The interest rate is a blunt and unsuitable instrument for achieving financial stability and it thus makes little sense to assign the objective of financial stability to monetary policy. However, it may make sense to assign the objective of financial stability to the central bank, if the central bank is given control of the appropriate supervisory and regulatory instruments. The fact that financial-stability policy and monetary policy are different does not mean that there is no interaction between them. Similarly, monetary policy and fiscal policy are distinct policies but both have an impact on inflation and resource utilisation. The interaction between monetary policy and financial-stability policy has to be considered. Monetary policy affects asset prices and balance sheets and can thereby affect financial stability. Financial-stability  being smaller after the crisis. In Europe, Canada and the Nordic countries, commercial banks dominate the financial sector. 4  BIS Review 118/2010  policy directly affects financial conditions, which affect the transmission mechanism of monetary policy. This motivates more research on how to incorporate financial conditions into the standard models of the transmission mechanism used by central banks. The outcome might very well be that financial conditions are considered to play a larger role in the transmission mechanism and as indicators of future inflation and resource utilisation. If so, central banks would end up responding more to financial indicators, in the sense of adjusting the policy rate and policy-rate path more to a given change in a financial indicator.
But those strains have also been exacerbated by an unexpected breakdown in the technology for liquidity insurance provided by central banks. For well over a century, throughout industrialised world there has in effect been something akin to a Social Contract between the banking system and the authorities. The banking system is permitted to profit from undertaking leveraged maturity transformation in the course of intermediating the liquid savings of depositors into illiquid loans to households, firms and others. In doing so, commercial banks provide liquidity insurance, whether via demand deposits or committed lines of credit. They can do this because their deposit liabilities are  BIS Review 38/2008  3  money, which puts them at the heart of the payments system and is what makes them special; banks are at the heart of a monetary economy. In return, the authorities respond with a combination of prudential supervision, to contain the risks that banks run; deposit insurance, to protect savers; and liquidity insurance from the central bank. Smaller commercial banks can try to buy liquidity insurance from their larger brethren. Large banks cannot realistically do the same. But there is no cast iron guarantee that asset markets will remain liquid in all conditions. So since Bagehot’s day, central banks have stood ready to provide unlimited liquidity against good collateral at a rate that is higher than the normal market rate.