A strong Central Bank mandate and credibility is essential for successful adoption of FIT. There is considerable evidence from around the world that weak legal mandates together with inadequate autonomy of central banks hinder the success of FIT. In this context, Sri Lanka will also have to introduce considerable changes to the existing mandate of the Central Bank through necessary legal reforms. The current framework is hampered by the focus on non-core activities, monetary financing and inadequate autonomy. These factors are structural impediments in the transition path towards FIT. Amending the Monetary Law Act (MLA) is, therefore, imperative to enhance the focus of the mandate as well as Central Bank autonomy, governance, transparency and accountability. These amendments would broadly include strengthening the mandate of price stability, separating the monetary and fiscal functions, strengthening the Central Bank’s autonomy, and introducing institutional arrangements for setting inflation targets and maintaining accountability. Second, to assure effective monetary policy conduct as a vital building block for maintaining low inflation under the FIT, we need to establish a sound, forward-looking decision-making process, based on reliable macroeconomic forecasts and projections. In this connection, the Central Bank has already improved technical capacity in modelling and forecasting of key macroeconomic variables. The Central Bank and the IMF have jointly developed a structural model-based Forecasting and Policy Analysis System (FPAS), which encompasses near-term and medium-term model-based projections. The current policy formulation process is gradually being aligned with the analysis based on FPAS.

There were manifest conflicts of interest, originators and brokers had limited interest in ensuring continued monitoring of products and credit ratings were inflated, conveying a false sense of security. A euphoric bubble thus developed, based, in Alan Greenspan’s words, on “the complexity of the interactions of asset markets and the economy”, and which concealed a massive global under-pricing of risk. Market participants seem to have been aware of the growing risks but were unwilling to retrench. You might recall Citibank’s Chuck Prince’s memorable words during the onset of the crisis that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing”. Market players failed to appreciate the speed at which demand could evaporate and risk aversion could increase. This soon resulted in record-high risk premia, seized-up interbank markets, acute liquidity and credit shortages, bank failures and a widespread loss of confidence. Meanwhile the high degree of financial market integration had created the premise for a simultaneous build-up of systemic risk. Financial institutions did not internalise the costs arising from the too-big-to-fail and too-interconnected syndrome. Central banks had been monitoring these trends, but it turned out that the regulatory tools were not designed to address systemic risk. Neither was the strength of the feedback loop between the financial  BIS Review 67/2010  1  system and the economy fully anticipated. Unfortunately, these all proved to be critical weaknesses.