This also includes those parts that may not be under the regulatory capture. Financial stress in a specific segment may no longer be confined to that segment but may rapidly be transmitted to the rest of the financial system. Thus, a piecemeal policy response would not be sufficient. It would require a comprehensive response to ensure that such stressed conditions does not evolve into a major financial crisis. Secondly, the build-up of risks to financial stability need to be identified early. Pre-emptive action would reduce the cost of the crisis on the financial system and the economy. Third, the regulatory authorities need to be accorded the necessary powers to manage the risks to financial stability. Fourth, the optimal policy mix may not only include policy actions to address immediate term issues but would also need to simultaneously address the underlying structural problems. Fifth, is to give recognition to the importance of enabling conditions that will render the implemented policies to yield the desired outcomes. Finally, to facilitate effective policy decision making there needs to be a platform and governance process for policy coordination across agencies within an economy and for this to be extended for regional and international collective action. Following the recent global financial crisis, the policy response at the national level has been extensive and on an unprecedented scale.
Our model captures the spirit of these dynamics, with short-run risk-taking to preserve reputation and boost returns (a credit boom) in time giving way to longer-term collective costs when the music ceases (a credit crunch). Chart 1 Price to book ratios for UK, US and European institutions(a)  Sources: Bloomberg, Thomson Datastream and Bank calculations  2.1  (a)  Chart shows the ratio of share price to book value per share. Simple averages of the ratio in each peer group are used. The chart plots the three month rolling average. (b)  Excludes Nationwide and Britannia from Major UK Banks peer group. The set up  We develop a simple framework, in the spirit of Rajan (1994), to capture these collective action failures. Rajan’s (op.cit.) model generates multiple equilibria. We use a version of the Morris and Shin (2003) “global games” framework to pin down a unique equilibrium for the coordination game among banks, which then allows an evaluation of policy options. 3  3  For other applications of the “global games” framework to banking, see inter alia, Rochet and Vives (2004) and Goldstein and Pauzner (2005). Broadly speaking, these models use the framework to pin down uniqueness in the coordination game played by the depositors of fragile banks, a la Diamond and  BIS Review 168/2010  3  The set up is as follows. Each period there is a continuum of agents, indexed by , all of whom work as financial intermediaries for a single period.