Procyclicality of balance sheets is another problem

Procylicality of balance sheet mean that leverage of balance sheets increase with rising asset prices  and vice versa. So when times are good leverage increases and then when we have sudden downfall, the entire thing is a mess.

I came across this paper from Adrian and Shin which show how strong this relationship has been over the years. The implication of this behavior is that we have upward sloping demand curves for assets and downward sloping supply curve.

It is a nice read. Really short and crisp. They gave a presentation at BIS which is also worth a look.

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