Together, these two studies suggest that a drop of between 9 and 10 percentage points of real GDP in the US and between 11.5 and 20.0 percentage points in the UK would have been necessary to totally erase the two countries real estate bubbles. These results highlight the unfavourable tradeoff between financial stability and output growth when “leaning against the wind” is the only instrument available to address the former. They also strongly suggest that, even if central banks had optimally followed the “inflation-targeting” principles (or the “Taylor rule”) ahead of the crisis, the higher interest rates that would have resulted would not have been sufficient to prevent the emergence of a bubble and the ensuing financial crisis. IV. How might systemic risk be reduced? The unfavourable trade-off I have just highlighted provides a powerful incentive to explore the potential of alternative instruments. This is where “macro-prudential tools” come into play. These tools focus on directly addressing the vulnerabilities to which the financial system as a whole is exposed. Their strength is that they target the problem directly at the root. Slide 7 summarizes the two main dimensions of systemic risk: the “structural” dimension, which covers the possible risks associated with individual institutions whose failure would endanger the entire system; the “cyclical” dimension refers to systemic risks which are not directly linked to an individual institution, but which stem from financial institutions’ collective responses to business or financial fluctuations and adverse shocks. “Structural tools” strive to reduce the impact of institutional failure by strengthening individual institutions.

Their potential utility is often cited with regard to institutions which are considered “too big to fail” or “too interconnected to be liquidated” and whose failure would impact the entire system. “Countercyclical tools” aim to address the cyclical dimension of risk by reducing feedback loops. As Slide 8 shows, these are designed to counter problems associated with the actions of individual financial institutions, which can lead them all to act in the same way after an initial shock, thus amplifying the initial movements of the markets and leading to a new wave of similar reactions.19 This is because individual financial institutions tend to react to a shock by shedding risks, either because it is rational to do so or because regulation oblige them to do so. If the system is not designed with the explicit aim of stopping such movements, a negative cycle can set in with dangerous consequences for individual institutions and the system as a whole. Countercyclical measures are intended to modulate, reduce and potentially prevent such instability. The aim of “capital buffers” is to ensure that, in good times, banks acquire capital base that is well above the minimum. The buffers can then be released in more difficult times, allowing financial institutions to absorb substantial asset price falls before legal constraints become binding. They should thus help avoid the mentioned pro-cyclical behaviour that typically leads to so-called “fire sales”. What is appealing in theory is not necessarily easy to implement in practice.