Coherent Financial Cycles for G-7 Countries : Why Extending Credit Can Be an Asset

We demonstrate that financial cycles (identified as common fluctuations in credit and asset prices, proxying balance-sheet leverage) strongly differ across countries, e.g., in duration. This is contradictory to a similar duration assumption inherent in prevalent proxies of financial cycles, such as the Basel III credit-to-GDP gap guiding countercyclical capital buffers. Against this backdrop, we propose a methodology for constructing financial cycles relaxing the similar-duration assumption and observe an improved capacity in predicting financial crises. Specifically, we use credit and asset prices as inputs to our methodology and show that constructed financial cycles significantly outperform the credit-to-GDP gap in predicting financial crises