One instrument (namely, the interest rate) is often not enough for pursuing two objectives. More generally, the two objectives should be addressed with more than one instrument. The choice of instrument will depend on both the cause of the financial fragility and the institutional setting of each country. For a start, central banks should work closely with “micro-prudential” supervisors, communicating potential risks so that these can be incorporated into the supervision process or into changes in regulation. A regional house bubble would be a good example of this kind of coordination, with supervisors adjusting provisions accordingly. In addition, central banks  4  Chapter V, Financial Stability Report 1st half 2009, Central Bank of Chile. http://www.bcentral.cl/publicaciones/politicas/pdf/ief2009_1.pdf  BIS Review 76/2010  5  should consider macro-prudential regulation that adjusts capital, liquidity or asset quality regulation through the cycle or in periods of higher risk taking. Finally, central banks should not discard using their balance sheet to “correct” the prices of financial assets when these asset prices are leading to increased vulnerabilities in the financial system. In EMEs this is typically the case of a boom where there are signs that the currency may be strengthening beyond its fundamentals, in which case a mechanism of selfinsurance, such as accumulation of reserves, may help to smooth the transition and to have the economy well-prepared for potential reversals of capital flows. In the case of Chile, we have intervened three times in the exchange rate market since the currency was allowed to float in 1999.
Closer attention must therefore be paid to the financial fragility that accompanied this process – both to the factors that led to the distortions in asset prices and to the factors that amplified the crisis once the adjustment took place. Let me touch briefly on two of these factors:   The first is financial innovation. Despite a lot of public debate and criticism I believe that financial innovation is essentially welfare enhancing. However, we must not forget that financial innovation can also become a form of circumventing regulation. The way some securitized assets where used was the clearest case of this abuse. They were structured in a way that only secure tranches remained in the balance sheets of banks, and the others were sold, many times to off balance vehicles, allowing credit to expand with a weak capital base. The result was excess demand for certain securitized assets, and excess exposure of highly leveraged intermediaries to these assets. Moving forward, financial innovation needs to move in step with regulation to ensure that it adds value and is not just a form of evading regulation and aggravating financial fragility.   The second is liquidity transformation. Along with important benefits, liquidity transformation entails significant risks. We have known the vulnerabilities of liquidity transformation in the presence of aggregate shocks for a long time; in fact, many countries paid very dearly for this risk before central banks where set up to provide aggregate liquidity.