Cliff effect (economics)

In economics, the cliff effect is a positive feedback loop, where downgrading a single security can have a disproportionate cascading effect. This has become pronounced with respect to the assessment of credit risk in a bank's portfolio. If a credit rating agency has the expectation that the credit risk of a position rises, it will downgrade its rating. As a consequence, a bank faces additional capital charges in order to comply with national capital requirements. Especially during the subprime mortgage crisis banks had to increase their capital substantially, because many ratings were considerably downgraded. In time banks needed their capital most to cope with high losses, this term emerged in the consultative process on reforms regarding existing capital requirements, namely criticizing the procyclical cliff effect.[1]