When borrowers default on loans, those losses eat into a bank's capital. The bank, under pressure from regulators to protect its eroded capital, stops lending. That, in turn, can force corporate borrowers to shrink and lay off workers. Those workers default on credit cards and other loans, further eroding bank capital. So banks lend even less. Next thing you know unemployment goes up, access to credit is down, banks fail, foreclosures skyrocket.
It is a tendency of banks, and the regulations that govern them, to exacerbate the cycle, both the ups and the downs.
Countercyclicality: Get the banks to arrange capital in good times that can be tapped in times of stress. This protects them from having to reach out to investors during times of stress, which makes the process more costly. (In other words, Contingent Collateral)
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