The purpose of this paper is to assess the choice between adopting a monetary base or an interest rate setting instrument to maintain financial stability. Our results suggest that the interest rate instrument is preferable, since during times of a panic or financial crisis the Central Bank automatically satisfies the increased demand for money. Thus, it prevents sharp losses in asset values and enhanced asset volatility.

This study investigates whether regulations have an independent effect on bank risk-taking or whether their effect is channeled through the market power possessed by banks. Given a well-established set of theoretical priors, the regulations considered are capital requirements, restrictions on bank activities and official supervisory power. We use data from the Central and Eastern European banking sectors over the period 1998–2005. The empirical results suggest that banks with market power tend to take on lower credit risk and have a lower probability of default. Capital requirements reduce risk in general, but for banks with market power this effect significantly weakens or can even be reversed. Higher activity restrictions in combination with more market power reduce both credit risk and the risk of default, while official supervisory power has only a direct impact on bank risk.