If the ESRB had been operational at this time, a risk warning would have been issued drawing attention to substantial price misalignments in mortgages and equity prices. Corrective measures could then have been recommended to curb credit growth, potentially distinguishing across countries depending of the magnitude of the imbalances. If followed, these policy measures could have deflated the asset price bubble before its dramatic burst in 2007. This example suggests that the analytical framework employed by the ESRB could significantly strengthen macro-prudential risk assessment. At the same time, whilst its policy recommendations are not legally binding, they should carry weight as they are addressed predominantly to the ESRB’s members, who would have to “comply-or-explain” in front of their peers. Additional pressure could derive from the publication of recommendations. Ultimately, the effectiveness of the ESRB’s recommendations will depend on the quality of the analysis behind them. Macro-prudential authorities will face a heavy burden of proof to justify concrete policy changes, and so their analysis must be beyond reproach. For this reason, in order to support the work of the ESRB, the ECB is enhancing its analytical tools with regard to risk surveillance and assessment. We have now operational models and tools to fulfil the three functions previously mentioned and we continue to work hard to improve them. Looking ahead, the area in which I see a need for particular focus from policymakers is to strengthen the link between stress testing of bank capital and recapitalisation.

To this end, an index of aggregate macro-financial imbalances, or of institution-specific vulnerabilities, is tested against variables such as credit growth, property price changes, private sector leverage and current account deficits, to discover which variables predict that index. Measures of bank leverage, balance sheet growth and maturity mismatches may also be used in order to gauge the extent to which the financial sector is driving developments. Second, to assess the relative importance of different risks for financial stability. This is done using “adverse scenarios” that are designed and macro stress-tested to establish the potential severity of different types of risk and the overall resilience of the financial system to severe shocks. Such models, including top-down stress test of individual institutions, allow risks to be assessed more broadly and at a higher frequency than is possible with bottom-up exercises run by financial institutions, thus enhancing the “real time” information on systemic risk available to policymakers. Third, to assess the financial channels through which risk can be propagated, thereby factoring-in potential second-round effects. The use of contagion and spillover models allows, for example, the assessment of the impact on the financial system of the failure of a particular financial institution or of turbulence in a particular sovereign debt market. BIS central bankers’ speeches  3  We could consider how this framework would have functioned if applied retrospectively. For example, the monitoring of the credit-to-GDP ratio as an early warning indicator of widespread asset-price misalignments would have initiated early warning signals as early as mid-2005.