one of the cornerstones of the turkish economy. a set of reforms for developing a functioning market economy was put into practice. interest rates were more and more determined in the markets, and some measures were taken regarding the supervision of the banking sector. however, before taking the necessary actions for strengthening the domestic financial markets, such as measures for more transparent balance sheets and more careful risk management in the intermediation process, the capital account was liberalized at the end of the 1980s. the turkish economy with an inefficient banking sector became open to intensive capital movements. in my view, the turkish economy turned into an open one before it became strong enough to cope with capital movements that would occur in the 90s. the sequencing of reforms for the turkish economy in general and its financial system in particular should have been set differently. what went wrong in the turkish economy in the 90s? policies did not concentrate on ensuring and maintaining macroeconomic stability ; different priorities, delayed reforms, loose fiscal policy and accommodative monetary policy led to dynamic instability throughout these years. as a result, inflation climbed to 79 percent on average, budget deficit widened so much that the public sector borrowing requirement reached 15. 5 percent of the gnp by 1999, the output growth was very low on average and volatile compared to other emerging markets. so, poor macroeconomic fundamentals and a fully liberalized capital account brought about vulnerability of the economy to external shocks and the turkish economy faced severe financial crises and turbulences in the 90s. such an environment had also important implications on the financial system. having suffered from the reckless and unstable macroeconomic management together with inefficient supervision, the system deteriorated severely and faced a serious moral hazard problem. dear participants, a closer look at the turkish financial system would be helpful to characterize its weaknesses and structural problems during that period. first of all, because of the high public sector borrowing requirement, fiscal dominance increased considerably in the financial markets and led the public sector to crowd out the private sector. hence, the relationship between the banking sector and real sector could not develop as it should have done. instead, the relationship between the banking sector and the public sector strengthened year after year. secondly, the banking sector as a whole failed to exercise good risk management in its credit allocation. since financing the public sector budget deficits with high real interest rates was an easy way to make profits, banks did not pay much attention to basic principles of risk management, such as maturity and currency

on the banking sector particularly, banks play a vital role in the economy, matching supply of capital with demand, so knowing how a downturn affects these institutions is important in understanding national economies ’ dynamics4. developments in financial markets have two important implications on the global economy and economic policies : firstly, stronger a country ’ s fundamentals are, less vulnerable it is to distortions caused by intensive capital movements. hence, the importance of macroeconomic stability and strong fundamentals. however, contrary to the general belief, turmoil in global markets in the 90 ’ s also showed that macroeconomic stability in general or price stability in particular does not necessarily guarantee financial stability. as historical evidence suggests, it is possible for financial imbalances to develop even in an environment of stable and low inflation. therefore as the second implication, it is impossible to avoid crises without discipline in financial markets. then it naturally follows that the risk management developed as a distinct banking discipline in the 1990s. new tools and methods to manage the market and credit risk were developed, and brought about a dramatic increase in the volume of capital movements in the financial sector and variety of instruments. efficient supervision became the vital part of this internal discipline. i should also admit that, as financial engineering contributes to development of new and complex instruments, such instruments also create obstacles to supervisory authorities given their sophisticated structures. as a result, a long debate started among both academics and policy makers as to whether the objective of price stability or financial stability should take priority for a central bank. i do not want to take sides in this debate. we, central bankers, are responsible for providing a stable economic environment, in which the economy operates efficiently in the long run. and prerequisites for a stable economic environment are both price stability and financial stability. so, there is always a strong reason for keeping financial stability in the central banks ’ reaction functions. therefore, these two objectives are not in conflict in the long run, but are complementary to each other. accordingly, financial stability has increasingly become an auxiliary objective of central banks to pursue. in fact, central banks ’ role in times of financial instability is not a new issue for the economic literature. the term “ lender of last resort ” originated in the writing of sir francis baring in 1797. in his book, “ observations on the establishment of the bank of england ”, sir baring referred to the bank of aninat, eduardo. ( 2003 ). foreword. challenges to central banking from globalized financial