Intellectual challenges to financial stability analysis in the era of macroprudential oversight

This article discusses the main intellectual challenges related to the conceptual foundations, analytical models and regulatory assessment tools in the field of financial stability analysis. The focus is on ways to detect and contain systemic risk. The article also tries to point in directions that could be helpful in resolving these intellectual challenges. The article starts with a discussion of the nature and origins of financial stability and systemic risk. It then goes through four areas in which lessons from the present crisis have illustrated major analytical challenges in enhancing the understanding of financial stability and systemic risk. The article concludes that 1) the understanding of the fundamental working of financial systems and the risks they generate needs to be deepened, in particular in relation to financial innovation and the role of nonbank financial intermediaries, 2) better insights need to be developed about when and how financial systems migrate from stability to instability, 3) models need to be developed that capture the interactions between widespread financial instability and the performance of the economy at large (including the related amplification effects and nonlinearities), and 4) such models need to be further extended to be able to assess the effectiveness and efficiency of macroprudential regulatory policies in containing systemic risks. Meeting this agenda will require reorienting significant resources in academia, central banks and supervisory authorities in these directions. It will also require enriching the way of thinking in economics and finance. New approaches should be considered that do not necessarily rely only on the notions of equilibrium, universal rationality and efficiency, but go beyond those concepts. Approaches that have been used successfully in other fields, such as the natural sciences, may be a helpful source of inspiration.