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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.

Suggested Citation

  • Prasanna Gai & Peter Kondor & Nicholas Vause, 2006. "Procyclicality, collateral values and financial stability," Bank of England working papers 304, Bank of England.
  • Handle: RePEc:boe:boeewp:304
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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP304.pdf
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    References listed on IDEAS

    as
    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. 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. Liu, Luke, 2011. "Asset price, asset securitization and financial stability," MPRA Paper 35000, University Library of Munich, Germany.
    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, March.
    3. Veronica Guerrieri & Peter Kondor, 2012. "Fund Managers, Career Concerns, and Asset Price Volatility," American Economic Review, American Economic Association, vol. 102(5), pages 1986-2017, August.
    4. Guido Lorenzoni, 2008. "Inefficient Credit Booms," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 809-833.
    5. David Mayes, 2011. "The future of financial markets: financial crisis avoidance," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 38(1), pages 77-101, February.

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