## 1. EUR economies pre- and post-GFC outturns ## Source details **Canonical URL:** [1. EUR economies pre- and post-GFC outturns](https://www.imf.org/-/media/files/publications/wp/2017/wp17256.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2017/wp17256.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2017/wp17256.pdf.json) --- ### I. Introduction: context, scope, and research questions - Context and sample: - Almost a decade after the global financial crisis (GFC) in 2008, economic activity and bank lending in Europe have yet to fully recover. - Sample and data: annual data for 1999–2016 (2015 for bank-level data) for 39 European countries in most analyses; extended data back to 1972 for a group of advanced and emerging market economies. - Key background findings from literature cited: - Recoveries after financial crises, especially credit-fueled booms and busts, tend to be weaker and longer. - Research questions: - How have post-GFC economic and credit dynamics in Europe evolved and compared to previous recoveries? - How has credit extension related to economic activity in Europe and has that relationship changed after the GFC? - Which financial and macroeconomic indicators correlate most closely with credit dynamics? - How has bank profitability been affected by credit developments? ### II. Post‑GFC Economic Developments in Europe (business-cycle characterization and counterfactuals) - Business-cycle phases since 1999: - Three phases: boom (1999–08), bust (2009–11), sluggish recovery (2012–16). - Key outcomes and magnitudes: - On average, output contracted about 7½ percent (unweighted) in the 35 European countries that experienced a recession in 2008–09. - Bank credit to GDP in the European Union remains about 10 percent below its pre-GFC peak level. - Empirical approach: - Control group: advanced countries and major emerging market economies with recessions in 1972–2006 (37 countries; 116 conventional and 28 financial peaks; reduced to 83 episodes due to missing data: 68 conventional and 15 financial episodes). - Method: local projections (Jordà, 2005) with indicators splitting conventional vs financial peaks and interacting with excess pre-recession credit growth. - Main patterns and counterfactuals: - Conventional (non-financial) recessions: - Advanced euro area: real GDP, consumption, and investment broadly returned to pre-GFC levels by 2015 (seven years after the GFC); double-dip pattern and prolonged investment drop observed. - Credit stock remained essentially flat relative to pre-GFC level across groups. - Global external demand correction explains only a small fraction of the dampened recovery in conventional episodes. - Accounting for the euro area sovereign debt crisis (timing peak in 2011) substantially alters projection comparisons; starting from 2011 brings many observed paths closer to projections. - Financial (banking-crisis) episodes: - Countries with banking crises underperformed historical patterns; cumulative real lending broadly aligned with weak projection path. - Counterfactual external demand brings projections closer to observed outcomes but does not fully explain underperformance. - Timing from 2011 shows investment and consumption overperformance relative to projections while credit remains subdued. - Exchange-rate regime effects: - Non-financial recessions: floaters performed better early; non-floaters caught up later; investment overperformed while credit underperformed, suggesting non-bank financing uptake. - Financial recessions: floaters (small sample: GB, IS) show stronger recoveries post-sovereign-debt-crisis controls (sample small). ### III. Credit Growth and Economic Activity (estimation, magnitudes, and structural break) - Estimation framework: - Dynamic system GMM (Blundell and Bond, 1998) for relationships between credit growth, GDP growth, and private investment growth. - Main GDP regression controls: lagged GDP growth, credit growth (real stock change), public consumption growth, credit/GDP ratio, trading partners’ external demand, log(VIX). Dummies for post-GFC recession and recovery and interactions with credit growth. - Investment regression controls include lagged GFCF growth, credit growth, general government balance-to-GDP, credit/GDP, policy interest rate, external demand, VIX. - Key quantitative relationships (preserve reported magnitudes): - A 10 percent increase in bank credit to the private sector is associated with: - 0.6–1 percent rise in real GDP growth (depending on specification and sample). - 2–2½ percent rise in real private investment growth. - Investment channel is dominant given investment weight in GDP generally ranging from 20–30 percent in European countries. - Structural break and creditless recoveries: - Interaction terms indicate the GFC-induced recession did not significantly change the credit–GDP relationship. - Recovery period shows evidence of creditless recoveries in countries that experienced a pre-GFC credit boom (Mendoza and Terrones (2012) methodology): combined coefficient on credit growth during recovery is small and statistically