Modelling the existence of joint large movements of asset prices in financial theory may potentially lead to significant improvements in specific areas of finance, such as asset pricing, optimal portfolio choice, derivatives valuation and hedging, and management and measurement of financial risks. However, the construction and estimation of models taking into account large movements of asset prices is a non-trivial task. Large movements may be directly modelled but more often their characteristics are implicitly assumed by adopting a general probability distribution used to model the asset prices.
This work is motivated by the following empirical regularities about the relationship between credit, growth and volatility. First, there is a positive cross–country relation between economic growth and credit market development as measured, for instance, by the ratio of private credit to GDP. While it is undisputed that financial development and growth go hand in hand, their causal relationship is a much debated issue in the empirical literature. Second, there is a negative cross–country relation between the volatility of GDP growth and the level of economic and financial development. Along a similar vein, in many developed countries aggregate output volatility has declined considerably together with an expansion of the financial sector during the last decades. And third, the fall in macroeconomic volatility has been accompanied by a rise in microeconomic (firm–level) volatility.
The purpose of this paper is to account for these observations in a model in which both economic growth and credit market development are endogenous. A more developed credit market improves the efficiency of resource allocation, contributing thus to higher growth. Conversely, a growth push makes credit markets more valuable, improves financial development and reinforces the initial growth effect. Thus, the model is consistent with the first stylized fact, incorporating a two–sided linkage between finance and growth. Our model is also consistent with the other two facts. An expansion of the credit market goes hand in hand with a decline in aggregate volatility. Moreover, there is a hump–shaped relation between credit market development and idiosyncratic (firm level) volatility. Thus, a credit expansion may easily induce a decline in aggregate volatility together with a rise in idiosyncratic volatility.
After the summer of 2007, credit to households has shifted into the focus of policymakers and the banking industry alike. What began with rising default rates in the US subprime mortgage market, may develop into a global credit crisis. European banks already face the consequences of borrowers being unable to service their contracts on time. In turn, central banks see their scope of action severely constrained, and the macroeconomic implications of these recent developments may be very farreaching.
Against this background, we provide a systematic international comparison of household debt holding and of access to credit, using microeconomic data that allow us to trace the evolution of debt and to assess constraints over the past one-and-a-half decades. Whilst current media attention is directed at whether access to borrowing has been too easy for some households, the academic literature has debated for a long time whether financial markets institutions may have inefficiently constrained household borrowing, and whether policy ought not to remove or ease such constraints.
