The first tells that an efficient monetary policy requires financial stability. The second that financial stability cannot be achieved irrespective of fiscal conditions. The third, that financial stability is contingent on a sound regulatory framework agreed upon at the internationally level and robust supervisory management at the domestic level. I. An effective monetary policy requires well-functioning financial systems  4. All the decisions taken by the European Central Bank during these last three years had the primary goal to secure the transmission of monetary policy. Three channels could affect these mechanisms through:   the price channel: the increase in government bonds yields may spill-over to the cost of financing of the private sector. Under normally functioning bond markets, sovereign bonds provide a floor for the funding conditions of the private sector.   the liquidity channel: government bonds are the primary collateral used by banks. Interruptions in the sovereign debt market reduce the function of government securities as liquidity buffers. This in turn impedes banks’ capacity to issue loans and refinance the real economy.   the balance sheet channel: falling bond prices induce valuation losses on assets and balance sheets of financial and non financial actors. For banks, these losses reduce their capital base, decreasing, hence, their supply of loans to the economy. BIS Review 113/2010  1  For borrowers, the losses on assets held, diminish their creditworthiness, affecting, thus, their capacity to borrow. 5.

Against this background, no alternative solutions – sometimes advocated by advisers referring to the Latin American previous crisis – were suitable options for the Euro area. In fact, the Euro area is not only built with a single currency ; it has also developed into a highly integrated economic and financial area. In this context, debt restructuring would hammer the banking sector impair financial markets and destabilize the real economy. 17. In addition, an EU stress test exercise was instrumental in alleviating pressures as we have observed significant spread reduction in the wake of the release of their results. Tensions on sovereign spreads have indeed abated somewhat as a result of an unprecedented transparency effort leading 91 European banks to disclose their detailed exposures to EU sovereigns. The severity of the stress scenario, which beyond assumed adverse macroeconomic conditions also incorporated assumption of losses due to renewed and persistent tensions in sovereign long term interest rates, revealed that even under extremely adverse conditions, European banks capital would still be maintained well above minimum regulatory requirements. III. Financial stability is contingent on sound international regulation and robust domestic supervisory management  18. The financial crisis has taught us some clear lessons which force us to review in depth the way the financial system is regulated and effectively supervised. The crisis has revealed weaknesses in the international regulatory framework. 19. The main flaws fall into three broad categories. BIS Review 113/2010  3  20. The first relates to the scope of the regulatory framework.