insignificant for boom countries. - Credit impulse analysis: the change in bank credit growth significantly affects GDP growth during the post-GFC recovery (credit impulse coefficient significant), but not during pre-GFC expansion or recessions. - Robustness and endogeneity checks: - Additional instruments: lending-standards-based survey instruments (bank officer surveys) added to internal lag instruments. - Wald tests: coefficients with additional instruments are not statistically different from baseline. ### IV. Financial and Macroeconomic Indicators Influencing Credit Growth (bank-level drivers) - Bank-level panel and estimation: - Bank-level panel: 39 countries, 1999–2015; system GMM including bank fundamentals and macro variables. - Benchmark explanatory variables (as defined in ANNEX II.3 and main text): - Bank fundamentals: customer deposit flows/assets, regulatory capital ratio (equity/assets), liquid assets/total assets, NPL ratio, return on assets (ROAA). - Macro: real GDP growth, inflation. - Dummies: Recession (DumRecession), Recovery (DumRecovery) and interactions. - Principal findings and magnitudes: - Loan quality: higher NPL ratio → weaker credit extension; average NPL ratio ~8 percent in post-GFC recovery vs <5 percent in 1999–2008 boom period. - Customer deposits: positive and significant association with credit growth; deposit growth averaged over 20 percent annually during 1999–2008 and about 9 percent in post‑GFC recovery. - Bank equity price index: positive association with credit growth; effect reverses in recessions. - Bank capital: negative and significant in recessions (indicating deleveraging or capital-raising via asset reduction), quantitatively small. - Real GDP growth: positive and significant correlation with credit growth (demand factor). - Heterogeneity across regions: - Advanced Europe: results broadly confirm drivers above; inflation significant at 10 percent level with negative sign. - CESEE: results less robust; only customer deposits and real GDP growth pass significance tests—potentially due to large foreign bank ownership and parent-bank support. ### V. Credit Growth and Bank Profitability (income links and magnitudes) - Income and profitability measures (all scaled by total assets): - Income components: gross interest income; net interest income; commissions and fees. - Profitability metrics: pre-impairment income; operating income; pretax income; net income. - Dynamic panel and controls: - Profitability regressed on credit growth, capital, credit risk (NPL ratio), funding risk (deposits share), liquidity, size, bank type, crisis/recovery dummies and interactions; system GMM. - Key quantitative results and examples: - Credit growth is significantly and positively associated with all measures of income and profitability. - Example magnitude: in pre-crisis and post-GFC recovery periods, a one percentage point of assets increase in credit growth implies a rise in gross interest income equal to 0.08 percentage points of assets. - Credit growth explains about 50 percent of the variation in gross interest income and about 40 percent in net interest income (standardized regressions). - The effect of credit growth on income/profits falls sharply in recessions in some specifications. - Credit growth and—sometimes—the NPL ratio and the lag of profits are statistically the most significant predictors of profits. - Robustness notes: - Relationship between credit and profitability remained practically the same in pre-crisis and recovery periods in most specifications; it weakened or broke during recessions in some specifications. ### VI. Summary of Main Findings and Policy Implications - Recovery patterns: - Countries without a financial crisis during/after the GFC had output and credit recoveries much worse than historical experience, even after controlling for weak external demand. - Countries with financial crises also had weaker recoveries, but after controlling for weak external demand their recoveries are not statistically significantly weaker. - Treating the GFC and euro area sovereign debt crisis as one episode yields recovery paths in line with or better than historical patterns. - Credit and aggregate activity (summary magnitudes): - A 10 percent increase in domestic bank credit to the private sector is associated with about a 0.6–1 percent increase in real GDP and a 2–2½ percent increase in private GFCF. - Relationships between credit growth, GDP growth, and investment remained broadly robust through the post-GFC recession and recovery, but evidence exists of creditless recoveries especially in economies that experienced pre-GFC credit booms. - Bank-level determinants: - Large customer deposit inflows and high bank equity prices support stronger credit extension; high NPL ratios depress credit growth. - Real GDP growth remains an important demand-side correlate of credit growth. - Credit and profitability: - Exceptional weakness in credit dynamics is associated with weaker bank profitability; credit growth explains a large share of variation in bank interest income. - The