Moving from finance to economics, the dominant approach over recent decades to modelling the macro-economy has probably been the Dynamic Stochastic General Equilibrium (DSGE) model (Smets and Wouters (2003)). In its plain-vanilla form, this comprises a set of representative, optimising households and firms. This model gives rise to an equilibrium which is unique and stationary, and dynamics around that equilibrium which are regular and oscillatory. Various knobs and whistles have been added to this workhorse framework, often involving market frictions in price-setting, competition and credit provision. These add colour to the model’s dynamics but, by and large, leave intact its properties – stable, stationary, oscillatory. It is not just among academics that this workhorse 5  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  5  framework has found favour. The majority of central banks also take the DSGE framework as their starting point, including the Bank of England (Burgess et al (2013)). The DSGE approach has many of the hallmarks of Newtonian physics. As every action has an equal and opposite reaction, every shock has an equal and proportional reaction in DSGE models. The economy’s dynamics exhibit the same damped harmonic motion as Newton’s pendulum, or if a rocking horse were to be hit with a stick. The rocking horse metaphor is apt, as it was first used by Swedish economist Knut Wicksell almost a hundred years ago to describe the business cycle motion of an economy (Wicksell (1918)).
These buffers, created in periods of good economic conditions and necessarily associated with the adequate mechanisms to draw them down during recessions, may come in the form of non-distributable reserves to compensate economiccycle losses. Nevertheless, the possible advantages and disadvantages of such a measure should be accurately calculated and appropriately compared to those coming from other tools that act in the same way but affect the profit and loss account. 2  BIS Review 55/2009  We should not forget the interconnection that exists between valuation, leverage and procyclicality and how these issues should be properly managed under a macro-prudential perspective. The introduction of supplementary floors to capital requirements under a risksensitive approach, could be a safety net,. Setting limits on the build-up of leverage in periods of rapid credit growth can be seen as a way of strengthening the incentives for correct risk pricing of institutions, as well as a deterrent of excessive risk-taking. Furthermore, the development of valuation reserves should also be under our consideration as a way to mitigate the cyclicality inherent in risky and illiquid securities. Improvement of general stress test practices and their wide implementation, particularly during the most favorable part of the economic cycle, should also be included in our toolbox approach to fight against procyclicality. Solid stress test frameworks will allow assessing the adequacy of buffers, both in their construction and in their applicability over the cycle. Finally, remuneration schemes may be another tool for dampening the undesired cyclical fluctuations of banking activity.