5 Third, some of the assumptions on which financial activity has been predicated turn out to be (or are seen as being) invalidated; eg, in the current  5  Ingves S, “A Cure for Crises: Confidence, Confidence and Trust”, a speech at the Eurofi Forum, Gottenburg, September 2009. Akerlof, George A, 1970 “The market for ‘Lemons’ Quality Uncertainty and the Market Mechanism”, The Quarterly Journal of Economics, MIT Press, vol 84 (3), pp 488-500, August. BIS Review 134/2009  5  crisis, the reliability of ratings of ABS. Fourth, the demand for liquidity rises, and its supply falls back. Markets become less liquid. Rising liquidity premia and forced sales depress asset values. Credit supply is reined in. A vicious circle is threatened by the excess leverage and liquidity mismatch that have developed in the financial system during the upswing. During that upswing, important contributory factors will typically have included illusions about risk-adjusted returns; underestimating the extent to which buoyant conditions are being driven by falling liquidity premia; and a sense that, if the bubble bursts, the central bank will somehow be able to contain the spillovers. This amounts to “risk illusion”, which should probably be as much debated as “money illusion” is in monetary economics. Separately, there is a potent collective action problem in getting off the dance floor. Not a few senior market participants felt from at least 2006 that financial risk was underpriced, and that conditions in, for example, the leveraged loan market were silly.
In the first place, a domestic authority increasing capital or liquidity requirements due to on lending by its banks to a particular sector could act as a signal to the home authorities of other, overseas banks. Plainly, it would be important to share analysis with international peers, even if things went no further than that. Transparency to the market would aid that dialogue. But it might be worth exploring whether there could feasibly be some kind of more or less co-ordinated or co-operative macroprudential response in some instances. This would entail risk weights being varied on  10  For a description of how banks used structured finance to try and transfer risk see, Tucker PMWT (2007a), “A Perspective on Recent Monetary and Financial System Developments”, a speech at the Merrill Lynch Conference for hedge funds, April 2007, (pp.8-10). 10  BIS Review 134/2009  the basis of both the economy of the borrowers and conditions in the home financial system of the lenders, with the aim of at least avoiding conflicting policy responses. As such, it would be a novel overlay on the Basel Concordat agreed thirty years ago for the division of labour between home and host supervisors. This might usefully form part of the international discussion on possible macroprudential instruments. (e)  The cross-sectional dimension: interconnectedness  Finally, to round up, just a few thoughts on the other dimension to the macroprudential challenge: the “cross-sectional” issue of interconnectedness.