Addressing Financial System Procyclicality: A Possible Framework
This note aims to provide an overall framework that could help evaluate policy options to address the procyclicality of the financial system. While the framework is general in nature, the note focuses exclusively on options for prudential and financial reporting arrangements and the associated risk management and incentives issues. It therefore excludes other possible policy levers, not least taxation/fiscal policy and monetary policy, including the provision of central bank liquidity. Likewise, the note does not consider any potential implications for the institutional set-up for the authorities responsible for financial stability.
The structure of the note is the following. The first section sets the stage by briefly defining the concept of procyclicality, outlining the mechanisms at work and their ultimate sources. The second section highlights the basic rationale for policy intervention and its guiding principle. It also explains how the policy fits with the macroprudential approach to financial stability. The third section puts forward a possible, quite general set of desirable features that could be used to assess the pros and cons of policy options. The final section lays out a set of such options and illustrates how the framework can be used to evaluate them. Continue reading