4  The existing evidence for the case of Chile shows no significant effects on inflows or the real exchange rate, and limited effects on composition of inflows (Cowan and De Gregorio, 2007). See Ostry et al. (2010) for further discussion on capital controls and conditions for them to be used. 4  BIS Review 124/2010  An important aspect of this regulation is whether it should be adjusted according to the availability of capital inflows, or whether it should be time invariant. Let me share some thoughts with you on this issue. First of all, macro-prudential regulation should aim at reducing a risk build-up that could lead to episodes of systemic financial instability. It is not a counter-cyclical macroeconomic tool. Interest rate policy should be the main counter-cyclical tool for central banks. This being said, regulation should not introduce additional procyclicality into the financial system. In Chile, for example, provisions are done on the basis of expected losses during the life of the credit. This stops short of the Spanish dynamic provisioning rule, but reduces the procyclical impact of regulation, in particular compared to the method of constituting provisions according to actual losses. Second, although desirable in several aspects, it seems to me that financial stability (and the build-up of risks) is such a multidimensional concept that either hinders the possibility of rules based macro-prudential policy or limits it to certain aspects (for example, dynamic provisions), which must be supplemented with additional discretionary measures.

As a striking example to this argument, we can mention the 2008–2009 global crisis that was triggered by the financial sector and paved the way to deteriorating macroeconomic indicators such as production, employment, unemployment and budget balance in many countries. We need to underline the fact that financial stability is also crucial for the economies of developing countries as well. During the convergence process, these countries experience rapid financial deepening and integration with global financial markets, as a result of which financial transactions become an indispensable part of economic activity. It is essential for a sound economic outlook in these countries that this process is managed effectively and risks likely to arise from the financial sector are predicted so as to contain their potential effects on the economy. BIS central bankers’ speeches  1  Another potential threat to financial stability is the international capital flows. Free flow of capital enables it to contribute to the growth prospects by moving where it is the most efficient. Yet, when capital flows are not stable, economies are likely to face severe damage. While on the one hand, the surge especially in short-term capital inflows ensure easier access to credit and boost consumption; on the other hand, they lead to over-appreciation of local currencies and thereby widen the imbalance between domestic and external demand. Overall, this leads to deterioration in external balance and increases the domestic economy’s susceptibility to sudden changes in global risk appetite, and in turn, poses risk to macroeconomic and financial stability.