is that central banks could be left with a responsibility for overall financial stability that is neither clearly defined nor supported with the necessary powers or access to information to discharge it. so where separate supervisory authorities are being established, it is important to set up a structure that promotes the necessary exchange of c a e goodhart : “ the organisational structure of financial supervision ”, fsi occasional paper no 1, bis, basel, 2000. information and coordination. much attention is being given to this subject in the united kingdom, japan and other countries where new supervisory structures are being put in place. my argument in this lecture, however, is that even with these developments, the basic conceptual framework for the promotion of financial stability is not fully adequate. it tends to see the interrelationship between monetary policy and financial supervision as being important in managing crises, rather than in their origination. there is not sufficient focus on the genesis of financial instability. it is this framework that i wish to try and broaden. my conjecture is that the relationship between monetary and financial stability runs deeper than is often imagined. more specifically, the pursuit of price stability can sometimes allow financial imbalances to arise inadvertently, and can sow the seeds of subsequent instability. conversely, the pursuit of prudential objectives, institution by institution, can take inadequate account of feedback mechanisms that can exacerbate macroeconomic cycles. allow me to elaborate on these points. beyond the current debate : the genesis of financial instability i will begin with two observations to support my conjecture that monetary and financial stability cannot be put in separate compartments and separately pursued. my first observation is that since the 1980s inflation has been largely conquered, and yet financial instability has, if anything, intensified. it has taken the form both of price misalignments and widespread financial distress, both in industrial countries and emerging market economies. exchange rate relationships have been highly volatile, and “ bubbles ” appear to have emerged and occasionally burst in property and equity markets. bond yields, too, have varied over a wide range. in financial systems, there have been highly damaging crises in the nordic countries, in japan, in east asia and in mexico. several common features of these episodes of instability are worthy of comment. first, they occurred in circumstances where inflation was either not a threat, or was on a downward trend. in a liberalised financial system, the absence of inflation is therefore a necessary but not sufficient condition to avoid financial instability. secondly, systemic problems were not caused by

##ies ). in implementing prudential policies, supervisory authorities may require a keener recognition that some of the main roots of systemic instability have been macroeconomic. one common macroeconomic element behind overextension in the financial system has been misjudgements about the economy ’ s potential growth rate – a major factor in japan in the 1980s and in south - east asia in the mid 1990s. another element is that financial market sentiment tends to move with the business cycle. many of the dilemmas of policy arise because it is difficult in practice to distinguish what is cycle and what is trend. likewise, in framing monetary policy, central banks may require a keener recognition of the role of monetary policy in unintentionally accommodating the credit expansion that contributes to the build up of financial imbalances. in developing these themes, i will try to derive some operative conclusions both for the monetary policy and the supervisory function. the structure of what i have to say is as follows : i will begin by recalling, in a somewhat stylised manner, the current debate on the relationship between monetary and financial stability. next, i will broaden the focus so as to bring out some of the under - appreciated aspects of this relationship. finally, i will try to draw some policy implications, both for the monetary and the supervisory authorities. the current debate the conceptual framework underlying the current debate is one in which the two objectives of monetary and financial stability, and the instruments used to achieve them, can be largely separated. the monetary authorities direct interest rate and credit policies towards a clearly defined objective of price stability. increasingly, this is being done in the framework of inflation targeting, though hong kong, for reasons related to both its history and its economic structure, has chosen to anchor its monetary policy on an external peg. against a background of price stability, financial stability is seen to be assured by rigorous prudential supervision, targeted at the risk management practices, and the solvency of individual institutions. within this broad conceptual framework, there are areas of agreement and disagreement. it is generally agreed that there is a clear division of responsibility between the monetary policy function and the prudential supervisory function. and it is accepted that information needs to be exchanged and actions coordinated, particularly during periods of financial turbulence. but otherwise, little need is seen for continuous interaction between the authorities responsible for these two functions. where disagreement has arisen is on the subject of whether supervisory functions should be placed in the central bank or