The argument would be that deflating an asset price bubble at an early stage contributes “per se” to long-term financial and monetary stability. Against this view, I tend to share the position of those arguing that asset price bubbles are very difficult to identify in practice and, even assuming that they were correctly recognised, there is a lot of uncertainty as to how asset markets would react to policy changes. Furthermore, this strategy may prove difficult to communicate to the public. As concerns financial policy, the regulators’ task of ensuring the long-term soundness of the financial system entails creating the right incentives for market participants not reacting in excess in a given cyclical position and avoiding excessive misalignments. To this end it is essential, first, to encourage better knowledge of the risks assumed, a long-term orientation to analyses and, consequently, more prudent management within financial institutions. Second, a greater heterogeneity among financial market players to avoid mimetic behaviour seems desirable, although this is something the markets would normally develop by themselves. Third, greater transparency and disclosure by the authorities and private institutions would help market participants to focus on fundamentals. Fourth, a better understanding and evaluation of liquidity patterns in financial markets is called for, on the part of both market participants and supervisors. Finally, the regulatory authorities should obviously not introduce rules promoting short-term strategies. Let me focus now on the relationship between bank credit, loan losses and provisions for loan losses.

BIS Review 35/2002  1  This sequence affects different categories of assets (commercial property, residential property, equity), whose impact on the real economy and transmission channels differ. Commercial property seems particularly linked to the business cycle, while residential property has a larger impact on consumption. Equity prices are intertwined with business profits and investment but are also related to spending through wealth effects, depending on the role equity plays in the determination of financial wealth. This interaction between credit cycles and asset price bubbles poses a number of challenges for the authorities and regulators, both in the monetary policy and financial stability domains. In the upswing, inflationary pressures related to excessive credit growth are compounded by financial imbalances resulting from unwarranted optimism on the part of corporations and households and excessive risktaking on the part of financial institutions. In the downturn, recessionary and deflationary forces are aggravated by credit contraction as a result of excessive risk aversion by lenders. The possible explanatory factors of this potential amplification of the cycle in the financial sector are many-faceted and complex. First, heightened competition in the banking sector and in financial markets leads in an upturn to riskier strategies that are only corrected when the rise in bad debts becomes evident in the downturn. Second, there seems to be a tendency for economic agents to overreact to changes in their environment, leading to over-optimism in times of plenty and over-pessimism in bad times. Third, herding usually reinforces existing trends and causes overshooting.