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The BIS issued a working paper which traces the implications of this financial revolution for the dynamics of financial distress and for policy. It argues that 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.
The paper concludes that more could be done in designing policies that would seek to limit overextension in risk-taking and balance sheets (“speed limits”). Ideally, speed limits would become more binding as the risk of overextension increases. Three guidelines could inform their design.
First, as with fiscal policy, built-in stabilisers appear to be, on balance, superior to discretionary measures. This could be achieved, for instance, by calibrating prudential instruments based on experience over whole business cycles or stress estimates.
Second, discretionary measures could be deployed to complement built-in stabilisers if and when it was judged appropriate. This could help to tailor the measures to specific features of the overextension.
Third, close cooperation between different authorities with responsibility for, or whose policies impinged on, financial stability would be needed. This would involve prudential and monetary authorities in the first instance, but also accounting standard setters and tax authorities.