What it means
The cycle usually runs through four recognisable phases. In the expansion phase losses are low, competition for borrowers is fierce and lenders relax terms; in the downturn losses arrive, lenders tighten sharply; in the repair phase balance sheets are rebuilt; and in the recovery phase appetite slowly returns.
What drives it is a feedback loop between recent experience and current policy. Low realised losses make risk look cheap, so lenders relax criteria and write weaker business, which produces the losses that force the next tightening.
The seeds of every downturn are planted at the top of the preceding expansion. For an operating business the practical implication is timing.
Refinancing, raising committed facilities and locking in fixed rates are far easier in the late expansion than in the downturn, even though the late expansion is exactly when they feel least necessary. Lenders manage the cycle through provisioning.
A bank that provisions using its current, benign loss rate flatters its profits in the good years and gets caught short in the bad ones, which is why accounting rules increasingly require expected losses to be recognised across the whole cycle. The nuance worth remembering is that credit cycles and business cycles are related but not the same.
Credit conditions often turn several quarters before economic output does, which makes lending standards a useful leading indicator for anyone planning capital expenditure.
In practice
Real-world examples.
Example
A private equity firm notices lenders offering six times EBITDA leverage with covenant-light terms, up from four times two years earlier. Reading it as a late-expansion signal, the firm refinances its portfolio companies early and extends maturities by three years before terms tighten.
Example
A hotel group secures a five-year fixed rate facility at 5.1% in a benign year. Eighteen months later comparable borrowers are quoted 9%, and the group's early refinancing saves roughly $780,000 a year on its $20,000,000 of debt.
Example
A community bank's loan officers report that competitors are approving deals it has declined. Rather than matching them, the bank holds its criteria, loses market share for two years, and then picks up quality borrowers cheaply when rivals stop lending altogether.
Formula
Calculation
The cycle is usually quantified through a through-the-cycle loss rate.
Through-the-Cycle Loss Rate = Average of Annual Loss Rates Across a Full Cycle
Expected Annual Loss = Loan Book x Loss Rate
A regional bank holds a $500,000,000 loan book. Over one full cycle its annual write-off rates run 0.3% in the late expansion, 0.4% at the peak, 1.2% in the first downturn year and 2.5% at the trough. The through-the-cycle rate is (0.3% + 0.4% + 1.2% + 2.5%) / 4 = 4.4% / 4 = 1.1%.
Provisioning at that rate means setting aside $500,000,000 x 0.011 = $5,500,000 a year. A bank that instead provisions at the 0.3% rate it is currently experiencing sets aside only $500,000,000 x 0.003 = $1,500,000, reports $4,000,000 more profit in the good year, and then meets $500,000,000 x 0.025 = $12,500,000 of losses in the trough year with almost no cushion built.Case study
Seen in the real world.
Wilder Creek Building Supplies is a fictional merchant used here for illustrative purposes. During a long expansion it grew by offering generous trade credit, stretching customer terms from 30 days to 75 to win volume, and its receivables book climbed from $3,000,000 to $11,000,000 over four years.
When the credit cycle turned, its housebuilder customers lost their own bank facilities and payment behaviour collapsed. Wilder Creek wrote off $1,400,000 in a single year, roughly 12.7% of the book, against an average of 0.9% in the four preceding years. The company survived only because it had a committed overdraft that its bank could not withdraw.
The illustrative lesson is that trade credit is lending too, and it follows the same cycle as bank credit. Extending terms to win business in an expansion means carrying the cycle's losses in the downturn.
Watch out
Common mistakes.
- Reading current low default rates as evidence of low risk. Loss rates are lowest just before a turn, because weak loans have not yet had time to fail.
- Assuming the cycle is on a fixed schedule. Phases vary in length and can be extended or cut short by policy intervention, so timing signals matter more than calendars.
- Ignoring trade credit when thinking about the cycle. Supplier terms tighten alongside bank lending and often affect small businesses first.
Questions
People also ask.
How long is a typical credit cycle?
There is no fixed length, but a full cycle commonly runs somewhere between seven and ten years from one peak in lending appetite to the next.
What indicators show where we are in the cycle?
Bank lending standards surveys, corporate credit spreads, leverage multiples on new deals and covenant quality are the most watched.
Should a business borrow more in an expansion?
Not necessarily more, but it should borrow longer, since the value of an expansion is cheap maturity and committed terms rather than extra debt.
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