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Procyclicality, collateral values and financial stability

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  • Prasanna Gai
  • Peter Kondor
  • Nicholas Vause

Abstract

This paper analyses how the risk-sharing capacity of the financial system varies over the business cycle, leading to procyclical fragility. We show how financial imperfections contribute to underinsurance by entrepreneurs, generating an externality that leads to the build-up of systematic risk during upturns. Increased asset price uncertainty emerges as a symptom of the sectoral concentration that builds up during booms. The liquidity of the collateral asset is shown to play a key role in amplifying the financial cycle. The welfare costs of financial stability, in terms of the efficiency costs due to financial frictions and the volatility costs due to amplification, are also illustrated.

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File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP304.pdf
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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 304.

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Date of creation: Aug 2006
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Handle: RePEc:boe:boeewp:304

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  1. Isabel Schnabel & Hyun Song Shin, 2004. "Liquidity and Contagion: The Crisis of 1763," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 929-968, December.
  2. Saint-Paul, Gilles, 1992. "Technological choice, financial markets and economic development," European Economic Review, Elsevier, vol. 36(4), pages 763-781, May.
  3. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
  4. Krishnamurthy, Arvind, 2003. "Collateral constraints and the amplification mechanism," Journal of Economic Theory, Elsevier, vol. 111(2), pages 277-292, August.
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Cited by:
  1. Guido Lorenzoni, 2007. "Inefficient Credit Booms," NBER Working Papers 13639, National Bureau of Economic Research, Inc.
  2. Prasanna Gai & Sujit Kapadia & Stephen Millard & Ander Perez, 2008. "Financial Innovation, Macroeconomic Stability and Systemic Crises," Economic Journal, Royal Economic Society, vol. 118(527), pages 401-426, 03.
  3. Veronica Guerrieri & Péter Kondor, 2009. "Fund Managers, Career Concerns, and Asset Price Volatility," NBER Working Papers 14898, National Bureau of Economic Research, Inc.
  4. David Mayes, 2011. "The future of financial markets: financial crisis avoidance," Empirica, Springer, vol. 38(1), pages 77-101, February.
  5. Liu, Luke, 2011. "Asset price, asset securitization and financial stability," MPRA Paper 35000, University Library of Munich, Germany.

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