Credit booms and crisis-emergent asset comovement: The problem of latent correlation

The typical fall of asset prices during crises and recessions implies that asset correlation is strong during these events while not necessarily discernible during the boom phase of the business cycle. Using insights from the malinvestment cycle theory, we show that this shift in correlation is not just the result of an exogenous shock. It is also the consequence of risk buildup induced by changes in macro-policy instruments and credit expansion during the boom. We provide a model where the probability of a crash increases with specific changes in macro-policy variables accommodating bank credit expansion during the growth phase. Our model hints at a “latent” asset correlation diverging from the estimated correlations. Credit expansion accommodated by monetary policy results in changes in market signals that feeds asset prices and widens the gap between future-oriented cash inflows and present-oriented cash outflows. As this gap widens, asset valuation becomes more funding-based rather than cash flow-based. Therefore, the probability of a market crash increases with credit expansion as companies increase their exposure to riskier projects. This process implies a “latent” asset correlation during the boom phase, which becomes “effective” with the crash. Practitioners and policymakers would thus benefit from adopting the insights of malinvestment cycle theory to complement their ad hoc empirical findings and estimations.