Malinvestment and Crisis-Emergent Asset Comovement: The Problem of Latent Correlation
28 Pages Posted: 3 Jun 2020
Date Written: May 5, 2020
The common fall of asset prices during crises and recessions implies that asset correlation is strong during these events, while not necessarily showing up during the boom phase of the business cycle. Using insights from the malinvestment cycle theory, we show that this shift in correlation is not just triggered by a crash-related shock. It is also the result of risk build-up induced by money-boosted malinvestment taking place during the boom. We provide a model where the probability of a crash increases with bank credit expansion during the growth phase, which hints at a “latent” build-up of asset correlation. Credit expansion feeds asset prices, but also widens a gap between future-oriented cash inflows and present-oriented cash outflows. As new credit widens this gap, asset valuation becomes more funding-based rather than cash flow-based. Therefore, default risk, and hence the probability of a crash, increases with credit expansion. A change in credit expansion cuts the asset price rise short and reveals the malinvestments in the economy. This process implies a “latent” build-up of asset correlation during the boom phase that becomes “effective” with the crash. Practitioners and policy-makers would thus benefit from adopting the insights of the malinvestment cycle theory to complement their ad hoc empirical findings and estimations.
Keywords: correlation shift, credit, disaster event, latent correlation, malinvestment
JEL Classification: E14, E51, G01, G11, G21
Suggested Citation: Suggested Citation