Deficit reduction and financial reform are both needed to ensure the stability of the financial system, the Bank for International Settlements said at its annual meeting in Basel, Switzerland.

Speaking at the meeting on Monday, BIS general manager, Jaime Caruana, outlined three primary policy challenges facing governments: deficit reduction; getting international agreement on financial reform; and improving the balance sheets and the behaviour of financial firms.

Caruana said that strengthening balance sheets in the financial sector is the precondition for restoring financial stability and scaling back public sector involvement. “Banks have raised new equity capital, but some are still not well positioned to absorb the losses and risks that may lie ahead. In addition, some banks have yet to make transparent the scale of losses already on their balance sheets, and remain too dependent on very short-term borrowing,” he said.

At the same time, a safer, more resilient financial system requires a coherent global financial stability framework, he said.

“We need more and better capital and liquidity buffers to make banks substantially more resilient. We must also reduce the moral hazard associated with the too-big-to-fail issue. And the systemic dimension of financial risk needs to become tightly woven into the new regulatory and supervisory fabric,” he said.

He noted that the Basel Committee is well on the way to reforming capital, liquidity and leverage, and that, according to preliminary estimates, the impact on global output as these reforms are phased in “is likely to be small and transitory”.

Finally, he said that the role of monetary and fiscal policy in ensuring financial stability must be recognized. “Unsustainably high fiscal deficits can quickly destabilize financial markets. And long periods of extremely low policy rates give rise to financial stability risks,” he said. “This means that, in order to play their financial stability roles effectively, central banks need realistic financial stability objectives and effective tools that are consistent with their monetary policy responsibilities.”

Christian Noyer, BIS chairman and governor of the Bank of France, said that, “The main task of the public sector now is to design policies that minimize the risks of future financial crises and promote sustainable growth. In this regard, international cooperation will continue to be essential.”

IE