First, procyclicality of the financial system poses risk to financial stability, and to address it, efforts call for policy to dampen the procyclical effects through counter-cyclical financial regulation and macroprudential measures. Second, to avoid large build-up of excesses, macroeconomic policy especially monetary policy has an important role to play. And in the case of emerging markets, the procyclical behaviour of international capital flows adds another dimension of challenge because of its effects on domestic monetary conditions. Hence, to effectively address the issue, a combination of macroeconomic policy and financial regulation is needed to restrain the build-up of imbalance, a process to which procyclical financial behaviour is a key contributing factor. The current financial crisis also raises the issue of procyclicality. Apart from its global nature, a key feature of the current crisis when compared with past crises is the scale of excessive risk-taking and leverage that took place that was accentuated by procyclical financial behaviour. This, therefore, puts the issue of procyclicality and financial regulation into the policy spotlight. What I want to do this afternoon is to discuss procyclicality and the policy approach to address it from a wider perspective of macroeconomic management aimed at ensuring financial stability. My focus is to offer a framework for analyzing procyclicality, and to propose a view that policies from different orientations, especially financial regulation, are needed to deal effectively with the issue. In its simplest form, procyclicality refers to the interactions between the financial system and the real economy which are mutually reinforcing.

Such interactions tend to amplify the amplitude of the bussiness cycle, thereby heightening the risk to financial stability. This description of procyclicality presupposes the existence of two cycles, namely the business cycle and the financial cycle, that interact and reinforce each other. However, economic and financial decisions underlying the two cycles are not independent. They are inherently linked by the risk-taking behaviour of economic agents: the behaviour which is prone to change in response to incentive, perception of risk, regulation, and new information. It is this change in risk-taking behaviour that explains large swings in investor sentiment, from a period of optimism when risk is disregarded to a period of pessimism when there is no willingness to  BIS Review 160/2009  1  take risk. And it is this change in risk-taking behaviour that underscores the abrupt change in financial behaviour, and in the direction and momentum of economic activities. It follows therefore that procyclicality is a mechanism that encompasses the interactions of at least three reinforcing cycles that move in tandem. They are the business cycle, the financial cycle, and the cycle of risk-taking beheviour represented by fluctuations in asset prices or the asset price cycle. The three cycles are self-reinforcing, and it is the ways the cycles interact with each others that define the amplitude and the momentum of the cyclical flunctuations, as well as risk of a financial crisis. Interactions of the three cycles can be illustrated with reference to a typical boom-bust cycle.