Why is finance pro-cyclical?

There are many explanations to this. I discuss them in my classes. But, a nice and elegant explanation was offered by Mr. Fabrizio Saccomanni, former Minister of Economy and Finance in Italy at a BIS Special Governors’ Meeting in Manila in February 2015 and I quote:

As I have argued in the past (Saccomanni 2008), although global financial intermediaries operate in a highly competitive environment, they have uniform credit allocation strategies, risk management models and reaction functions to macroeconomic developments and credit events. Thus, competition and uniformity of strategies combine, in periods of financial euphoria, when the search for yield is the dominant factor, to generate underpricing of risk, overestimation of market liquidity, information asymmetries and herd behaviour; in periods of financial panic, when the search for safe assets is predominant, they combine to produce generalised risk aversion, overestimation of counterparty risk and, again, information asymmetries and herd behaviour. [Link]

Nice. I like it. The statements are testable hypotheses. I like it because I have long held the view that competition in the financial services industry is not the same as competition elsewhere in the real world. That does not mean that the optimal number of firms in the banking industry is ONE but that competition requires regulation and ‘leaning against the wind’ norms – countercyclical credit buffers come to mind – to ensure that competition in the banking industry is not welfare-subtracting for the economy.

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