This is applied both to the banks’ loan portfolio and to market risks arising from their foreign currency, interest rate, liquidity, equity and commodity risk exposures. Finally, a Financial Intelligence Analysis Unit was established, thus completing the institutional framework for strengthening the anti-money laundering regime and for combating the financing of terrorism. It is worth noting here that both the 1994 and the 2002 financial reforms were unanimously approved by Malta’s Parliament - a rare event, and one that should inspire investor confidence. A further important development in Malta’s efforts to establish itself as a reputable financial centre occurred in late 2002 when Malta requested the IMF/World Bank to conduct a Financial Sector  BIS Review 31/2004  3  Assessment Programme (FSAP). The assessment, which was published in August 2003, noted that Malta’s financial system appeared to be healthy and well supervised, and that its domestic banks were profitable, liquid and well capitalised. Moreover, it had a comprehensive legal framework and adhered strongly to most international standards and codes. At the same time, the report noted that, mainly because of the predominance of two large banks, the system was highly concentrated and exposed to the country’s narrow economic base. Among the more recent developments on the banking scene has been the introduction of a number of innovative products and delivery channels, such as equity-linked deposits and mobile and internet banking. On the legislative front, a major development has been the introduction of a Depositor Compensation Scheme.

It is an irrefutable empirical fact that inflation variability rises with the level of inflation, which in turn increases uncertainty for investors and long-term interest rates through a rise in the inflation risk premium. A permanent increase in inflation curtails, rather than stimulates, long-term growth. A considerable body of empirical research finds that the Phillips curve has a negative bent in the long run: inflation and inflation volatility penalise capital formation and thus detract from the economy’s growth potential. Empirical evidence confirms this negative relationship, with a 100 basis point permanent increase in inflation being associated with a 10–30 basis point decrease in trend output  2  BIS Review 22/2010  growth. Hence, if this is applied to the euro area, a 4% inflation target would shave no less than half a percentage point per year off trend growth! As for using monetary policy to manage macroeconomic risk, it should be recognised that this would introduce harmful asymmetries. It avoids policy restriction when positive supplyside shocks reduce inflation, fuelling asset price booms; and when the asset price boom finally turns into a bust, it leads central banks to overreact to negative demand-side shocks. So, financial instability meets two formidable multipliers, the first being a pro-cyclical monetary response to expansionary disinflations in good times and the second being moral hazard in financial markets, namely the expectation that the central bank will aggressively protect the markets from “tail events” in bad times. These expectations encourage markets to tend towards risky strategies, over-exposures and exuberance.