This paper shows novel evidence of the mechanism through which financial constraints amplify fluctuations in asset prices and credit demand. It does so using contractual features of housing finance. Among agents whose housing demand is constrained by the availability of collateral, those who can borrow against a larger fraction of their housing value (achieve a higher loan-to-value, or LTV, ratio) have more procyclical debt capacity. This procyclicality underlies the financial accelerator mechanism. Our study uses international variation in LTV ratios over three decades to test whether (a) housing prices and (b) demand for new mortgage borrowings are more sensitive to income shocks in countries where households can achieve higher LTV ratios. The results we obtain are consistent with the dynamics of a collateral-based financial accelerator in international housing markets. Theoretical research has argued that endogenous developments in the financial markets can greatly amplify the effects of small income shocks through the economy (e.g., Kiyotaki and Moore, 1997; Bernanke et al., 1996, 1999). Bernanke et al. (1996) call this amplification mechanism the “financial accelerator” or “credit multiplier”. The key idea behind the financial accelerator is the notion that shocks to the net worth of firms and households have a procyclical effect on their borrowing capacity.

How can one identify whether there is an independent spending effect coming from an endogenous change in financing capacity following an income or wealth shock? The theory suggests that the effect of an income shock on constrained agents’ spending should be greater when debt capacity is more procyclical. Accordingly, one way to pin down the dynamics of the financial accelerator is to explore cross-sectional differences in the spending responses of constrained, cyclical agents to aggregate income shocks. This study explores the features that characterize housing finance contracts to pursue such an approach. It does so using a unique data set on asset prices and credit in international housing markets. Our results provide novel evidence on the financial accelerator mechanism.