There is ample international evidence on the cyclical pattern of credit, which is very strongly correlated to GDP growth, as shown in Graph 2 for the case of Spain (with an elasticity higher than one, meaning that when real product grows, credit tends to grow more, and when real product falls, credit likewise tends to fall even more). Demand and supply effects are difficult to disentangle in credit cyclical dynamics. On the one hand, more economic activity tends to cause more credit demand. At the same time, credit rationing tends to diminish when the economy is booming and tightens when the economy is in recession. Both demand and supply seem to account therefore for credit cyclical swings. Competition is a key factor in explaining credit supply dynamics. Strong competitive pressures may exacerbate the trend towards looser credit conditions in the upturn, because the fight for a market share coincides with the observation of low non-performing loans, leading towards an over-optimistic perception of low risk. The probability of losses exists from the moment the loan is granted, but it will only become apparent ex-post, with the emergence of default problems. Most credit risk mistakes are actually made during  BIS Review 35/2002  3  the expansionary phase, when optimism is prevailing, although only in the downturn will they become evident. Empirical estimates show that there is a strong correlation between credit growth and bad loans, with an average lag of around three years (see upper part of Graph 3).

BIS Review 35/2002  1  This sequence affects different categories of assets (commercial property, residential property, equity), whose impact on the real economy and transmission channels differ. Commercial property seems particularly linked to the business cycle, while residential property has a larger impact on consumption. Equity prices are intertwined with business profits and investment but are also related to spending through wealth effects, depending on the role equity plays in the determination of financial wealth. This interaction between credit cycles and asset price bubbles poses a number of challenges for the authorities and regulators, both in the monetary policy and financial stability domains. In the upswing, inflationary pressures related to excessive credit growth are compounded by financial imbalances resulting from unwarranted optimism on the part of corporations and households and excessive risktaking on the part of financial institutions. In the downturn, recessionary and deflationary forces are aggravated by credit contraction as a result of excessive risk aversion by lenders. The possible explanatory factors of this potential amplification of the cycle in the financial sector are many-faceted and complex. First, heightened competition in the banking sector and in financial markets leads in an upturn to riskier strategies that are only corrected when the rise in bad debts becomes evident in the downturn. Second, there seems to be a tendency for economic agents to overreact to changes in their environment, leading to over-optimism in times of plenty and over-pessimism in bad times. Third, herding usually reinforces existing trends and causes overshooting.