A year after, as the Russian ruble collapsed, we had to deal with both international and domestic loss of confidence in the financial system during the economic downturn. Again, the interest rates more than doubled (from 8-18%) in a few weeks due to the temporary loss of confidence in the currency. These two episodes provided clear examples of the importance of financial stability for the monetary and, ultimately, economic conditions in case of a fixed rate. But these experiences also provided policy insights that are useful not only under the present circumstances but also for the financial policy making in a common currency area. II. What are the main challenges for the central bank? Central bank's direct responsibilities to maintain the financial stability, apart from direct supervisory functions, can be divided into three large areas. Firstly, central banks are responsible for analysis of financial system developments and to determine the early signs of possible financial difficulties. Central banks are well positioned for that task because of the close relations with market participants and because of the analytical skills that provide natural ground for analyzing the so-called macroprudential indicators and perform regular stress testing. BIS Review 63/2001  1  Secondly, central banks are by definition involved in designing and building up financial system safety nets. The so-called "traditional" central banks are directly responsible for short-term emergency liquidity support to prevent the problems of one institution to develop into a systemic crisis.

Secondly, Estonia has avoided volatile short-term capital flows due to strong fiscal stance. While these "soft" policy principles support crisis prevention by providing relatively stable and transparent environment, the resilience of the system depends ultimately on the actions of market participants themselves. The task of the authorities is to provide an adequate regulatory framework and to undertake maximum effort for the supervision of the implementation of these regulations. There is another interesting, albeit still debated issue – to what extent should the supervisors rely on banks' internal risk control models and ratings. Estonian banking supervisors have taken relatively forward-looking approach in that respect by increasingly relying on risk-based approach of supervision. At the same time, and having in mind rapidly developing economy and currency board arrangement, we believe that our banking system should have also robust liquidity buffers as well as sufficient capital to withstand the fluctuation of asset prices. Therefore, we have set relatively high reserve requirement half of what the banks can meet by the holdings of high-rated foreign assets. We will further adjust the system of reserve requirements in the future as monetary policy framework will converge towards the eurosystem principles. Finally, I would like to stress that as an essential element of the safety net, the Deposit Insurance Fund is functioning well and has proved its usefulness already two years ago. The immediate task for Estonian authorities is to introduce the investor protection scheme for the other parts of the financial system.