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Understanding how credit flows rise and fall alongside economic shifts is crucial for lenders, policymakers, and borrowers alike.
Economic activity tends to oscillate through recurring phases, each with distinct characteristics and implications for credit markets.
A credit cycle reflects similar fluctuations in lending behavior, standards, and risk appetite. In expansions, credit growth surges and standards loosen; in recessions, lenders tighten and defaults climb. These cycles not only mirror economic trends but often amplify booms and busts.
Typical macro conditions during an upswing feature rising GDP, strong labor markets, and growing corporate profits. Central banks may maintain accommodative rates early on, fueling further expansion.
Credit markets respond with easier lending standards and increased risk appetite. Banks compete aggressively, reducing collateral requirements and approving larger loans for both households and firms. Spreads narrow as investors chase yield, driving bond and loan issuance to new highs.
Evidence from the U.S. in 2017–2019 shows annual loan growth of 6–8% at major banks, with delinquencies unexpectedly low. VantageScore analysis found that two-year default probabilities fell across all score bands during this period, illustrating how strong growth depresses realized risk at given credit ratings.
However, beneath the surface, excessive credit growth and relaxed criteria can sow seeds of financial stress. Federal Reserve research indicates that aggressive pricing of risk and a large share of high-yield issuance often precede widening spreads and economic slowdowns one to two years later.
At the cycle’s zenith, output hovers at or above potential, and inflationary pressures mount. Policymakers may begin to tighten monetary policy, while real and financial assets reach stretched valuations.
Credit remains widely available, but the marginal borrower population becomes more fragile. Leverage and indebtedness are at peak levels. Credit spreads, though still narrow, show signs of volatility, particularly in high-yield or subprime segments. Supervisors monitor the credit-to-GDP gap closely, using it to inform countercyclical capital buffers.
When growth turns negative, rising unemployment and falling incomes weigh on borrowers’ ability to service debt. Demand for credit wanes, and lenders respond in kind.
Standards tighten sharply. Lenders require higher collateral, shorter maturities, and more conservative covenants. Credit supply contracts substantially as institutions de-risk their portfolios. Spreads widen in both bond and loan markets, reflecting elevated risk premia.
Defaults and delinquencies climb across the board. MAPFRE’s research highlights how pre-crisis credit excess often leads to severe asset-price corrections, deepening and prolonging downturns. Recent data show near-record delinquencies in U.S. subprime auto loans, a sign that lower-income borrowers bear the brunt of tightening credit.
At the trough, economic indicators hit their nadir. Unemployment peaks, but stabilizes as stimulus measures take effect. Policymakers typically deploy aggressive monetary and fiscal support.
Credit conditions remain restrictive initially. Banks focus on balance sheet repair, provisioning for losses, and strengthening underwriting practices. Riskier borrowers especially struggle to access new financing.
As recovery takes hold, profits and incomes improve. Nonperforming loans peak and then gradually decline. Cautious risk appetite returns, and spreads begin to narrow from their post-crisis highs. Early-cycle expansions often see renewed credit growth lag macro recovery, since banks rebuild capital before resuming aggressive lending.
While credit trends often follow economic conditions, strong evidence suggests that credit expansions and contractions also play a causal role in shaping growth trajectories.
For instance, Federal Reserve studies show that elevated junk bond issuance and narrow high-yield spreads predict subsequent spread widening, which in turn constrains credit supply to lower-quality firms and depresses economic activity.
The late-2000s housing boom in the U.S. was marked by rapid mortgage credit growth, high-LTV loans, and lax underwriting standards. As house prices plateaued and then declined, defaults surged, triggering losses that reverberated through global financial institutions.
This episode exemplifies how a credit boom can not only reflect a strong expansion but also massively amplify the ensuing downturn through collateral collapse and balance-sheet distress.
The pandemic shock caused an unprecedented contraction, swiftly followed by vast policy interventions. Many lenders employed stress testing and scenario analysis to adjust credit risk models, leading to widespread forbearance and government-backed loan programs.
VantageScore reports one of the largest upward migrations in consumer scores in recent history, driven by forbearances and fiscal stimulus. Default probabilities fell even as the macro environment deteriorated. As relief programs end, however, delinquencies are rising once again, especially among student and auto borrowers.
Credit behavior can vary significantly across borrower segments and industries, masking vulnerabilities if only aggregate metrics are considered.
By understanding these patterns, stakeholders can better anticipate credit conditions, adjust risk frameworks, and support sustainable growth throughout the cycle.
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