A recent paper, co-authored with Prasanna Gai and Sujit Kapadia, attempts to fill that gap.4 We  1  For example, Committee on the Global Financial System (2010), “The role of margin requirements and haircuts in procyclicality”, CGFS Publications No. 36, Geanakoplos, J (2010), “Solving the present crisis and managing the leverage cycle”, Federal Reserve Bank of New York Economic Policy Review, August, 16 (1) and Kashyap, A K, Berner, R and Goodhart, C, “The Macroprudential Toolkit”, forthcoming in the IMF Economic Review. 2  http://www.hm-treasury.gov.uk/d/consult_newfinancial_regulation170211.pdf. 3  http://www.treasury.gov/press-center/press-releases/Pages/tg1202.aspx. 4  “Complexity, Concentration and Contagion”, which is forthcoming in the Journal of Monetary Economics, Vol 58 (5). 2  BIS central bankers’ speeches  develop a model of a banking network, inter-connected through unsecured interbank lending and secured funding markets. This financial web exhibits classical tipping point properties. It is even-tempered most of the time. Indeed, having a tight-knit circle of financial friends helps keep the financial system strong and stable. Risks are diffused across the system. A problem shared is a problem halved. The system is in a high-liquidity equilibrium. But, on occasion, the system can be pushed beyond its tipping point. Connectivity then generates contagion. A problem shared is a problem multiplied. The best of financial friends become the worst of enemies. In the model, one of the key channels for contagion is the secured financing market as banks hoard rather than lend liquidity when haircuts rise. The liquidity feast then turns to famine as secured and unsecured financing markets dry up.

This calls for a seachange improvement in risk management practices among the clearing houses, as more financial transactions come to be centrally cleared to meet G20 commitments. Otherwise the too-important-to-fail problem simply re-emerges in a different guise.   Liquidity policy: One implication of the model is the importance of banks maintaining buffers of the highest-quality liquid assets. These have a doubly beneficial effect. First, they reduce banks’ need to hoard liquidity in situations of stress. Second, high-quality assets reduce the amplitude of the haircut cycle in the first place, as Table 1 demonstrates. The first reduces the impact of a liquidity event, the second its probability. The upshot is a fall in the chances of a systemic liquidity crisis. The new Basel III liquidity regulation uses a strict definition of what counts as liquid assets. The model underlines the importance of sticking to that definition. The model suggests that financial system robustness would be further enhanced by  4  BIS central bankers’ speeches  targeting liquidity requirements on the most connected banks in the system, as this would lean against the destabilising effects of system-wide concentration. Hot heads make for bad decisions, frozen ears for uncomfortable ones. Financial markets have felt the effects of this change in the weather more dramatically than most. Suitably designed, macroprudential policy can help moderate those swings in temperature, thereby improving the health of the financial system. BIS central bankers’ speeches  5