The interaction between price stability and financial stability I think that probably the main challenge that emerges from the recent crisis is in the conduct of policies by central banks – and in particular in the interaction between the two key objectives I mentioned above, price stability (PS) and financial stability (FS). Let me begin by discussing the interaction between financial and price stability in normal times, that is, before an event leading to a period of financial turmoil like the one we witnessed in late 2008. In many cases there is no conflict between setting short term interest rates to pursue financial stability and price stability. For example, faced by a change in future income perception that leads to higher consumption, debt levels and rising inflation, rising rates will be conducive to both PS and FS. In several other cases, however, the optimal short term policy decision for FS and PS conflict and additional tools are required. I will argue that these cases fall into two broad categories. The first is when the monetary policy framework itself can amplify financial vulnerabilities. Financial agents take the distributions of asset prices into account when determining their risk exposure, and as such, they adjust their portfolios according to the policy framework. The problem arises because policies cannot always bring stability when faced with unusual  4  BIS Review 76/2010  shocks, which may even require changes in the policy regime. There are some important examples of this. One example is currency mismatches.
Thus, for financial institutions with insuperable solvency problems, it is proposed that the appropriate rescue solution be implemented. For other institutions, that are solvent, but in difficulties that make a strengthening of their capital advisable, many governments have made capital available to them through shares, or other debt instruments that are, for regulatory purposes, deemed to be capital, such as preference shares. Apart from capital strengthening, and in order that solvent institutions should start to function again as normal and have access once more to financial markets that have remained blocked, government guarantees are going to be granted for issues of bank debt. This latter line of action, i.e. that relating to the availability of liquidity and financing, has been supplemented in the case of Spain by the purchase of highquality assets. Finally, and in order to boost the confidence of depositors, practically all countries have increased the amount covered by deposit guarantee schemes and have proposed reducing the period within which such deposits must, where necessary, be returned to depositors. The Spanish government has prepared a roadmap that envisages all these actions. It will be implemented not so much to alleviate solvency problems, which have not materialised in our country, as to help restore confidence and facilitate institutions’ access to financing. The ultimate aim is to avoid institutions’ financing difficulties being the cause of a reduction in lending to firms and households.