Second, periods of higher productivity growth may lay the basis for high corporate earnings, heightened optimism and reduced risk awareness. At the same time, with strong productivity growth, inflation remains low. Banks that record low losses and solid results can increase lending without eroding their capital. Debt-financed investments may then lead to a faster rise in property prices. Third, strong international competition may contribute to curbing inflation during a period of strong economic expansion. Given that a conflict between the two goals may arise; how are financial stability considerations incorporated into monetary policy decisions? There seems to be widespread agreement among central banks, that extreme events which could threaten financial stability should be met by resolute use of monetary policy. For example, leading central banks made an effort to ensure continued liquidity in the markets in the aftermath of the terrorist attack on the World Trade Centre on September 11, 2001. As a consequence, the risks confronting the financial system were limited. However, risks to financial stability due to evolving financial imbalances are likely to develop over a long period of time. From this perspective, the question of whether financial stability considerations should be explicitly included in monetary policy is heavily debated, both in academia and within central banks. The answers diverge and international consensus has not yet been reached. One view is that an explicit and proactive monetary policy response to financial imbalances is neither desirable nor feasible. A number of concerns have been raised to explain this view.

147  2  BIS Review 34//2005  Financial markets and institutions have become more interdependent. The possibility of contagion across borders thereby increases. Cross-border capital flows have increased considerably in recent decades. Equity markets have moved more in tandem, particularly since the mid-1990s. This also applies to bond markets. Investors are increasingly spreading their investments across countries. They are both diversifying risk and seeking high returns. In parallel, governments, banks and companies are issuing more debt externally. The corresponding development in financial institutions, towards an increasing share of large cross-border banks, makes it essential to go beyond a purely national analytical focus. However, this can be a difficult task, as cross-border banks are complex and often part of an even more complex financial conglomerate. Examples:   The Iceland-based Kaupthing Group is present in 10 countries and the group’s total asset holdings at the end of 2004 were almost twice the size of Iceland’s GDP.   The Sweden-based Nordea Group has substantial market shares in all four Nordic countries. While Nordea’s home country is Sweden, Nordea has its largest market share in Finland.   The HSBC Group has 110 million customers world-wide.   Citigroup is present in about 100 countries and territories. The central bank has a special responsibility for analysing and monitoring the financial system. The examples of cross-border integration show how important it is to have a strong international focus in financial stability analysis. Generally, the increasing range of analytical challenges has forced central banks to be more innovative.