But it also drives up volatility due to risk illusion. Because riskadjusted returns are constant, this must entail an increase in the probability of there being a severe negative shock, so the probability of a crash rises. Chart 2 shows a simulation of the model when for 100 periods with normally distributed shocks. The frictionless benchmark model generates the path shown by the maroon line. As specified, the path is mean reverting, with movements in the macro state around trend. Allowing for reputational effects generates the blue path, giving a threshold level of fundamentals shown by the green dashed line. As the macro state hits the threshold, banks adopt risky policies to signal high ability. In this simulation this happens four times, in periods 3, 50, 68 and 72. Consider the threshold breach in period 72. As during the Great Moderation, the good macro state at first persists. The credit boom fuels high fundamentals. But while headline fundamentals have improved, risk-adjusted fundamentals have not. Eventually, this results in a crunch in credit and a sharp deterioration in the macro state, as risk is realised. 10  In particular, the Sharpe ratio (the expected value of fundamentals relative to their standard deviation) is constant across both regimes. BIS Review 168/2010  7  Now suppose that financial liberalisation generates heightened competition between banks, in the model. increasing the market premium on reputation. This raises the value of Chart 3 shows the effects of the reputational weight being raised . The threshold for risky policies falls.

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