paying particular attention to the larger and more complex institutions, a step consistent with the shift suggested here. the planned strengthening of pillar ii can be a powerful instrument in this connection. a second, no doubt more complicated and controversial, possibility would be to consider extending the calibration to regulatory capital and other tools as well. obvious concerns about level playing fields would need to be addressed in the process. in terms of the measurement and mitigation of risk over time, the key challenge is to take better account of the financial cycle that underlies financial instability. if risk increases in upswings and materialises in recessions, it stands to reason that defences should be built up in upswings so as to be relied upon when the rough times arrive. this would strengthen institutions ’ ability to weather deteriorating economic conditions, when access to external financing becomes more costly and constrained. moreover, by leaning against the wind, it could reduce the amplitude of the financial cycle, thereby limiting the risk of financial distress in the first place. the reasoning is very familiar to macro - economists. it underlies, for instance, the operation of built - in fiscal stabilisers : tax revenue automatically rises as income increases and falls as income declines, dampening expenditures in booms and encouraging them in recessions. but it can equally apply to financial stability objectives, whether couched in terms of individual institutions or the system as a whole. a crucial element of this perspective is the length of the horizon over which risk is measured and managed. the horizon is clearly longer than one year, a common yardstick for current banking practices in the area of credit risk, in line with the calendar rhythm for accounts and taxes. conceptually, it should span whatever time is needed for a cycle to unfold. and because the timing of downswings is exceedingly hard to predict, the approach implies a focus on measuring the vulnerabilities that build up in the upswing and on the more recurrent features of cycles. we may not know exactly when the rainy day will come, but we can be pretty sure that it will. it is not wise to decide on policies or business strategies on the assumption that it will not, or that we can predict its timing with sufficient foresight. translating the basic logic of the argument into a set of practical arrangements raises a host of difficult issues. what instruments could be employed? the range is potentially quite large, including provisioning rules, regulatory capital, loan - to - value ratios and

, accumulates in balance sheets, masked in part by the favourable asset price developments. the trigger for a reversal is essentially unpredictable. it can originate either in the financial sphere ( eg, an asset price correction ) or in the real economy ( eg a spontaneous unwinding of an investment boom ). the process then moves into reverse. ex post, a financial cycle is evident. behind this recurrent pattern are serious difficulties in measuring underlying risk, and a structure of incentives that hinders an appropriate behavioural response to changes in risk, even when these are correctly identified. indicators of risk tend to be at their lowest at or close to the peak of the financial cycle, ie just at the point where, with hindsight, we can see that risk was greatest. asset prices are buoyant, credit spreads are narrow and loan loss provisions low. the tension between the micro - and macro - prudential perspectives is obvious both with respect to the measurement of risk and the behavioural response to it. as regards measurement, economic agents and markets appear reasonably good at assessing the relative risk of instruments, debtors and counterparties. they seem to find it considerably harder to evaluate the absolute, undiversifiable risk associated with the financial cycle. this requires a more sophisticated understanding of correlations and their evolution through time. in turn, a proper evaluation of the robustness of any historical relationship can only be based on some theory about the forces driving the economy and the interaction between the financial and real sectors. and such a theory would need to recognise the impact of the collective behaviour of institutions on financial distress. the contrast between this perspective and current methodologies for assessing market and credit risk is striking. typically, current approaches are based on some form of short - term extrapolation or, at best, time - invariant historical averages. consider, for instance, the mechanical inputs used in calculating var for market risk. at bottom, approaches to measuring credit risk are not very different. this view has important implications for how we think of risk evolving through time. the received wisdom is that risk increases in recessions and falls in booms. in contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materialising in recessions. the length of the horizon here is crucial. i will return to this point in a moment. as regards behavioural responses, incentive structures in financial markets can compound the problems arising from difficulties