The Bank for International Settlements, known as the bank for central banks, which is based in Basel, Switzerland, on Monday issued a stern warning to central banks -- keeping rates low for too long, and other actions like buying government bonds, creates risks to financial stability and opens central banks up to political pressure.

The warning, contained in BIS’s annual report, came as Europe’s sovereign debt crisis has pushed rate-increase forecasts for major central banks including the Federal Reserve, Bank of England and European Central Bank off until well into 2011.

The BIS acknowledged that cutting rates to record lows “was necessary to prevent the complete collapse of the financial system.” It is not howevernow suggesting immediate hikesbut is concerned that the Eurozone debt problems may delay for too long a “necessary” return to normal monetary policy. “Keeping interest rates very low comes at a cost - - a cost that is growing with time,” BIS said. “Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance sheet adjustments,” BIS said.

At the Annual General Meeting of the BIS, held today in Basel, Christian Noyer, BIS chairman and governor of the Bank of France, said that "over the past two years policymakers worldwide, acting in close cooperation, have succeeded in containing the financial crisis".

He continued, "The BIS has provided key support to the international cooperation of central banks and supervisory authorities. The main task of the public sector now is to design policies that minimise the risks of future financial crises and promote sustainable growth. In this regard, international cooperation will continue to be essential, and the progress made by the Financial Stability Board and the Basel Committee on Banking Supervision has been encouraging."

In its 80th annual report, released Monday, BIS notes that the steps taken by governments and central banks prevented a financial system meltdown and helped bring to an end the great contraction in global economic activity. The policy tasks that lie ahead, which are no less daunting than they were a year ago.

The BIS General Manager Jaime Caruana underlined three policy challenges: 

• "The first and most immediate challenge is to make a convincing start on reducing budget deficits in the advanced economies. Placing public debt on a sustainable path must be accompanied by structural reforms to enhance sustainable growth. At the same time, greater exchange rate flexibility in some emerging market economies could improve the prospects for more balanced global growth. 

• "The second challenge is to foster the strengthening of balance sheets and necessary behavioural changes in the financial industry. Official support was intended to facilitate orderly adjustment. But if such support is maintained for too long, it will create moral hazard, undermine private sector financial intermediation and generate new, hidden risks.

• "The third challenge is to finalise international agreements on financial regulation reform. The Basel Committee and the Financial Stability Board are well advanced in the design of concrete reforms. Systemic risk awareness is to be embedded in all aspects of regulation and supervision. In building a broader financial stability framework, we must make sure that macroprudential and macroeconomic policies complement and reinforce each other to limit the build-up of financial vulnerabilities in a pre-emptive way.

"Early effective action to meet these three challenges would strengthen confidence and help put the financial crisis behind us.

"In today's fragile economic and financial environment, international cooperation is vital for rebuilding confidence. Supporting such cooperation is central to our work at the BIS."

He welcomed some recently announced policy measures. "Fiscal consolidation in several countries, the plan to publish stress tests for European banks and the support of the G-20 for the regulatory reform agenda are all important steps forward," he said.