In these circumstances, tightening prudential measures early on might seem a very reasonable thing to do. It is important to underline that in heavily bank dominated financial system, banking regulations might serve also as an instrument to affect domestic demand more directly than under other circumstances. Indeed, Bank of Estonia increased capital adequacy ratio on more or less cyclical grounds in 1996 and tightened capital requirements further at the onset of Asian contagion, before the peak of the cycle. Having said that, one should not look over the possible caveats of this "macro-prudential" policy approach. One obvious shortcoming is that as financial markets do mature and financial instruments become more complex, tightening banking regulations will simply intensify financial disintermediation. In that case, major capital flows will be channeled to less regulated areas that will bring about new risks of potentially systemic nature. The second problem is that the determination of the exact stage of business cycle is simply impossible. The longer it takes, the more weight is given to the consideration whether the tightening would not emerge too late and contrary to the best intentions, would contribute to pro-cyclical behavior of banks. To be honest, we have recently thought what approach would be suitable for us to take at present and we have understood that the topic is debated also in several present EU member states. VII.
Secondly, Estonia has avoided volatile short-term capital flows due to strong fiscal stance. While these "soft" policy principles support crisis prevention by providing relatively stable and transparent environment, the resilience of the system depends ultimately on the actions of market participants themselves. The task of the authorities is to provide an adequate regulatory framework and to undertake maximum effort for the supervision of the implementation of these regulations. There is another interesting, albeit still debated issue – to what extent should the supervisors rely on banks' internal risk control models and ratings. Estonian banking supervisors have taken relatively forward-looking approach in that respect by increasingly relying on risk-based approach of supervision. At the same time, and having in mind rapidly developing economy and currency board arrangement, we believe that our banking system should have also robust liquidity buffers as well as sufficient capital to withstand the fluctuation of asset prices. Therefore, we have set relatively high reserve requirement half of what the banks can meet by the holdings of high-rated foreign assets. We will further adjust the system of reserve requirements in the future as monetary policy framework will converge towards the eurosystem principles. Finally, I would like to stress that as an essential element of the safety net, the Deposit Insurance Fund is functioning well and has proved its usefulness already two years ago. The immediate task for Estonian authorities is to introduce the investor protection scheme for the other parts of the financial system.