Procyclicality, Collateral Values and Financial Stability

37 Pages Posted: 28 Sep 2006

See all articles by Prasanna Gai

Prasanna Gai

University of Auckland Business School; Australian National University (ANU); Bank of England

Peter Kondor

London School of Economics & Political Science (LSE); Central European University (CEU)

Nicholas Vause

Bank of England

Date Written: August 2006

Abstract

This paper analyses how the risk-sharing capacity of the financial system varies over the business cycle, leading to procyclical fragility. We show how financial imperfections contribute to underinsurance by entrepreneurs, generating an externality that leads to the build-up of systematic risk during upturns. Increased asset price uncertainty emerges as a symptom of the sectoral concentration that builds up during booms. The liquidity of the collateral asset is shown to play a key role in amplifying the financial cycle. The welfare costs of financial stability, in terms of the efficiency costs due to financial frictions and the volatility costs due to amplification, are also illustrated.

Keywords: Financial stability, procyclicality, collateral constraints

JEL Classification: E32, E44, G13, G18

Suggested Citation

Gai, Prasanna and Kondor, Peter and Kondor, Peter and Vause, Nicholas, Procyclicality, Collateral Values and Financial Stability (August 2006). Bank of England Working Paper No. 304, Available at SSRN: https://ssrn.com/abstract=933292 or http://dx.doi.org/10.2139/ssrn.933292

Prasanna Gai (Contact Author)

University of Auckland Business School ( email )

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Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

Bank of England ( email )

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Peter Kondor

London School of Economics & Political Science (LSE) ( email )

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United Kingdom

HOME PAGE: http://fmg.lse.ac.uk/~kondor

Central European University (CEU) ( email )

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Budapest, H-1051
Hungary

Nicholas Vause

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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