 Thanks very much. And good afternoon. I'm very pleased to participate in this second annual ESRB conference here in Frankfurt. Today I would like to speak about market potential policy and financial vulnerabilities. Let me start my remarks by revisiting a basic question. What is financial stability? A first and well-accepted answer equates financial stability with the absence of systemic risk, that is, the risk of a disruption to the capacity of the financial system to perform its functions and especially to its capacity to provide credit to the economy. An alternative answer that has recently gained in currency equates financial stability with the absence of sharp movements in financial conditions. Sharp movements in financial conditions that arise from large increases in the price of risk and negative externalities created by financial vulnerabilities can give rise to financial stability concerns. In this speech, I will propose that policymakers might care about sharp movements in financial conditions even if those do not necessarily lead to systemic disruptions of the financial sector's intermediation capacity. How does this fit with the accepted understanding of the goals of market potential policy? As is well known, market potential policy has two dimensions. Structural policy aims to mitigate externalities from the failure of individual systemic institutions and the systemic risks arising from the interconnectedness within the financial system, including its plumbing. Cyclical market potential policy is often described as mitigating systemic risk in the time dimension. However, in practice, I will argue that this amounts to aiming at mitigating the risk of sharp reversals in financial conditions. The reduction of systemic risk, the tail of the distribution of changes in financial conditions, is therefore an important outcome of these policies. What do I mean by financial conditions? Financial conditions refer to the ease of financing across funding markets, including credit, equity, money, and foreign currency markets, reflecting the pricing of risk and underwriting standards in different asset markets. I distinguish financial vulnerabilities from financial conditions. There are many dimensions to financial vulnerabilities. For example, one could distinguish the amount of leverage and maturity transformation that are prevailing in different sectors of the economy, such as the household sector, the non-financial corporate sector, the banking sector, or the shadow banking system. Financial vulnerabilities can lead to fire sales or investor runs creating negative externalities. Of course, financial conditions and financial vulnerabilities interact. Easy financial conditions sow the seeds of the buildup of financial vulnerabilities. When financial vulnerability is high and financial conditions are loose, risks to financial stability going forward are likely higher than when financial vulnerability is high and financial conditions are broadly neutral. Both financial vulnerabilities and financial conditions tend to exhibit cycles. Cycles in the pricing of risk tend to be somewhat shorter than cycles in leverage or maturity transformation. In general, periods of easy financial conditions tend to be followed by a tightening, though the timing and durability of the tightening may vary from cycle to cycle. In some cases, easy financial conditions are associated with a buildup of vulnerabilities that reflect the unchecked underlying externalities spread across institutions and markets via fire sales runs or disorderly denavaging. In those cases, easy financial conditions could be followed by a sharper and even more prolonged tightening with larger adverse impacts on economic growth. The greater the imbalances that have built up during times of easy financial conditions, the larger the risks of a sharp adjustment in financial conditions, even if it does not result in systemic disruption of financial intermediation. I will explain in more detail shortly the key frictions that can lead to excessive variation in financial conditions can be fueled by a certain market failures. I will expand on three of those, extrapolative expectations, competition leading to excessive risk taking across institutions, and the leverage cycle due to mismanagement practices. In the face of these frictions, the task of cyclical market financial policies are twofold, to lean against the buildup of financial vulnerabilities with the goal of reducing micro financial amplification mechanisms, and secondly, to build temporary buffers when financial conditions are overly easy and financial vulnerabilities are growing. The rationale for the first of these objectives is to counteract temporary distortions and risk taking, i.e. to counteract the tendency of financial intermediaries to dance until the music stops. Aiming for temporary increase in resilience makes sense because increasing resilience amounts to taking out insurance, and taking out insurance when financial conditions are easy is cheap. So to illustrate, figure one shows the net equity issues in the run up to the financial crisis using data of US trading institutions. Clearly these institutions paid out in the run up to the crisis well into the end of 2007, actually early 2008. This is the red line. They only started to