In addition to misperceptions of risk, complementary explanations of excessive procyclicality point to actions that, when taken in isolation, may appear reasonable, if not compelling, but that collectively add up to undesirable social outcomes. In other words, risk may be correctly perceived, but the response to it may not, in the aggregate, be appropriate. This outcome may result from a failure to internalise the consequences of the actions of others, the impossibility of coordinating responses or simply the fact that the costs would be borne by other groups in society.Certain types of response may be reasonable when seen from the perspective of individual agents regardless of what the others do. 24 For instance, in a downturn, it may be compelling for an individual bank to tighten lending terms. 25 Others, faced with the similar situation, would have the incentive to do 19 One version of this notion, known as "rational beliefs", has recently been formalised by Kurz (1997) and, who also derives implications for the behaviour of financial markets generally and asset prices in particular. 20 In statistical terms, the problems of limited power that plague tests of the validity of estimates of the tails of probability distributions for market risk (Kupiec (1995)) are therefore compounded in the case of credit risk (eg Saunders (1999)). The problems are particularly acute in the case of estimates of parameters such as correlations of default (McCallister and Mingo (1996)). 21 See the original treatment by Herring (1984) and. See also Herring (1999) for a discussion of disaster myopia in the context of recent techniques for the measurement and management of credit risk. 22 These are known, respectively, as "availability heuristic" and "threshold heuristic". On the former, see Tversky and Kahneman (1982); on the latter, see Simon (1978) and Slovic et al (1977). Kunreuther et al (1978) contains experimental evidence in favour of these hypotheses. See also Herring (1999). 23 The theory was developed by Festinger (1957).24 This is known as the "prisoner's dilemma" or more correctly, in the case of many agents, the "tragedy of the commons".25 This is almost certainly the case if others do not tighten. It also makes sense if others do tighten, since the action of any individual bank, taken in isolation, would not be such as to lead to a sufficient deterioration in the economic environment to make the bank worse off. The exception might be highly concentrated banking systems.39 Above all, experience suggests that overextension in the financial system, in the form of rapid credit expansion and unusually sharp increases in asset, especially property, 40 prices during the economy's 35 To avoid confusion, in what follows the movement in a financial indicator is said to be "procyclical" if it tends to amplify business cycle fluctuations. According to this definition, for instance, provisions behave procyclically if they fall in economic upswings and rise in downswings.36 Formal econometric evidence on credit/asset price...
This volume is dedicated to Palle Andersen, who passed away on 13 April 2005. The overview paper was co-authored by him, but the full extent of his contribution to this volume was far greater. His exceptional abilities as an economist, his generosity with advice, and his detailed knowledge of so many countries made an enormous contribution to economic analysis at the BIS over the past two decades. His unfailing kindness endeared him to his colleagues and friends throughout the world. He will be sadly missed.
This overview in particular, and the volume in general, has greatly benefited from the cooperation, comments and statistical input of the central banks represented at the meeting. Thanks go to Steve Arthur, Marc Klau and Michela Scatigna for the tables and graphs, to Patricia Mosquera and Tracy Provenzano for secretarial assistance, to Nigel Hulbert, Arwen Hopkins, Tom Minic and Alison Spurway for editorial suggestions and to Liliana Morandini for production assistance with the whole volume. Helpful comments were received on this paper from Eli Remonola, Bill White and the authors of the BIS papers in this volume. Particular thanks are due to Peter Stebbing, who made extensive comments and suggestions. Opinions expressed are those of the author and not necessarily shared by the BIS or the central banks involved.
Financial soundness indicators:the core and encouraged sets Core set Deposit-taking institutions Capital adequacy Regulatory capital to risk-weighted assets Regulatory Tier I capital to risk-weighted assets Nonperforming loans net of provisions to capital Asset quality Nonperforming loans to total gross loans Average daily turnover ratio in the securities market 1 Real estate markets Real estate prices Residential real estate loans to total loans Commercial real estate loans to total loans 1 Or in other markets that are most relevant to bank liquidity, such as foreign exchange markets.
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