The tendency of financial variables to fluctuate, as per a certain pattern or trend, during the economic cycle. A pro-cyclical variable fluctuates in a way that is positively correlated with the economic cycle (as reflected in business activity- e.g., gross domestic product, GDP). Increased pro-cyclicality simply implies fluctuations with bigger proportions, and vice versa.
Pro-cyclic or pro-cyclical describes a condition of a positive correlation between the value of an asset or an economic indicator (variable) and the overall state (performance or direction) of the economy.
In banking, pro-cyclicality implies a positive relationship between a financial variable (e.g., credit, money supply, etc.) and the broader economic conditions. Normally, loan loss provisions are “negatively” related to GDP growth, however, this variable is pro-cyclical (the better the GDP growth, the better (i,e., the lower) the losses, and hence the lower the provisions). These provisions tend to show higher pro-cyclicality at larger and better capitalized banks.
A high pro-cyclicality of banks’ loan loss provisioning is undesirable from a financial stability standpoint, as it implies that bank equity (capitalization) is more negatively affected at the lower part of the economic cycle (trough)- i.e., capital market conditions for banks are at the lowest. Furthermore, the pro-cyclicality of loan loss provisions can be a driver of cyclical loan supply, as lower bank equity during economic downturns can lead to a credit crunch.
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