Financial Sector Pro-Cyclicality: Lessons from the Crisis

Abstract

We analyze the main forces affecting financial system pro-cyclicality (the fact that developments in the financial sector can amplify business cycle fluctuations). We first review some major structural developments in financial markets that may influence pro-cyclicality and that have been overlooked in earlier analyses. We then examine three issues that are center stage in the current debate: capital regulation, accounting standards and managers’ incentives. After reviewing the institutional set-up and the key mechanisms at work, we critically examine a series of proposals designed to mitigate pro-cyclicality.

Keywords: pro-cyclicality, financial accelerator, capital requirements, leverage, accounting standards, incentives

JEL Classification: E5, G1, G2, G3, M4