influence of credit on profitability weakened markedly in some specifications during recessions. - Policy implications and recommendations: - Stimulating credit growth is not a substitute for structural reforms: efforts to stimulate lending at any cost have modest payoffs and can produce large adverse side effects. - A successful restart of credit flows typically requires a concerted policy package addressing binding constraints on credit extension (e.g., bank capital repair, NPL resolution, demand-side measures), implemented in a complementary manner. - Financial and macroprudential policies should curb credit growth ahead of fundamentals to avoid future credit crash-led recessions. - Proactive bank disposal of impaired loans, improved legal frameworks, and tax incentives encouraging prompt handling of problem loans are vital to reinvigorate sustainable credit growth. ### Appendix I. Economic hypotheses about post-financial-crisis recoveries (core mechanisms) - Core hypothesis: - Post-financial-crisis recoveries tend to be weak, long, and creditless; larger pre-crisis booms yield larger corrections and longer recoveries. - Boom–bust–recovery mechanics and expectations: - Theories emphasize exuberant expectations, learning and information frictions, three phases (boom, bust, recovery), and recalibration of expectations and balance sheets. - Financial sector amplification and lending behavior: - Financial intermediation can amplify booms via collateral and financial accelerator effects; after busts banks may be less willing and less able to lend. - Equity cushions and debt-recovery efficiency: - Size of equity cushions and efficiency of debt-recovery processes affect recovery length and creditlessness; example empirical magnitude: Mian et al. (2015) find that "a 6 percentage-point increase in household debt over GDP over three years predicts a 2 percentage-point lower GDP in the subsequent three years." - Policy modeling insights: - Severe deleveraging may require expansionary fiscal policy in a liquidity trap; structural policies can interact non-trivially with debt dynamics. ### Annex II.3. Description of data used in Section IV (macros, bank fundamentals, and dummies) - Macroeconomic variables (MACRO): - Source: WEO. - GDP growth: percentage change of real gross domestic product. - Average inflation: the average annual change of the CPI. - Bank fundamentals (B_FUND): - Source: Fitch Connect. - Deposit growth: defined as the annual change of domestic deposits scaled by assets. - Profitability: proxied by the annual return to assets. - Capitalization: defined as total bank capital scaled by assets. - Bank liquidity: proxied by liquid assets as a ratio of total assets. - Loan quality: proxied by non-performing loan ratio as a percent of gross loans. - Recession and recovery indicators: - DumRecession: dummy variable taking a value of 1 during recessions and 0 otherwise (recessions dated by peaks and troughs in the level of real GDP). - DumRecovery: dummy variable taking a value of 1 during recoveries and 0 otherwise (recoveries defined as periods following the recessions). *IMF staff analysis from wp17256 (PDF chapter/section).* ### 1. EUR economies pre- and post-GFC outturns ____________________________________8 ### 1. EUR economies pre- and post-GFC outturns ____________________________________8 ### Main sections - 2. Non-financial Episodes: Recession and Recovery Period _________________________15 - 3. Financial episodes: Recession and Recovery Period _____________________________16 - 4. Non-financial Episodes: Breakdown by Exchange Rate Regime ____________________17 - 5. Financial Episodes: Breakdown by Exchange Rate Regime _______________________18 ### Tables listed in the unit - 2.1 Cyclical properties of real output and real bank credit to the private sector ___________9 - 2.2 External demand comparison ______________________________________________12 - 3.1 Regressions using lending standards-based instruments _________________________22 - 3.2 Credit Growth and GDP Growth ___________________________________________31 - 3.3 Credit Growth and Private Investment Growth ________________________________32 - 3.4 Credit Growth (total credit) and GDP Growth _________________________________33 - 3.5 Credit Impulse and GDP Growth ___________________________________________34 - 4.1. Cross-Country Analysis of Determinants of Credit Growth: Regression Results ______35 - 5.1. Models for Bank Profitability and Credit Growth ______________________________36 - 5.2. Models for Bank Profitability and Credit Growth ______________________________37 ### Appendices included - I. Economic Hypotheses about Post-Financial-Crisis Recoveries _____________________38 - II: Selected Data Issues _____________________________________________________41 - A. Countries and Period Covered ______________________________________________41 - Data Sources ____________________________________________________________41 - Data Cleaning ___________________________________________________________42 - Selected Definitions and Concepts __________________________________________42 ### Annexes included - II.1. Description of Data used in Section II ______________________________________44 - II.2. Description of Data used in Section III ______________________________________44 - II.3. Description of Data used in Section IV ______________________________________46 - II.4. Description of Data used in Section V ______________________________________47 *Source: wp17256 - 1. EUR economies pre- and post-GFC outturns ____________________________________8 (PDF chapter/section).