The recent financial crisis showed that a financial institution's equity may be sufficient to absorb losses during normal times, but insufficient during periods of systemic distress. In recognition of this risk, the Basel III agreement last year introduced a new element of macroprudential...

The enormity of the recent financial shock was not fully apparent until well into the crisis. One result was that banks did unusually low levels of pre-reserving against eventual loan losses. Much of that underreserving was related to the extraordinary decline in real estate values that led to...