Regulation that Encouraged Herding
During booms, asset prices rise and measured risks fall. Acting prudently, financial firms will feel it is safe to expand lending. All financial firms expanding together will lead to a scramble for assets that will lead to unsustainable valuations and lending.
In this context, risk rules for individual firms tend to be procyclical. In good times, asset values are high and capital is adequate for expansion. When times turn bad, everyone has to sell the same assets in order to meet capital requirements.
Thanks to Mark Thoma for the pointer.
In 2000, Persaud wrote a paper that anticipated many of the problems that emerged in the recent crisis. He wrote,
markets find it hard to distinguish between the good and the unsustainable, market participants herd and contagion is common.
It is not just markets that find it had to distinguish between the good and the unsustainable. See a subsequent post on Gillian Tett’s new book.