* ### REFERENCES ___________________________________________________________48 ### wp17256 - REFERENCES ___________________________________________________________48 ### I. Introduction - Context and scope - Almost a decade after the global financial crisis (GFC) in 2008, economic activity and bank lending in Europe have yet to fully recover. - Sample and data: annual data for 1999–2016 (2015 for bank-level data) for 39 European countries in most analyses; extended data back to 1972 for a group of advanced and emerging market economies. - Key background findings from literature cited - Recoveries after financial crises, especially credit-fueled booms and busts, tend to be weaker and longer. - IMF (2008, 2009A, 2009B), Bordo and Haubrich (2009), Claessens, Kose and Terrones (2009A and 2011), Jordà et al. (2013A, 2014), Taylor (2015), Caselli, Greenberg, and Scott (forthcoming), Takáts and Upper (2013), Bech et al. (2012), Abiad, Dell’Ariccia, and Li (2011), Sugawara and Zalduendo (2013), Bodnár et al. (2014), Biggs et al. (2009). - Research questions addressed - How have post-GFC economic and credit dynamics in Europe evolved and compared to previous recoveries? - How has credit extension related to economic activity in Europe and has that relationship changed after the GFC? - Which financial and macroeconomic indicators correlate most closely with credit dynamics? - How has bank profitability been affected by credit developments? ### II. Post‑GFC Economic Developments in Europe - Business cycle characterization since 1999 - Three phases: boom (1999–08), bust (2009–11), sluggish recovery (2012–16). - On average, output contracted about 7½ percent (unweighted) in the 35 European countries that experienced a recession in 2008–09. - Bank credit to GDP in the European Union remains about 10 percent below its pre-GFC peak level. - Empirical approach - Control group: advanced countries and major emerging market economies with recessions in 1972–2006 (37 countries; 116 conventional and 28 financial peaks; reduced to 83 episodes due to missing data: 68 conventional and 15 financial episodes). - Method: local projections (Jordà, 2005) with indicators splitting conventional vs financial peaks and interacting with excess pre-recession credit growth. - Sample medians and cyclical statistics reported (expansion amplitudes, annual average rates, durations). - Main patterns and counterfactuals - Conventional (non-financial) recessions: - Advanced euro area: real GDP, consumption, and investment just (broadly) returned to pre-GFC levels by 2015 (seven years after the GFC); double-dip pattern and prolonged investment drop. - Advanced non-euro area: recovery slower than pre-GFC recoveries but qualitatively similar to projections. - CESEE: sharp initial drops and unprecedented current account adjustment; recovery speed once underway was similar to pre-GFC patterns but levels remain below historical projections. - Credit stock remained essentially flat relative to pre-GFC level across groups. - Global external demand correction (counterfactual using Europe post-GFC external demand) explains only a small fraction of the dampened recovery in conventional episodes. - Accounting for the euro area sovereign debt crisis (timing peak in 2011) substantially alters projection comparisons: starting from 2011 brings many observed paths closer to projections; advanced euro area recovery remains delayed. - Financial (banking-crisis) episodes: - Countries with banking crises underperformed historical patterns; cumulative real lending broadly aligned with weak projection path. - Worldwide reach of GFC notably affected recoveries in banking-crisis countries; counterfactual external demand brings projections closer to observed outcomes but not fully. - Timing from 2011 (sovereign debt crisis) shows investment and consumption overperformance relative to projections while credit remains subdued. - Exchange-rate regime effects: - For non-financial recessions, floaters performed better early, non-floaters caught up later; investment overperformed while credit underperformed, suggesting non-bank financing uptake. - For financial recessions, floaters (small sample: GB, IS) show stronger recoveries post-sovereign-debt-crisis controls, but sample is small. ### III. Credit Growth and Economic Activity - Estimation framework - Dynamic system GMM (Blundell and Bond, 1998) for the relationship between credit growth, GDP growth, and private investment growth. - Main GDP regression controls: lagged GDP growth, credit growth (real stock change), public