The Credit Cycle and why it Matters to Investors

In simple terms, a credit cycle consists of an upturn during which credit expanded and lending standards are eased, and a downturn during which credit contracts and lending standard are tightened. As this happens in cycles across the market, there seems to be a correlation between the lending standards of banks, but it is not immediately obvious why this is the case.

R. G. Rajan argues that part of this correlation in the fluctuation of lending standards can be explained in terms of managers’ concerns for their reputations. Their reputations suffer if they fail to expand credit while other managers are doing so, leading to excess credit and increased intensity of the eventual downturn. Readers should note that this dynamic is not unique to banks, as mutual fund managers have been suspected of much the same failing during bull markets. The problem can be explained in terms of four possible outcomes for the banker or fund manager:

1. He succeeds and everyone else fails.
2. He succeeds and everyone else succeeds.
3. He fails and everyone else fails.
4. He fails and everyone else succeeds.

The first outcome is clearly desirable for him, but in order to achieve it he has to make a contrarian gamble. If such a gamble succeeds his reputation might improve, but if it fails, he might very well be without a job because his superiors and/or shareholders judge him on the basis of relative performance. During a rapid growth phase he will therefore tend to follow the crowd, as in the event of failure, he will fail along with everyone else and will consequently not be punished.

According to this view of the credit cycle, lending standards start to tighten simultaneously at all banks because of some external shock. In the case of the 2007 mortgage trouble, this would be the rise in defaults, exacerbated by the bad loans made under the hitherto excessively loose standards. Bank managers would then see other banks performing worse and tightening lending standards. This would make them tighten lending standards themselves, which might drive the borrowers who rely on new loans to pay off old ones to default and cause a further tightening of lending standards.

The default of these “ponzi borrowers”, as the economist Hyman Minsky called them, is accompanied with an abundance of revealed fraud and swindles as the fruit of the past excesses of greed begins to drop. Enron and the other scandals of the 2000 stock market peak is one example of this phenomenon. Another is the banking fraud which suddenly came to light when the real estate bubble in Japan peaked out.

Bank managers then have to prove to their boards of directors that they will not be harmed by the turmoil that has hit other banks, so they heighten their standards for loans again. The downward spiral of tightening makes it harder for companies and individuals to take out loans and thus puts a dampener on economic growth. Credit cycles bottom when all the excesses have been cleared out and an exogenous shock has pushed the economy back into motion.

As prospects begin to look better banks begin to adjust their ambitions and expectations upwards, expanding credit once again, looking over their shoulders to make sure that their competitors are not able to steal market share by expanding faster than them. Economic expansion encourages greed and the least conscientious of the lenders will again engage in fraudulent practices.

Thus the cycle is brought to its peak again.

Investors in particular should pay close attention to the fluctuations of this cycle as the earnings of many companies are under downward pressure during times of tightening credit and corporate debt has a higher rate of default. The Credit Cycle also leads the business cycle and can thus be used as an indicator of things to come for the economy as a whole.

(The view presented above is just one among many, although fairly uncontroversial, and readers are encouraged to do their own research in general works on economics as well as in the works of Minsky, Kindleberger, Schumpeter and others.)

I hope this will be of help to you.