The First Half of the Cycle

Financial liberalization’s boom-to-risk pattern is easiest to understand as one connected domestic system rather than a collection of separate findings. The focus here is to connect policy directness, credit quantity and allocation, collateral, and bank funding into a single judgment: when does observed growth look like a supply-driven expansion, and when does that expansion begin to make the system fragile? The answer matters because a local bank balance sheet may show the first phase of the process while concealing the wider exposure that develops later.

One chain, not five separate facts

Start with the policy, not the crisis. A direct credit-supply reform removes a constraint close to the bank’s lending decision. The bank can now originate more loans, serve a wider market, or transform a larger share of its funding into private credit. The reform does not dictate that every bank will expand, nor does it decide which borrower receives the funds. It changes what the banking system can do.

The next link is the quantity response. The Federal Reserve study estimates that a one-unit supply-side liberalization is associated with about a 3.5 percent increase in real private credit over the following five years. A major episode involving at least three supply policies produces a much larger increase in the study’s estimates. Those figures are not the mechanism by themselves. They matter because the direct-supply index produces a stronger lending response than the broader collection of banking reforms, which mixes credit constraints with policies affecting risk, funding, international allocation, or demand.

Then comes allocation. The additional credit is not spread evenly across the economy. It flows disproportionately toward non-tradable sectors, especially construction and real estate. Real-estate credit rises by more than 10 percent in the five years after the reform in the reported estimates. That matters because these activities are often smaller, more dependent on external finance, and more reliant on property as collateral. The sectoral pattern connects a change in bank capacity to an asset market whose prices can influence the next round of borrowing.

Collateral creates the feedback. If easier credit raises demand for property, property prices can rise. A borrower who owns a more valuable property appears to have greater collateral and may be able to borrow more. The new loan can add to property demand, which supports another price increase. In a rising market, this loop can look like prudent balance-sheet improvement rather than excess: the value supporting the loan is increasing at the same time as the loan.

Funding determines how much of that expansion the bank can carry. As lending grows, the loans-to-deposits ratio can rise if loans outpace the deposit base. Non-core funding can become more important as banks reach beyond their most traditional liabilities. In calm conditions, this additional funding expands the system’s capacity and connects banks to a wider investor base. It also creates a renewal problem.