consumption growth, credit/GDP ratio, trading partners’ external demand, log(VIX). Dummies for post-GFC recession and recovery and interactions with credit growth. - Investment regression (GFCF): controls include lagged GFCF growth, credit growth, general government balance-to-GDP, credit/GDP, policy interest rate, external demand, VIX. - Quantitative results (key coefficients and magnitudes) - A 10 percent increase in bank credit to the private sector is associated with: - 0.6–1 percent rise in real GDP growth (depending on specification and sample). - 2–2½ percent rise in real private investment growth. - The main channel: private investment (investment weight in GDP generally ranging from 20–30 percent in European countries). - Structural break and creditless recoveries - Interaction terms indicate: - The GFC-induced recession did not significantly change the credit–GDP relationship. - Recovery period shows evidence of creditless recoveries in countries that experienced a pre-GFC credit boom (Mendoza and Terrones (2012) methodology): combined coefficient on credit growth during recovery is small and statistically insignificant for boom countries. - Credit impulse (change in credit growth) analysis: - The change in bank credit growth significantly affects GDP growth during the post-GFC recovery (credit impulse coefficient significant), but not during pre-GFC expansion or recessions. - Robustness and endogeneity checks - Additional instruments: lending-standards-based survey instruments (bank officer surveys) added to internal lag instruments. - Wald tests: coefficients with additional instruments are not statistically different from baseline, suggesting baseline estimates are robust to residual endogeneity concerns. ### IV. Financial and Macroeconomic Indicators Influencing Credit Growth - Bank-level panel (39 countries, 1999–2015; bank fundamentals and macro variables) estimated via system GMM. - Benchmark explanatory variables - Bank fundamentals: customer deposit flows/assets, regulatory capital ratio (equity/assets), liquid assets/total assets, NPL ratio, return on assets (ROAA). - Macro: real GDP growth, inflation. - Dummies: Recession, Recovery, and interactions. - Principal findings (standardized and raw effects highlighted) - Loan quality: higher NPL ratio → weaker credit extension; average NPL ratio ~8 percent in post-GFC recovery vs <5 percent in 1999–2008 boom period. - Customer deposits: positive and significant association with credit growth; deposit growth averaged over 20 percent annually during 1999–2008 and about 9 percent in post‑GFC recovery. - Bank equity price index: positive association with credit growth; effect reverses in recessions. - Bank capital: negative and significant in recessions (indicating deleveraging or capital-raising via asset reduction), quantitatively small. - Real GDP growth: positive and significant correlation with credit growth (demand factor). - Heterogeneity - Advanced Europe: results broadly confirm the above drivers; inflation significant at 10 percent level with negative sign. - CESEE: results less robust; only customer deposits and real GDP growth pass significance tests—potentially due to large foreign bank ownership and parent-bank support. ### V. Credit Growth and Bank Profitability - Income and profitability measures analyzed (all scaled by total assets) - Income components: (i) gross interest income; (ii) net interest income; (iii) commissions and fees. - Profitability metrics: (iv) pre-impairment income; (v) operating income; (vi) pretax income; (vii) net income. - Dynamic panel specification: profitability regressed on credit growth, capital, credit risk (NPL ratio), funding risk (deposits share), liquidity, size, bank type, crisis/recovery dummies and interactions; system GMM. - Key quantitative results - Credit growth is significantly and positively associated with all measures of income and profitability. - Example magnitude: in pre-crisis and post-GFC recovery periods, a one percentage point of assets increase in credit growth implies a rise in gross interest income equal to 0.08 percentage points of assets. - Credit growth explains about 50 percent of the variation in gross interest income and about 40 percent in net interest income (standardized regressions). - The effect of credit growth on income/profits falls sharply in recessions in some specifications—coinciding with sharply falling lending during the GFC and more resilient profits supported by other bank activities. - Credit growth and—sometimes—the NPL ratio and the lag of profits are statistically the most significant predictors of profits. - Robustness and interpretive notes - The relationship between credit and profitability remained practically the same in pre-crisis and recovery periods in most specifications; it weakened or broke during recessions in some specifications. - Results based on standardized regressions confirm economic significance of credit growth relative to other bank-specific factors. ### VI. Summary of Main Findings and Policy Implications - Recovery patterns - Countries without