issue once the book equity, which is the blue line, started to decline due to crisis losses. So this illustrates very nicely what it means to dance until the music stops. So you keep paying out, you keep paying out, and then you issue equity when it's most expensive in the midst of the crisis. On net, firms issued equity when it was most expensive in the midst of the crisis. It would have been cheaper to accumulate a larger equity cushion in the boom. But the three frictions that I alluded to earlier, extrapolative expectations, excessive risk taking, and the leverage cycle all lead firms to keep paying out. Such behavior is more likely when banks are interconnected or highly leveraged. I will argue that policymakers may care about sharp changes in financial conditions even if those changes do not necessarily lead to crystallization of systemic risk within the financial system. It is sufficient for them to have measurable effects in amplifying economic volatility because such amplification might well translate into adverse outcomes of GDP. There are a number of economic channels that can lead to such amplification over time. From a cyclical market potential perspective, what matters is that the amplification mechanisms exhibit temporary time variation. The first amplification mechanism that I believe is important are extrapolative beliefs. The recent literature documents the pervasiveness of the phenomenon using a variety of equity, housing, and banking data. Analysts and CFOs extrapolate past returns to form expectations about future returns. For example, in equity markets. This is what is illustrated in this chart. That means that they tend to expect the highest returns at the peak and the lowest returns at the depth of the crisis. That type of behavior is the opposite of what would be expected from rational economic theories which predict that expected returns are low in the boom and high in the bust. Of course, the presence of a significant amount of extrapolative economic actors means that asset pricing cycles tend to be exacerbated and so that generates a cycle in financial conditions in the pricing of risk. In the similar vein, housing market professionals including real estate brokers, real estate lawyers, secretization experts continue to accumulate housing positions well into 2007. There is no evidence that they expected the housing cycle to turn. More generally, based on data since the 1920s across 20 economies, bank credit expansion strongly suggests neglected crash risk. Banks tend to lend well into the boom even if such behavior strongly forecasts negative bank returns in the subsequent correction. In some, there is solid evidence that key economic actors tend to underestimate risk of adjustments to the pricing of risk and consequently take on excessive risk in the boom, leading to the buildup of financial vulnerabilities when financial conditions are easy. A second key economic friction consists of the competitive behavior across financial institutions. High returns on equity, so these are book returns RE, like book return on equity, a cross firm forecasts high equity market returns, so that's a cross sectional. So this is basically a cross sectional forecast of equity market returns of financial institutions using RE up to 60 quarters into the future. So in the short run, firms that generate higher RE generate higher equity returns cross sectionally. However, in the longer run, so in the longer run, and in the aggregate as well, high financial sector RE forecast, equity market returns negatively. So in the aggregate, it's the opposite relationship and in the long run, you see the long run here in this plot. In the long run, it's the opposite. Clearly, firms have incentive to take risks to increase RE as that gives them a competitive advantage relative to their peers. However, in the aggregate, that leads to an erosion of profitability and hence aggregate RE is forecasting returns negatively. So there's a difference in the cross sectional forecasting power and in the aggregate forecasting power. Verse incentives of individual firms to take risk in order to maximize RE might well lead to excessive risk taking in the aggregate. Capital with a tendency for extrapolative beliefs, the consequence is that behavior that looks short-sighted. Again, everyone dances until the music stops. The combination of extrapolative beliefs and competition across institutions can act as amplification mechanisms for the leverage cycle. Theories of the leverage cycle tend to feature investors with heterogeneous beliefs where optimists are pricing assets in the boom, while pessimists are the marginal investors in the busts. As a result, the leverage cycle leads to distorted pricing of risk and distorted re-enacted financial allocations. In my own work, I've presented leverage cycles that are associated with agency fridgens between investors and the managers of financial institutions. The temptation of managers to invest in risky assets associated with their limited liability needs investors to impose a leverage constraint that depends on measured risk. In the boom, when those measured risks are low, institutions are able to take on leverage which is excessive from a macroeconomic perspective. Hence, prudent microeconomic risk management can be associated