The latter, on the other hand, focuses on strengthening the institutional framework for monetary policy and financial supervision as well as fostering financial sector development that improves the ability of the system to absorb shocks by itself, in a way that minimizes the impact on the real economy without the need for policy intervention. Given the significant gap that emerging market economies have in this respect relative to developed economies, it becomes more crucial that the pursuit of monetary and financial stability in emerging markets be accompanied by a vigilant focus on making progress on structural reforms. In what follows, I will discuss some specific challenges to monetary and financial stability in emerging markets from both the short and the longer run perspectives. Let’s begin first with the short run stabilization challenge. As we have seen in past years, the search for yield among international investors has resulted in a resurgence of capital inflow into emerging markets, leading to a pick-up in asset price volatility. 3 Given the high degree of dependence on foreign trade, and the inadequate experience with modern financial risk-management tools particularly at the firm level, these asset price fluctuations have become an important policy issue in emerging markets. Typically, when large capital flows into financially shallow markets, it puts pressure on emerging market central banks to lower interest rates or to increase sterilized intervention in  3  This global liquidity glut may have stemmed from various factors, both structural and cyclical.
Regulators will need to be alert for pure regulatory arbitrage – seeking to change the form but not the economic substance of transactions in order to lower regulatory requirements. We have already seen, for example, transactions seeking to take credit risk in the form of derivatives rather than loans in order to lower the leverage exposure measure. More legitimately, banks might switch from activities for which risk weights have increased to activities which carry lower risk weights (Chart 2). The leverage ratio will, however, set an effective floor on the ability of banks to improve their capital position by shifting into low riskweighted assets, providing a safeguard against uncertainties around our estimates of risk. Conversely, banks for which the leverage ratio is a binding requirement may have incentives to move into higher risk-weighted activities (Chart 3) but the risk-weighted ratio should limit the extent of any such risk shifting. In this way, the risk-weighted and leverage ratios should complement one another. It will be interesting to see how banks allocate capital in a world  2  2  http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech765.pdf. BIS central bankers’ speeches  where they are subject to multiple capital constraints – risk-weighted, leverage and stresstest-based.