a financial crisis during/after the GFC had output and credit recoveries much worse than historical experience, even after controlling for weak external demand. - Countries with financial crises also had weaker recoveries, but after controlling for weak external demand their recoveries are not statistically significantly weaker. - Treating the GFC and euro area sovereign debt crisis as one episode yields recovery paths in line with or better than historical patterns. - Credit and aggregate activity - A 10 percent increase in domestic bank credit to the private sector is associated with about a 0.6–1 percent increase in real GDP and a 2–2½ percent increase in private GFCF. - Relationships between credit growth, GDP growth, and investment remained broadly robust through the post-GFC recession and recovery, but evidence exists of creditless recoveries especially in economies that experienced pre-GFC credit booms. - Bank-level determinants - Large customer deposit inflows and high bank equity prices support stronger credit extension; high NPL ratios depress credit growth. - Real GDP growth remains an important demand-side correlate of credit growth. - Credit and profitability - Exceptional weakness in credit dynamics is associated with weaker bank profitability; credit growth explains a large share of variation in bank interest income. - The influence of credit on profitability weakened markedly in some specifications during recessions. - Policy implications and recommendations - Stimulating credit growth is not a substitute for structural reforms: efforts to stimulate lending at any cost have modest payoffs and can produce large adverse side effects. - A successful restart of credit flows typically requires a concerted policy package addressing binding constraints on credit extension (e.g., bank capital repair, NPL resolution, demand-side measures), implemented in a complementary manner. - Financial and macroprudential policies should curb credit growth ahead of fundamentals to avoid future credit crash-led recessions. - Proactive bank disposal of impaired loans, improved legal frameworks, and tax incentives encouraging prompt handling of problem loans are vital to reinvigorate sustainable credit growth. *Italicized source attribution: IMF staff analysis from wp17256 - REFERENCES ___________________________________________________________48 (source PDF content).* ### Appendix I. Economic Hypotheses about Post-Financial-Crisis Recoveries ### Appendix I. Economic Hypotheses about Post-Financial-Crisis Recoveries ### Core hypothesis: post-financial-crisis recoveries tend to be weak, long, and creditless - Credit-fueled booms that precede financial crises are often "large, persistent, and driven by exuberant expectations." - The larger the boom, the larger the correction when the bubble bursts, and hence the longer the recovery. - Small precautionary equity cushions among the most affected agents enlarge shifts in asset prices, balance sheets, and the perceived real natural interest rate required to reconcile post-crisis savings and investment decisions. - The corrective powers of the economy and the "quality and timeliness of policy actions" influence recovery length. - Initial recoveries are more likely to be creditless if debt is high, the correction is large, and cushions are small—adversely affecting both willingness and ability to borrow and lend. ### Boom–bust–recovery mechanics and expectations - Exuberant expectations followed by shattered confidence drive most boom-bust theories: - Expectations serve as proxies under incomplete and imperfect information; learning through trial and error creates risk, uncertainty, and sometimes exuberance (Knight, 1921). - Self-fulfilling erroneous expectations can fuel bubbles (Kindleberger, 1978; Minsky’s Financial Instability Hypothesis; Guttentag and Herring, 1984). - Myopic behavior may be irrational ex post but can be rational under certain constraints, including non-linear time preferences (Strotz, 1955; Laibson, 1997; Bordalo, Gennaiola, and Shleifer, 2016). - Most theories identify three distinct phases: boom, bust, and recovery. - Boom: heterogeneous rational agents observe aggressive competitors prevailing; asset-price overshooting occurs (inelastic supply, new technology, new regulation, etc.); investors convinced "This Time is Different" (Reinhart and Rogoff, 2009). - Bust: a trigger event exposes unrealistic prospects, especially when prices were driven by expectations of future price increases rather than net present value of underlying returns. - Recovery: expectations recalibrate and balance sheets adjust, sometimes producing asset price deflation and excessive pessimism; credit policies may be introduced to support recovery (IMF, 2013). - Recovery dynamics: - Agents with adequate own resources may resume consumption and investment when prices appear to have bottomed. - Indebted agents deleverage; once deleveraging ends, optimism and lending can resume. - Crisis-prevention safeguards enacted after collapses can be perceived as recovery obstacles; reducing them