With close to 120,000 employees 8 in 2014, the banking sector is a major employer. The size of the banking sector, as measured by the ratio of total assets to GDP, is high by international standards. 9 Macroeconomic stability is thus a long-term asset for Switzerland. Low interest rates make borrowing conditions for firms and households cheaper. This leads to higher investment and supports the real sector. Macroeconomic stability is not only a precondition for sustained economic growth, but has helped to build a stable and robust financial sector. It is the longterm stability, combined with high quality work, which has helped create ‘brand Switzerland’. The Swiss financial sector has not only benefited from this brand but also contributed to its international propagation. However, long-term stability can sometimes be associated with short-term costs. As a small open economy, Switzerland can be subject to short-term exchange rate volatility resulting from the safe-haven status of its currency. The costs of this volatility are substantial at times. Strong fluctuations in the Swiss franc have had major effects on the Swiss economy in the past. For example, in the early 1990s, during the European Monetary System crisis, the Swiss franc appreciated strongly against European currencies. The entire economy had to adjust to a strong currency. More recently, Switzerland has been particularly heavily affected by international disturbances since the beginning of the financial crisis. The Swiss economy and its inflation outlook have been subject to strong downside pressures, due to massive exchange rate appreciation, weak international demand, and volatile financial markets.

Some have proposed a more active role for monetary policy in addressing financial imbalances (Taylor (2010), White (2009)). Others have suggested using new macro-prudential tools to rein in credit excesses (Borio and Lowe (2002), Bank of England (2009), Kashyap et al (2010)). Others still have proposed a radical root-and-branch reform of the structure of banking (Kay (2009), Kotlikoff (2010)). Evaluating the merits of these proposals requires a conceptual understanding of the causes of the credit cycle and an empirical quantification of its dynamic behaviour. What is the underlying friction generating credit booms and busts? Are credit cycles distinct from cycles in the real economy? And how have they evolved, both over time and across countries? Answers to these questions should help frame public policy choices for curbing the credit cycle. To fix ideas, Section 2 sketches a model of the credit cycle. In this model, a lack of information provides incentives for banks to expand their balance sheets to boost profits and signal their ability to investors. This gives rise to a coordination failure, as banks collectively risk-up. That, in turn, generates a systematic credit boom and subsequent bust when risk is realised. Sections 3 and 4 present some empirical evidence on the credit cycle. Across countries and across a sweep of history, credit cycles are both clearly identifiable and regular. Typically, they presage banking crises. In their frequency and amplitude, credit cycles are distinct from the business cycle.