Possible policy implications of such developments from a monetary and a financial stability perspective  All the factors I have just mentioned require authorities to consider – in conjunction with the financial industry – ways of preserving monetary and financial stability in this changing environment. A. A stability-oriented monetary policy is a fundamental prerequisite for the smooth functioning of financial cycles. Financial deregulation has radically changed the conduct of monetary policies. More open economies and greater interdependence between financial systems have completely overhauled the context in which monetary policy is implemented. •  Financial markets can now penalise inflationary monetary policies by withdrawing capital, with a subsequent rise in long-term interest rates and/or depreciation of the exchange rate. •  At the same time, monetary policy transmission mechanisms have become more diversified and complex. This situation has prompted the authorities to separate the different instruments for implementing economic policy. In this context, monetary policy has been clearly been assigned the objective of maintaining price stability. Today, monetary policies are conducted within a framework characterised by three features: •  Firstly, reducing inflation expectations depends on compliance with a number of rules that have been clearly defined in advance. Consequently, this policy can only be effective if the authority responsible for defining and implementing it is credible. The conjunction of a clear, overriding objective of price stability (which has been explicitly laid down in the statute of the ECB), with well-established institutional independence ensures the continuity of the monetary policy decisions made by the authorities.

In parallel, investors have become more reluctant to invest in the banking sector when profit expectations are low, making it difficult for banks to raise new funds. Banks’ soundness therefore tends to be more correlated to economic fluctuations than in the past, contributing to the amplification of the credit cycle. •  Accounting regulations so far may also contribute to amplifying credit cycles to some extent. In most financial centres, current provisioning behaviour does not allow banks to take a forward-looking view of their risks, as accounting and tax rules only accept loan-loss provisions for impaired loans. Such a regulatory environment may amplify the credit cycle, contributing to low provisioning and over-lending during upswings and paving the way to sharp corrections during downswings. Using full fair value accounting for loan portfolios might further amplify credit cycles by increasing the volatility of banks’ earnings. •  Prudential rules may also have been unable so far to always prevent these developments. Current capital adequacy rules are not risk-sensitive; as a result, credit  2  BIS Review 41/2001  deterioration does not require additional regulatory capital unless loan losses erode the capital base under minimum requirements. As most banks – particularly large ones – have capital far beyond the prudential minimum requirements, they can bear a reduction of their capital base without being compelled to restrict their credit granting. Therefore, capital ratio is not pro-cyclical as such.