which the financial system is operating (the macro-financial and real economic outlook), and the health of the balance sheets of households and nonfinancial corporations.

A thorough understanding of the main linkages within the financial system is a precondition for an informed use of measures to contain interconnectedness. The concept of interconnectedness is often interpreted in a rather restrictive manner, with interbank exposures being the main area of focus. While this is indeed an important aspect, there are many additional linkages within the financial system that can be highly relevant, including interconnectedness through the payment systems, ownership linkages between financial institutions,<sup>6</sup> and banks as providers of contingent credit lines for other financial institutions.

The time series dimension refers to the cyclical dimension of systemic risk. The financial system is characterized by strong procyclical tendencies. Consequently, the financial system can act as an amplifier rather than as an absorber of economic and financial shocks. The procyclical tendencies of the financial system were already well-documented in the academic literature before the global financial crisis, including in Minsky (1982) and Kindleberger (2000), but interest in these tendencies has increased recently (see Brunnermeier and others 2009; Adrian and Shin 2009). Borio (2012) has observed that the financial cycle is on average about twice as long as the traditional business cycle and has significantly larger amplitude. Contractions of the financial cycle that coincide with recessions are particularly disruptive. In the upturn of the financial cycle, credit growth tends to outpace economic growth, while financial firms, nonfinancial corporations and households become increasingly indebted against the backdrop of a high appetite for risk. Once the virtuous circle ends, credit availability becomes more constrained as the creditworthiness of borrowers worsens (because of declining household income and wealth and deteriorating profitability in the corporate sector), collateral values deteriorate, and risk aversion increases. The damage to the real economy can be exacerbated by procyclical tendencies induced by financial regulation, as banks that have been faced with a significant deterioration of asset quality may seek to restore their capital adequacy ratio by moderating credit growth, restraining access to credit for those categories of loans that represent a high risk weight, such as uncollateralized loans to small and medium enterprises (SMEs) (Repullo and Suarez 2008).

A significant number of emerging market economies have had experience before the crisis with lean-against-the-wind measures aimed at moderating the financial cycle. These measures need to be seen against the background of potentially destabilizing capital flows, concerns about excessive credit growth, and the volatility of financial asset prices, often in an environment characterized by limited investment opportunities. Several East Asian economies have used macroprudential instruments to avoid excessive procyclicality in sectors that are considered prone to speculative bubbles, particularly real estate, either through a more rigorous use of ceilings on credit and large exposure limits or through leverage limits, such as the lowering of loan-to-value (LTV) and debt-to-income (DTI) limits during real estate booms (see CGFS 2010;

> 6 This includes the Special Purpose Vehicles (SPVs), which in the early stages of the global financial crisis exposed their parent banks to serious contagion effects. Although the SPVs were separate entities from a legal point of view, the sponsoring banks came to their rescue for reputational reasons.

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