (2016). Page 7/16  environment often take higher risks in order to achieve return and growth targets despite the low interest rates. Other key drivers for the increase in credit are movements in prices of assets such as shares and real estate. Rising prices for these assets and growing credit volume often go hand in hand and are mutually reinforcing. This applies to the real estate market in particular, since real estate is almost always part-financed by loans. Two mechanisms are at work here: First, rising asset prices produce ‘wealth effects’ in households. Households become richer and thus more creditworthy. This has a positive impact on household demand for loans. At the same time, rising asset prices translate into higher-value collateral for households to use.
During this crisis, the precipitate rise in liquidity premia and fall in asset prices may have called into question the viability of many banks had their assets been fair-valued. Consider again the banking book of UK banks on a mark to market basis. Chart 7 shows the loss of value on this book, which would have peaked at over £ billion during the early months of 2009. The total capital resources of UK banks at that time were around £ billion. In other words, the UK banking system in aggregate would have been technically insolvent on a mark to market basis. The recent recovery in asset prices has been almost as remarkable as the preceding fall. It has meant UK banks were back in the black within a matter of months.   “Liquidity and fire-sales”  The act of marking to market may itself have a bearing on asset price dynamics. This arises because of its potential effects on banks’ behaviour. If swings in perceived solvency cause banks to sell assets, these fire-sales may themselves add to downward pressures on asset prices. Under mark to market, these pressures are felt by all institutions, not just the seller. In effect, fire-sales by one firm have negative externalities for all others. And as other banks adjust their own balance sheets in response, there is a risk the downward dynamic is perpetuated. 18  8  Khan (2009).