Working Papers No 284
Over the last decade or so, addressing financial instability has become a policy priority. Despite the efforts made, policymakers are still a long way from developing a satisfactory operational framework. A major challenge complicating this task is the "fuzziness" with which financial (in)stability can be measured. We review the available measurement methodologies and point out several weaknesses. In particular, we caution against heavy reliance on the current generation of macro stress tests, arguing that they can lull policymakers into a false sense of security. Nonetheless, we argue that the "fuzziness" in measurement does not prevent further progress towards an operational framework, as long as it is appropriately accounted for. Crucial features of that framework include: strengthening the macroprudential orientation of financial regulation and supervision; addressing more systematically the procyclicality of the financial system; relying as far as possible on automatic stabilisers rather than discretion, thereby lessening the burden on the real-time measurement of financial stability risks; and setting up institutional arrangements that leverage the comparative expertise of the various authorities involved in safeguarding financial stability, not least financial supervisors and central banks.
JEL Classification Numbers: E30, E44, G10, G20, G28
Keywords: financial (in)stability, risk measurement, macroprudential, procyclicality