Analytically, it is useful to distinguish between procyclicality of capital and procyclicality of leverage. Procyclicality of capital is easy to understand. When conditions are good, financial institutions are profitable and their strong capital base allows them to take larger positions in the markets. This mechanism has been amplified by mark to market accounting 4 . In a mark to market environment, an increase, for instance, in asset prices quickly translates into stronger capital for financial institutions. This, in turn, triggers additional demand for assets and a further increase in their prices. This kind of "inverted demand curve", where demand increases with prices, potentially creates powerful feed back loops. Procyclicality in leverage is more subtle. It has been shown that financial institutions' balance sheets expand and contract with the economic cycle 5 . Many different mechanisms are at work: •  First, risk management techniques: tools used to measure and value risk, such as VaR are naturally and strongly procyclical, especially when constructed with very short data series. Risk management practices hardwired to valuations (such as margin calls) strongly amplify fluctuations in leverage and may lead to fire sales and "one sided" markets. •  Another mechanism 6 relates to the dynamics of short term money markets : when liquidity is perceived as abundant, there is strong incentive for dealer-brokers to engage in maturity transformation through strongly leveraged positions. •  Finally, risk appetite itself moves along the economic cycle. Animal spirits obviously play a role.

I will briefly deal with the general approach, then discuss the instruments available to mitigate procyclicality. General approach As in many matters of public policy, there is a choice between rules and discretion in dealing with procyclicality. The rule based approach can be built on "automatic stabilizers" which would constrain institutions in their behaviour, regardless of their own individual situations. Examples would include contra cyclical capital requirement, for instance, as well as dynamic provisioning. Alternatively, discretionary action could consist in "top down" interventions from macro prudential authorities. They would step in and impose (or relax) constraints whenever they come to the conclusion that dangerous imbalances are building up (or unwinding). We probably cannot dispense of this second approach. The difficulty to date cycles makes it dangerous to rely purely on automatic mechanisms, which cannot be precisely calibrated. Financial cycles, in particular, are driven by changes in risk appetite which are impossible to predict. Actually, one essential objective of macro prudential supervision may be to "regulate" (not in the legal sense, but economically) the aggregate level of risk appetite inside the financial system. This unavoidably involves some degree of discretionary judgement. How that judgement is made will determine the relevance and effectiveness of macro prudential supervision. The prudential apparatus has worked in the past on the presumption that all movements in asset prices were based on fundamentals. This approach may prevent supervisors from dealing with excessive procyclicality until it is too late. The existence of bubbles, for instance, is impossible to prove until they burst.