with an amplification of the leverage cycle in the aggregate. Of course, the mechanisms of the leverage cycle could be reinforced by the economic mechanisms described earlier, i.e. the tendency of market participants to extrapolate and the urge of financial institutions to compete on ROE without taking aggregate consequences into account. All three economic mechanisms provide incentives for the buildup of vulnerabilities during times of easy financial conditions. And these vulnerabilities tend to be associated with sharper declines in output once a batch of hits. To illustrate, this figure shows the dependency of GDP volatility on financial conditions. At short horizons, up to five quarters, easier financial conditions forecast GDP volatility to be lower. But at longer horizons, there's a reversal. And easier financial conditions signal higher GDP volatility as a shock is amplified by larger vulnerabilities. So the financial conditions index that is used here is higher when conditions are worse. Like a credit spread or market volatility. So there's a positive slope, basically. So think of that as an impulse response function. So there's a positive slope up to five quarters into the future. So when financial conditions are easy, conditional GDP volatility is low. But easy financial conditions today forecast higher conditional GDP volatility further in the future, say, two years or three years into the future. So it's easy financial conditions that are sowing the seeds of the crisis. And so this finding is actually very robust. It's very robust across countries. This type of phenomenon is sometimes referred to as the volatility paradox. Now, let's think about the effects on output. So those occur through a number of mechanisms. Those are at work both when the app sowing and leverage results in full-blown crisis or when it merely results into a sharp reversal of financial conditions. When vulnerabilities are high, an adverse shock will tend to increase borrower defaults. And this increase will be sharper when financial vulnerability is associated with a weakening of lending standards. When intermediaries sustain losses, they become constrained and reduce the supply of credit to the economy. Importantly, using bank level evidence, such credit crunch effects have been found to be at work both in crisis times and outside of full-blown crisis. In other words, credit crunch effects are pervasive and can contribute to a deepening recession even outside of crisis periods. The collapse in the supply of credit that is associated with a full-blown crisis is therefore best understood to be just an extreme outcome of a more common phenomenon associated with movements in financial conditions. Tightening financial conditions can also lead to resettlement of debt levels, potentially forcing and leveraging on the part of borrowers, particularly the household and corporate sectors. Using cross-country data for the United States, recent research shows that U.S. counties that experienced a larger increase in household leverage from 2002 to 2006 experienced a larger increase, experienced a sharper decline in consumption, particularly durable goods consumption, starting as early as the end of 2006. This pattern also holds across countries. The drop in consumption was the larger, this is from 2007 to 2012, the higher household debt-to-income ratios were prior to the financial crisis in 2007. So a higher leverage cycle is associated with a sharper decline in consumption once a bad shock hits. The available evidence thus shows that these mechanisms are not confined to episodes of full-blown financial crisis. Even outside such episodes empirical research based on long runs of historical data has found that there's a close relationship between the build-up of credit during the expansion and the severity of subsequent recessions, even if it's not systemic risk per se. Hence vulnerabilities build up during times of easy financial conditions and lead to amplification and downturns in reaction to adverse shocks. So there's a case for counter-circuitly market potential policy aiming at taming these types of dynamics. And I pointed to three types of market failures that gave us justification for such policy interventions. Of course there are trade-offs. Adjusting policy today might mitigate risks in the medium run, but that comes at the cost of distorted activity in the short run. Quantifying these types of trade-offs is an important item on the market potential policy agenda and the topic that is only now starting to be explored. So one way to quantify that trade-off is basically to look at the slope or the short run as the long-run slope in these types of impulse response functions. Now one might ask shouldn't such counter-circuitly policies relative to financial conditions be undertaken by monetary policy? There's clearly a close connection to monetary policy which acts as impacting financial conditions always and everywhere. Monetary policy can also be steered deliberately to offset changes in financial conditions. Indeed many have argued that monetary policy should take financial conditions into account even if central banks are targeting inflation. And in practice monetary policy often offsets the easing or tightening of financial conditions. The advantage of using monetary