, this is not a settled issue. there is no onesize - fits - all answer, as is clear from the variety of regulatory models around. each country and each central bank will have to resolve this issue according to its specific circumstances. central banks and financial stability while there is broad agreement that financial stability is neither automatic nor inevitable, there is less agreement on whether it should be explicitly included in the mandate of central banks. one argument is that explicit inclusion would be redundant, because financial stability is a necessary – although not sufficient – condition for achieving the conventional central bank objectives relating to inflation, output, and employment. on the other hand, there is a growing view that unless financial stability is explicitly included in the mandate of central banks, it is likely to fall through the cracks. complicating matters, defining financial stability in a precise, comprehensive, and measurable manner is proving to be difficult. nevertheless, we now know that there are two attributes of financial instability : excessive volatility of macro variables such as interest rates and exchange rates that have a direct impact on the real economy ; and financial institutions and markets threatened by illiquidity to the extent of jeopardizing systemic stability. do central banks have the instruments to address the mandate of financial stability? one clear instrument for preserving financial stability is the lender - of - last - resort function. during the crisis, central banks pumped in enormous amounts of liquidity to unfreeze the system through the lender - of - lastresort window. while this made individual institutions liquid, the market remained illiquid, thereby revealing the limitation of the window instrument in combating illiquidity. a central bank can infuse liquidity, but it ’ s hard to ensure that the available cheap and abundant money is used to purchase assets whose value is rapidly eroding. the only option may be for the central bank to buy the assets. this means that the central bank must be not only the lender but also the market maker of last resort. these issues have yet to be clearly defined, let alone resolved. but they must be resolved soon. managing the costs and benefits of regulation to safeguard financial stability, the reserve bank of india used a variety of prudential measures, including specification of exposure norms and preemptive tightening of the risk weights attached to assets and the requirements for loss provisioning. but these measures often carry a cost. for instance, tightening risk weights arguably tempers the flow of credit

duvvuri subbarao : “ central banks must distill lessons from the global crisis and make concrete reforms ” – interview in finance & development interview with mr duvvuri subbarao, governor of the reserve bank of india, in finance & development, 2 july 2010. * * * central banks have been at the heart of the global financial crisis. they have been blamed for policies and actions that got the world into the crisis ; they have been praised for leading the world out of it. both are fair assessments. central banks have been a part of the problem and a part of the solution. as the crisis unwinds and recovery takes hold, central banks face a number of issues, of which i will address five. monetary policy in a globalizing environment the crisis has demonstrated the difficulties of macroeconomic management in a globalizing world. even as governments and central banks acted with an unusual show of policy force, they were unable to get the situation under control because of the interconnectedness of the financial system and the effects, positive and negative, of external developments on domestic policy actions. most important, they found that sentiment and confidence were remarkably correlated across countries. external developments interact with the domestic economy in complex, uncertain, and even capricious ways. central banks have to deepen their understanding of these interactions. some of the channels through which cross - border transmission occurs are quite familiar – global prices, including commodity price movements ; synchronization of business cycles ; capital flows ; strong comovement of asset prices ; exchange rates of key international currencies ; and interest rate policies of major central banks. some of the transmission channels are less familiar. for example, the crisis has shown that even differences in regulatory regimes can trigger arbitrage - based action and dilute the efficiency of domestic policies. take managing capital flows. emerging market economies experienced a sudden stop in capital inflows during the crisis as well as capital outflows – the result of global deleveraging. now the situation has reversed and many emerging market economies again have net inflows. managing these flows, especially if they are volatile, will test the effectiveness of central bank policies in semi - open emerging market economies. a country whose central bank does not intervene in the foreign exchange market will incur the cost of currency appreciation unrelated to fundamentals. if central banks intervene to prevent appreciation, they will have to contend with additional liquidity and potential inflation pressures. if they sterilize