without addressing underlying risks can set conditions for the next cycle. ### Financial sector amplification and lending behavior - Severe boom-bust cycles are typically amplified by excessive debt provided by an unrestrained financial sector: - Irving Fisher (1933, page 341): "...over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt." - Financial intermediaries can both facilitate growth and amplify bubbles by believing they can diversify and cover risk via collateral. - As asset and collateral values rise, lending increases, creating a financial accelerator (Kiyotaki and Moore, 1997; Bernanke, Gertler and Gilchrist, 1999). - Financial innovation can lead to neglected risks (Gennaioli et al., 2012); distorted short-term incentives and "too big to fail" perceptions can increase risk-taking (Laeven et al. 2014). - During recovery, credit institutions may become: - Less willing to lend due to excessive pessimism after large losses among aggressive lenders. - Less able to lend because losses have absorbed regulatory capital, funding has become prohibitively expensive for weaker banks, and management focuses on recovering non-performing loans. - Reluctant to lend until clarity on new "financial-crisis-prevention regulation" emerges. ### Equity cushions, debt-recovery efficiency, and balance-sheet recessions - Size of equity cushions and efficiency of debt-recovery processes affect recovery length and whether the recovery is initially creditless: - Adequate cushions reduce fire-sale risks and the need to rebuild precautionary savings after a collapse. - Households often target precautionary savings buffers (Carroll et al., 1992), which depend on liquidity constraints (Deaton, 1991). - Large declines in real estate prices—typically the most important household asset (Mian and Sufi, 2014)—dilute targeted savings and, together with poorer employment prospects, can further contract demand among less wealthy households. - Firms prioritize survival, reducing debt and rebuilding equity even when net present value of new investments is positive, potentially producing a more severe balance-sheet recession (Koo, 2003, 2011). - Empirical magnitude: - Mian et al. (2015) find that "a 6 percentage-point increase in household debt over GDP over three years predicts a 2 percentage-point lower GDP in the subsequent three years." - Country-specific factors affect buffer magnitude and distribution; larger and easier-to-rebuild cushions support faster recoveries and renewed credit demand. ### Modeling severe debt-fueled recessions and policy implications - Reconciliations of debt-deflation (Fisher), financial instability (Minsky), and balance-sheet recession (Koo) approaches: - Eggertsson and Krugman (2012) propose a New Keynesian-style model capturing private sector debt-overhang where some agents become over-indebted. - After a deleveraging shock, aggregate demand can collapse; monetary policy may alleviate modest shocks, but severe recessions hit the zero-lower bound quickly. - Even promises of future inflation and resulting negative real interest rates may fail to clear markets; an expansionary fiscal stance may be needed to temporarily support demand while balance-sheet readjustment occurs. - Fiscal impact is typically larger during recessions and will not be fully crowded out; its effectiveness depends on: - How well over-indebted agents are relieved. - How measures are financed and how those taxed today or in the future adjust their current demand. - The model derives that productivity-enhancing structural policies can worsen debt dynamics under a liquidity trap by further subduing aggregate demand; however, structural policies that raise perceived real-risk-adjusted returns can increase marginal propensity to invest and consume and thus help recovery. *Source: Appendix I. Economic Hypotheses about Post-Financial-Crisis Recoveries (excerpt).* ### ANNEX II.3. DESCRIPTION OF DATA USED IN SECTION IV ### ANNEX II.3. DESCRIPTION OF DATA USED IN SECTION IV ### Macroeconomic variables (MACRO) - Source: WEO. - GDP growth: percentage change of real gross domestic product. - Average inflation: the average annual change of the CPI. ### Bank fundamentals (B_FUND) - Source: Fitch Connect. - Deposit growth: defined as the annual change of domestic deposits scaled by assets. - Profitability: proxied by the annual return to assets. - Capitalization: defined as total bank capital scaled by assets. - Bank liquidity: proxied by liquid assets as a ratio of total assets. - Loan quality: proxied by non-performing loan ratio as a percent of gross loans. ### Recession and recovery indicators - DumRecession: dummy variable taking a value of 1 during recessions and 0 otherwise. - Recession periods are dated given the peaks and troughs in the level of real GDP. - DumRecovery: dummy variable taking a value of 1 during recoveries and 0 otherwise. - Recoveries are defined as periods following the recessions. *Source: ANNEX II.3. DESCRIPTION OF DATA USED IN SECTION IV (wp17256).* --- _Source: https://www.imf.org/-/media/files/publications/wp/2017/wp17256.pdf_