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Change and constancy in the financial system: implications for financial distress and policy

  • Claudio E. V. Borio

Over the past three decades, the financial system has been going through a historical phase of major structural change. This paper traces the implications of this financial revolution for the dynamics of financial distress and for policy. It argues that, despite this revolution, some fundamental characteristics of the financial system have not changed and that these hold the key to the dynamics of financial instability. These characteristics relate to imperfect information in financial contracts, to risk perceptions and incentives, and to powerful feedback mechanisms operating both within the financial system and between that system and the macro-economy. As a result, the primary cause of financial instability has always been, and will continue to be, overextension in risk-taking and balance-sheets. The challenge is to design a policy response that is firmly anchored to the more enduring features of financial instability while at the same time tailoring it to the evolving financial system. Using an analogy with road safety, policy has so far largely focused quite effectively on improving the state of the roads and on introducing buffers. More attention, however, could usefully be devoted to the design and implementation of speed limit.

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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 237.

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Length: 27 pages
Date of creation: Oct 2007
Date of revision:
Handle: RePEc:bis:biswps:237
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  1. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
  2. Philip Lowe, 2002. "Credit risk measurement and procyclicality," BIS Working Papers 116, Bank for International Settlements.
  3. Ilhyock Shim & Goetz von Peter, 2007. "Distress selling and asset market feedback," BIS Working Papers 229, Bank for International Settlements.
  4. Bank for International Settlements, 2004. "Foreign direct investment in the financial sector of emerging market economies," CGFS Papers, Bank for International Settlements, number 22.
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  6. Jeffery D Amato & Jacob Gyntelberg, 2005. "CDS index tranches and the pricing of credit risk correlations," BIS Quarterly Review, Bank for International Settlements, March.
  7. Claudio Borio & Ilhyock Shim, 2007. "What can (macro-)prudential policy do to support monetary policy?," BIS Working Papers 242, Bank for International Settlements.
  8. Rajan, Raghuram G, 1994. "Why Bank Credit Policies Fluctuate: A Theory and Some Evidence," The Quarterly Journal of Economics, MIT Press, vol. 109(2), pages 399-441, May.
  9. Schwert, G William, 1989. " Why Does Stock Market Volatility Change over Time?," Journal of Finance, American Finance Association, vol. 44(5), pages 1115-53, December.
  10. Peltzman, Sam, 1975. "The Effects of Automobile Safety Regulation," Journal of Political Economy, University of Chicago Press, vol. 83(4), pages 677-725, August.
  11. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and financial cycles," BIS Working Papers 256, Bank for International Settlements.
  12. Frankel, Jeffrey A & Froot, Kenneth A, 1990. "Chartists, Fundamentalists, and Trading in the Foreign Exchange Market," American Economic Review, American Economic Association, vol. 80(2), pages 181-85, May.
  13. Patrick McGuire & Eli Remolona & Kostas Tsatsaronis, 2005. "Time-varying exposures and leverage in hedge funds," BIS Quarterly Review, Bank for International Settlements, March.
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