What Do We Know About Credit Booms?

• Author: Marco E. Terrones
• Pages: 1-5

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Credit booms are generally defined as periods of unusually sharp, abovetrend expansions in real credit. More specifically, a credit expansion is identified as a boom if it exceeds some multiple of the standard deviation of a given country's credit fluctuations around trend (Terrones, 2004; and Mendoza and Terrones, 2007). Alternatively, credit booms can be definedPage 4 as episodes where the credit-to-GDP ratio deviates from its rolling trend, which uses information until the boom is identified, by a given factor (Gourinchas, Valdés, and Landerretche, 2001). The former definition seems to be superior to the latter because it allows real credit and real GDP to have different trends and cyclical properties, which is important if countries are undergoing a process of financial deepening. In addition, the use of a rolling trend, instead of a long-term trend, could affect the characterization of the boom by distorting its timing and duration.

Credit booms can be the result of various factors, such as explicit or implicit government guarantees, herding behavior by banks, information asymmetries, and agency problems.

(Dell'Ariccia and Marquez (2006) show that as information asymmetries across banks decrease, banks loosen their lending standards and increase aggregate credit.) They can also be associated with hasty financial liberalization and large capital inflows, particularly in countries with weak prudential regulation and supervision. One important mechanism that could lead to a credit boom is the financial accelerator, by which shocks to asset prices are amplified through balance-sheet effects. For example, excessive optimism about future earnings could boost asset valuations and incomes, which would enhance the net worth of the households and firms that hold the assets and, in turn, increase their capacities to borrow and spend. Thus, the expansion phase of the credit boom is characterized by the leveraging of households and firms. (This is a key feature of the transmission mechanism emphasized in the literature on emerging market crises-see, for instance, Arellano and Mendoza, 2003.) This process may be unsustainable, however, and when the overly optimistic expectations are revised downward, asset prices and incomes fall, pushing the financial accelerator into reverse. These large and rapid changes in credit, which occur as the quality of funded projects declines and misperceptions about risk increase (Borio, Furfine, and Lowe, 2001), could often lead to crisis, particularly in countries with weak legal and financial institutions.

What do credit booms look like? Many countries around the world...