10 These further requirements consist of an integrated approach between micro and macro components which encompass primarily four main aspects: (i) a dynamic approach that includes consideration of the bank’s reaction to the scenarios; (ii) a comprehensive two-way interaction between banks and the real economy; (iii) the assessment of contagion effects stemming from interconnectedness among financial institutions, including non-banks in the shadow banking sector; (iv) finally, the analysis of the interaction with other non-financial sectors that are relevant for banks’ risk management. Let me dwell upon these four points, which are being addressed at the ECB. Dynamic approach including the bank’s reaction to the scenario: Going beyond the static assessment of solvency of individual banks, macroprudential stress tests should account for more realistic features, in particular banks’ behavioural reaction to the stress which could come in the form of deleveraging, straight capital increases or work-out of nonperforming loans. To take that into account, the dynamic balance-sheet is implemented in  10  4  See also keynote address by V. Constâncio (2015), “The role of stress testing in supervision and macroprudential policy”, London School of Economics Conference on Stress Testing and Macroprudential Regulation: a Trans-Atlantic Assessment, 29 October: http://www.ecb.europa.eu/press/key/date/2015/ html/sp151029.en.html. BIS central bankers’ speeches  our framework by allowing banks to re-optimise their portfolio according to the risk-return optimisation criterion. 11 To account for two-way interactions of banks with the real economy we have developed Dynamic Stochastic General Equilibrium (DSGE) models which are being calibrated at the individual country level to assess these effects.

In shaping the macroprudential policy framework, six aspects can be identified as guiding principles: First, macroprudential policy should be pre-emptive and strongly counter-cyclical. Early identification of risks is an essential first step in the policy-setting process supported by early warning indicators and models to predict potential sources of systemic risk. Macroprudential policy should then act forcefully to smoothen the financial cycle avoiding that it reaches a dangerous peak. Second, and relating to the first, macroprudential policy should rely on the concept of the financial cycle in order to assess the position of the economy, predict its development and appropriately calibrate the use of macroprudential instruments. The concept of a financial cycle is therefore crucial for the rationale of macroprudential policy, justifying the need for dedicated policy instruments. To effectively tame the financial cycle, a time-varying dimension is crucial in the design of policy instruments – that is, the instruments must be adjustable over the cycle. Counter-cyclical capital and liquidity requirements are thus important tools. Third, the real estate component in the financial cycle is of paramount importance. This implies that instruments in the macroprudential policy toolkit should contain borrowerside tools to influence the demand for credit, in addition to capital-related measures conditioning bank credit supply. Financial asset prices are admittedly difficult to tame with targeted policy intervention.