Second, fluctuations in the inflation rate are often accompanied by interest rate variations. A sharp rise in interest rates can also result in substantial losses on financial assets such as bonds and equities. Loans that have been granted against collateral in the form of such assets are even more exposed to losses. When rising inflation and inflation expectations necessitate a substantial tightening of monetary policy, a crisis may ensue. In several countries the financial system has been on the verge of collapse during such a period of adjustment. This was the case in the US in the early 1980s and in the Nordic countries around 1990. Interest rates are the central banks’ most “direct” tool for contributing to both monetary and financial stability. Financial stability primarily contributes to price and exchange rate stability by facilitating the use of policy instruments for monetary stability purposes. Unstable institutions and markets constrain the use of interest rates. Tighter liquidity and higher interest rates may increase the uncertainty concerning the stability of the financial system. BIS Review 78/2000  4  This suggests that situations may occur where there is a conflict between the two objectives. Asset prices are an important link between monetary and financial stability. For example, a surge in property prices, with a risk of a subsequent fall, may threaten to undermine banks’ collateral and increase loan losses. This can put financial stability at risk. A surge in asset prices without accompanying pressures on prices for goods and services raises a dilemma for central banks.

Banks are in a special position. They transform short-term deposits into long-term loans. They are responsible for payment settlements, and bank deposits serve as a means of payment. The volume of amounts outstanding in the interbank market is sizeable. As a result, problems in one bank may rapidly spread to other banks. The financial strength of banks is thus important for financial stability, even more so in countries where banks are the main financial intermediaries. Long-term profitability has a decisive influence on financial strength. Obviously, there are many factors that can influence the future profitability of banks. The topics you will discuss during these two days are of great importance. Financial unrest spreads through payment and settlement systems. These systems can also be a source of risk. This occurs when banks credit customers before they have received settlement from the payer bank. Payment and settlement systems must thus be designed to reduce settlement risk. This is an issue high on the agenda of most central banks. Interdependence of monetary and financial stability The objectives of monetary stability and financial stability are interdependent. High - and thereby in practice varying - inflation and unstable exchange rates can threaten financial stability through several channels. First, it is more difficult to assess the risk of an investment project. Inflation makes it difficult to differentiate between a change in prices for goods or service and a change in the overall price level. It makes it more difficult to determine the discount rate to be applied.