policy most systematically to steer financial conditions is that it can get into all of the cracks while market potential policy can be arbitraged across jurisdictions, markets or institutions. But there are also limits to using monetary policy in this way. Monetary policy cannot induce changes in resilience unlike market potential policy. For instance a tightening of the counter-circuitly capital buffer can bring about an increase in resilience. This can be very useful to protect against a future tightening of financial conditions but it is not easily achieved by tightening of the monetary policy stance. In fact that may act in the opposite direction. Monetary policy is not targeted enough to address differential financial conditions across sectors of the economy. For instance a residential or commercial real estate boom may develop because of the behavior of lenders or borrowers in that segment and occur at times when financial conditions are not unusually easy otherwise across the economy. Targeted market potential policy is then preferred. Furthermore monetary policy has priced stability as primary mandate. It may not be able to respond enough to offset the build-up of risks given trade-offs relative to its inflation objective. For instance where the central bank is determined to stimulate it cannot be used to offset easy financial conditions and one may need additional tools to reduce the risk of borrow overextending themselves. Finally monetary policy may not be able to ease aggressively enough when it is already at the lower bound. When financial economic shocks result in stress on the financial system the relaxation of market potential buffers can help alleviate those stresses complementing and easing of monetary policy. Operationalizing cyclical market potential policy requires addressing some thorny issues. At what point in time should prevention policy tools be used for cyclical market potential policy purposes and by how much should they be adjusted? The challenge is that we have very little evidence to guide us. The first key issue is at what horizon do indicators forecast risk. In general leverage type indicators like credit to GDP, household leverage or corporate sector leverage tend to forecast downside risks at medium-term horizons such as 2 to 5 years into the future. Market indicators such as asset prices or the financial conditions tend to have a shorter forecasting horizon though of course the chart above that I showed earlier does indicate that financial conditions may also contain information about medium-term risks. In general one can visualize a term structure of financial stability risks. So if you imagine that financial stability is defined as the downside risk to GDP as a function of financial vulnerability. So then you can imagine that financial stability is spanned by different indicators that have information content at different horizons. The financial stability risks could be measured in the aggregate or by sub-sectors. Such a term structure of financial stability risks could help market potential policy makers in determining what type of tools should be deployed at what point in time. In fact in the upcoming global financial stability report which will be released in 2 weeks from now or 3 weeks actually at the annual meetings we have an analytical chapter where we present some tentative results showing how the term structure of global financial stability risks is forecast by indicators such as household leverage or financial conditions. Another key consideration in deploying market potential tools are implementation lags. While monetary policy transmission is subject to lags the policy stance can be changed at a moment's notice. Prudential policy tools however often take many months or even a full year to change. Hence they are typically not well suited to addressing rapidly changing risks in the tightening phase. However in response to an initial shock prudential policy tools can certainly be released quickly as was for example the case in the UK when the capital buffer was lowered following the praxit referendum or in the US following September 11, 2001 attacks when the leverage ratio was released on the banks because the Fed was injecting liquidity. Talking a little bit about the way forward. So I've argued that cyclical market prudential policy might aim at mitigating sharp movements in financial conditions even if those do not entail systemic disruptions in the intermediation capacity of the financial system. There's ample evidence that adverse movements to financial conditions impact risks to GDP growth adversely even in the absence of systemic disruptions. The economic channels that I've laid out link the ease of financial conditions to the buildup of vulnerabilities. When financial conditions deteriorate financial vulnerabilities are reduced with adverse impacts on real activity. Importantly the buildup and the unwinding of vulnerabilities has asymmetric effects on economic activity. Of course I'm not arguing that policy makers should target financial conditions. Rather the monitoring of financial conditions and vulnerability provides useful information about downside risks to GDP in the short and medium run and thus can usefully guide the stance of policy. So thank you. I'm happy to take some questions.