Financial Stress

• Author: Selim Elekdag
• Pages: 1-3

Page 1

Few would disagree that recent global downturn is closely tied with one of the most severe episodes of fi nancial stress since the 1930s. The fi nancial crisis that fi rst erupted with the U.S. subprime mortgage collapse in August 2007 has deepened further, and has been felt across the global fi nancial system, including in emerging markets to an increasing extent. While an episode of fi nancial stress includes the recent crisis, for the purposes of this survey, related topics such as asset price booms and busts, banking crises, contagion, and policies to expedite rapid recoveries will also be discussed.

Page 2

Motivated by the recent crisis, a natural starting point is to discuss the links between fi nancial cycles and business cycles in advanced economies. Claessens, Kose, and Terrones (2008) examine the relationship between fl uctuations in credit, stock and house prices, and the business cycle. Their main fi nding is that recessions associated with credit crunches and house prices tend to be deeper and longer than other recessions. Related studies focusing on credit booms fi nd evidence supporting their conclusion. For example, as noted by Terrones (2007), although rapid credit expansion is associated with fi nancial deepening or favorable external fi nancing conditions, it also raises concerns because of the role of excessive credit expansion in some fi nancial crises (Mendoza and Terrones, 2008). Turning to assets prices, Cardarelli, Igan, and Rebucci (2008) draw attention to the close ties between house prices, stock prices, and economic cycles.

Although the studies cited above discuss the linkages between fi nancial variables and the business cycle, they do not pay much attention to the role of the banking system.

However, as emphasized in Cardarelli, Elekdag, and Lall (forthcoming), episodes of fi nancial turmoil characterized by banking sector distress are more likely to be associated with more severe and more protracted downturns than other types of episodes. These authors also fi nd that the likelihood that fi nancial stress will be followed by a downturn appears to be associated with the extent to which house prices and aggregate credit rise in the period before the fi nancial stress. Moreover, greater reliance on external fi nancing by households and nonfi nancial fi rms is associated with sharper downturns in the aftermath of fi nancial stress.

In other words, banking system distress combined with highly levered balance sheets throughout the economy tend to be associated with the longest and deepest recessions.

The role of banking systems is also...