policymakers demonstrate

Financial Regulation in Europe: Foundations and Challenges 483
which precludes the existence of bubbles. The global crisis that started in 2007
provides a stark example. In numerous countries, including the US, Ireland, the
UK and Spain, real estate prices were steadily rising up to 2007 and the financial
crisis was triggered precisely when they collapsed. Numerous other crises
show a similar pattern of events. As documented, among others by Kaminsky
and Reinhart (1999) and Reinhart and Rogoff (2011), a common precursor to
most crises is financial liberalization and significant credit expansion. These are
followed by an average rise in the price of stocks of about 40 per cent per year
above that occurring in normal times. The price of real estate and other assets
also increases significantly. At some point the bubble bursts and the stock and
real estate markets collapse. Given that banks and other intermediaries tend to
be overexposed to the equity and real estate markets, typically a banking crisis
starts about one year after the bubble burst.
There is a substantial literature attempting to understand how shocks, and
in particular negative shocks, are amplified through the system and generate
negative bubbles. Some theories rely on the so-called financial accelerator
(Bernanke and Gertler, 1989, Bernanke et al., 1996). The idea is that negative
shocks to borrowers’ wealth are amplified because of the presence of asymmetric
information and of an agency problem between borrowers and lenders.
In a similar spirit but focusing on the role of collateral, Kiyotaki and Moore
(1997) suggest that a shock that lowers asset prices may lead to a crisis. The
reason is that by lowering the value of collateral, lower asset prices imply less
borrowing and thus further reduction in asset prices and borrowing capacity,
and triggering a downward spiral. Geanakoplos (1997, 2003, 2009) and Fostel
and Geanakoplos (2008) push this analysis further by investigating the effect
of asset prices on collateral value and borrowing capacity in more general equilibrium
settings.
From a regulatory framework perspective, there are important lessons to be
learnt about asset price cycles. Specifically, there are common trends and exposures
of financial institutions; while these might make individual institutions
look safe and sound when assessed on a stand-alone basis, they could also mask
an increase in systemic risk. Overall, this calls for the regulatory framework to
use capital requirements and other regulatory tools not just on the individual
bank-level but also as a system-wide tool.
Interbank Connections and Contagion
One important source of market failures in the financial system is due to banks
exerting externalities on each other. The fact that they do not internalize externalities
implies that there is a need for government intervention to try and push
the system towards a more efficient outcome.
Inefficiencies of this kind have been discussed in the context of interbank
markets, which play a key role in financial systems. Their main purpose is to