During the recent financial crisis, microprudential regulation of the banking system turned out to be unable to maintain financial stability largely because it did not recognize the problem of systemic risk. This chapter discusses in detail the sources of systemic risk, their importance for financial stability and the macroprudential policies that are necessary to address them. Systemic risk arises from the following sources: 1. common exposure to asset price bubbles, particularly real estate bubbles; 2. liquidity provision and mispricing of assets; 3. multiple equilibria and panics; 4. contagion; 5. sovereign default; 6. currency mismatches in the banking system. We discuss each of these in turn in Section 2. Section 3 then considers the macroprudential policies that can be used to counter these systemic risks. Herring and Wachter and Reinhart and Rogoff provide persuasive evidence that collapses in real estate prices, either residential or commercial or both, are one of the major causes of financial crises. In many cases these collapses occur after bubbles in real estate prices that are often created by loose monetary policy and excessive availability of credit. When the bubble bursts, the financial sector and the real economy are adversely affected. The current crisis provides a good example of this. Allen and Carletti argue that the main cause of the crisis was that there was a bubble in real estate in the US and in a number of other countries such as Spain and Ireland.
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