Transmissions occur through networks whose structure and architecture is constantly changing through financial innovation and regulatory arbitrage. Also, financial systems are "human" systems. Their behaviour is shaped by the way human beings react to shocks in their environment. Herd behaviour has long been known to be an essential feature of financial markets. More subtly, individual reactions, by themselves rational, can, by the virtue of their mutual interaction, produce strong amplification effects 3 . A broader definition of procyclicality would thus encompass three components, which cannot easily be distinguished in real life: (1) fluctuations around the trend (2) changes in the trend itself and (3) possible cumulative deviations from equilibrium value. This points to the policy challenges regulators face. They have to try and identify when pure cyclical fluctuations morph into something different: either a change in the trend itself or the start of a cumulative process. A good operational approach to procyclicality would look at all amplification mechanisms which provoke (or allow) the financial system to deviate durably or permanently from its predetermined path) so that the trend itself may be affected in the short or medium run. 1  Quote from FRBNY Economic Policy Review Issue on Systemic Risk (November 2007, page 26). 2  See Haldane (2009). 3  This has been luminously shown by Danielsson and Shin in their seminal article on "endogenous risk", based on the now famous parable of the Millennium Bridge. BIS Review 94/2009  1  What are the mechanisms at work?
2  BIS Review 94/2009  •  Finally, cyclicality in the real economy can be beneficial to long term growth as it is one mechanism through which "creative destruction" can take place in the productive system. Real and significant damages occur if and when financial imbalances are allowed to build for a long time with two consequences: first asset prices significantly deviate from their fundamental trend, which creates distortions in the allocation of resources; and second, those imbalances unwind suddenly and abruptly, triggering major disruptions in growth and the economic cycle. This is what is happening right now. And this closely resembles the definition of a bubble. This clearly points to one possible mandate for macro prudential supervision that, it were feasible, would be both pragmatic and legitimate: to avoid bubbles. Bubbles are not always triggered within the financial system. They may have roots in productivity shocks, for instance. But cyclical fluctuations cannot develop into a bubble – like process unless some amplification mechanisms are allowed to work fully in an overall permissive financial environment. What role did procyclicality play in the current crisis? During the first phase of the crisis, it was possible to take a "short term view" of procyclicality. It may have looked as if mark to market accounting, together with highly illiquid markets, generated downward spirals in asset prices and created "excessive" losses, with no relation to real underlying economic reality. Such liquidity spirals may have occurred at some critical moments 7 .