Living with Procyclicality

This paper began by discussing the broad rise in risk-taking and leverage that took place in the years preceding the crisis. The recent recommendations of the FSF and the subsequent work program deal with the various ways that regulators, firms, investors, and rating agencies can improve the system's ability to measure, assess, and manage risk, which are important steps. But whether there is anything more fundamental that financial authorities can do to prevent financial crises remains an open question. The 2008 crisis shares many characteristics with past crises in terms of underlying causes, most notably the inherent procyclicality of the financial system. It seems reasonable, therefore, to suggest that more could be done to reduce this tendency of the financial system to accumulate too much risk in good times and to shed it rapidly in bad times. But how can this be achieved?

In the foreword to its April 2008 report to the Group of Seven, the FSF stated its intention to examine the drivers of procyclical behavior and possible options to mitigate it. This process has now begun. Among the issues that are being considered are capital requirements, fair value accounting, compensation systems, and funding liquidity. In each case, the idea is to investigate the procyclical drivers involved and potential policy responses. This is not always easy, in view of ongoing structural changes in financial systems. Many more recent structures are only now being fully tested in a downturn. But the authorities can seek to ensure that regulatory systems, such as the capital regime, do not reinforce the natural cycles of the financial system. Authorities can also seek to ensure that the incentives are well-aligned, which points policymakers toward taking a closer look at private sector compensation systems and counter-party risk management to ensure that these do not foster excessive risk-taking behavior.

In a widely cited paper, Borio, Furfine, and Lowe (2001: 2) call for the use of supervisory instruments in an “explicitly countercyclical fashion.” The object of this policy is to encourage the build-up of “a protective cushion in good times that can be drawn down in bad times.” In principle, the cushion could take the form of loan-loss provisions as well as capital. It may also involve the lowering of regulatory loan-to-value ratios at times when the prices of the underlying assets have been rising at an especially rapid pace. Recent events suggest that a further cushion could take the form of robustly liquid securities—for example, highly rated and actively traded government bonds—which the repo markets will always accept as collateral, to guard against the runs that have been seen recently on most other forms of repo collateral.

Finally, an unusual buoyancy of markets should serve to remind the financial stability departments of central banks and supervisory authorities to monitor especially closely any related innovative financial instruments. This is because excesses in risk-taking tend to involve the use of such instruments. The object of these monitoring efforts would be to understand the various ways in which these instruments are used and track the channels through which they proliferate. The development of such market intelligence would then help alert the authorities to times when it would be appropriate to apply countercyclical supervisory instruments to particular segments of the financial markets.

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