Procyclicality

What Is Procyclicality?

Procyclicality describes the tendency of economic and financial variables to move in the same direction as the economic cycle, amplifying its peaks and troughs. This phenomenon occurs when market participants, institutions, and even regulatory frameworks adopt behaviors and policies that reinforce existing trends, leading to stronger expansions during booms and more severe contractions during economic recessions. It is a key concept within macroeconomics and a significant concern for financial stability. Procyclicality can exacerbate volatility in financial markets and the broader economy, often contributing to the formation of asset bubbles and subsequent sharp downturns.

History and Origin

The concept of procyclicality, while receiving increased attention during and after the 2008 global financial crisis, has roots in earlier economic thought. Economists have long observed that financial systems can amplify business cycle fluctuations. During periods of economic expansion, for example, banks might increase lending, contributing to rising asset prices and potentially less stringent lending standards. Conversely, in a downturn, banks may tighten credit, leading to a credit crunch and further exacerbating the economic contraction. The Financial Stability Forum (now the Financial Stability Board) published a significant report in April 2009, highlighting procyclicality as a major factor in the severity of the crisis and proposing recommendations to mitigate it, particularly concerning bank capital requirements and loan loss provisioning.⁵

Key Takeaways

• Procyclicality refers to actions or policies that intensify the existing phase of the economic cycle.
• In financial markets, it often manifests as increased lending and risk-taking during booms, and sharp retrenchment during downturns.
• This phenomenon can amplify both economic growth and contractions, leading to greater volatility.
• Regulatory frameworks and accounting standards can inadvertently contribute to procyclicality if not designed with countercyclical measures.
• Mitigating procyclicality is a primary goal of macroprudential policy, aiming for greater financial and economic stability.

Interpreting Procyclicality

Interpreting procyclicality involves understanding its impact on the real economy and financial markets. When financial systems exhibit high procyclicality, they act as an amplifier of economic shocks. For instance, in an upturn, optimistic sentiment can lead to excessive risk-taking, where lenders become less stringent with their criteria and borrowers take on more debt. This fuels the boom, but also builds vulnerabilities. Conversely, in a downturn, a procyclical response means that lenders rapidly withdraw credit, asset values decline sharply, and fear dominates, leading to a vicious cycle of deleveraging and economic contraction. This dynamic underscores the importance of robust risk management frameworks within financial institutions.

Hypothetical Example

Consider a hypothetical country, "Prosperity Land," experiencing a strong period of economic growth. Banks, fueled by positive sentiment and rising collateral values, loosen their lending standards and offer loans more readily, even for speculative ventures. Real estate prices soar, creating a perceived increase in wealth, which encourages more borrowing and spending. This procyclical behavior amplifies the boom, leading to a rapid expansion of credit and a significant increase in asset valuations.

However, when an external shock occurs, such as a sudden drop in export demand, the economy begins to slow. The procyclical behavior reverses: banks, now wary of rising defaults, quickly tighten lending, recall loans, and demand more collateral. Property values, which were inflated, begin to fall, leading to defaults and forcing banks to write down assets. This rapid contraction of credit, combined with declining asset values, exacerbates the downturn, turning a moderate slowdown into a severe recession, demonstrating how procyclicality can amplify economic swings.

Practical Applications

Procyclicality has significant practical applications across finance and economics, particularly in the realm of regulation and policymaking. Central banks and financial regulators actively study procyclicality to design policies that promote stability rather than exacerbate cycles. For instance, monetary policy decisions and changes in capital requirements for banks are often framed with procyclicality in mind.

During the global financial crisis, the procyclical nature of financial regulation and accounting standards was widely recognized. For example, rules requiring assets to be marked-to-market can lead to a downward spiral during crises, as falling prices trigger further sales and write-downs. Similarly, bank capital rules based on current risk assessments can lead to banks reducing lending precisely when the economy needs it most. The Federal Reserve Bank of San Francisco, in a 2010 Economic Letter, discussed how the financial system's inherent procyclicality contributes to financial instability, emphasizing the need for policy interventions to lean against the wind.⁴ Furthermore, the financial crisis highlighted how accounting rules could contribute to procyclicality, prompting discussions on reforms to make them less amplifying of economic swings.³

Limitations and Criticisms

While the dangers of procyclicality are widely acknowledged, efforts to mitigate it face limitations and criticisms. One challenge lies in correctly identifying and forecasting economic turning points, as policies designed to be countercyclical could inadvertently become procyclical if timed incorrectly. For example, tightening fiscal policy too early in a recovery could stifle nascent growth.

Another criticism revolves around the potential for regulatory arbitrage, where financial institutions may find ways around new regulations designed to curb procyclicality. Additionally, some argue that certain procyclical behaviors are simply rational responses to changing market conditions by individual actors, and attempting to suppress them entirely could hinder efficient capital allocation. The International Monetary Fund (IMF) has noted that while reducing procyclicality is crucial, avoiding it completely, especially at the peak of a crisis, can be difficult.² This highlights the complex interplay between individual rational behavior and the collective, potentially harmful, systemic outcome, particularly concerning the build-up of systemic risk. Efforts to make the global financial system less procyclical often involve balancing necessary regulation with maintaining market dynamism.¹

Procyclicality vs. Countercyclicality

Procyclicality and Countercyclicality represent opposite behaviors in relation to the economic cycle.

While procyclicality tends to worsen economic swings by reinforcing existing trends, countercyclicality aims to mitigate these swings. For example, a procyclical tax system might collect more revenue during a boom and less during a recession, thereby amplifying the cycle. A countercyclical tax system, through automatic stabilizers like unemployment benefits, would inject funds during a downturn and withdraw them during a boom, thus smoothing the cycle. Understanding the distinction is crucial for policymakers aiming to achieve greater economic and financial stability and manage liquidity risk.

FAQs

What does "procyclical" mean in finance?

In finance, "procyclical" means that a variable, action, or policy tends to move in the same direction as the overall economic cycle. For instance, if banks lend more during an economic boom and less during a downturn, their lending behavior is procyclical.

Why is procyclicality considered problematic?

Procyclicality is problematic because it can amplify economic fluctuations. During booms, it can lead to excessive risk-taking, asset bubbles, and unsustainable credit expansion. During busts, it can exacerbate contractions by causing a sharp withdrawal of credit and a fire sale of assets, leading to deeper recessions and greater financial instability.

How do regulations contribute to procyclicality?

Certain regulations can inadvertently contribute to procyclicality. For example, mark-to-market accounting rules, while aiming for transparency, can force financial institutions to value assets at depressed market prices during a downturn, triggering further sales and write-downs. Similarly, risk-weighted capital requirements may require banks to hold more capital when risks appear low (during a boom) and less when risks are high (during a bust), potentially amplifying credit cycles.

What are some examples of procyclical policies?

Examples include bank lending practices that expand rapidly during booms and contract sharply during busts, or regulatory frameworks that do not incorporate countercyclical buffers. Unregulated growth in certain financial instruments can also exhibit procyclical tendencies, contributing to the build-up of systemic risk.

How can procyclicality be mitigated?

Procyclicality can be mitigated through macroprudential policy tools, such as countercyclical capital buffers for banks, which require them to build up capital during good times that can be drawn down during stress. Other measures include dynamic loan loss provisioning, reforms to accounting standards, and central bank actions aimed at leaning against excessive credit growth or contraction.