The increased complexity of the financial system is illustrated by the rapidly expanding market of credit derivatives. This is a relatively new financial instrument that comes in many and complicated forms. While contributing positively to greater flexibility in risk management, there is also the possibility that risk is more easily concentrated, and that economic agents can take on risks without being fully aware of their ramifications. Analysing risk originating inside the financial system, it can be useful to divide the approach into two areas.3 The microprudential analysis focuses on the developments within individual institutions, and is concerned with limiting the distress of individual institutions, thereby protecting depositors. The macroprudential analysis focuses on the financial system as a whole, and aims at limiting system-wide distress and avoiding output costs. An important concept here is systemic risk; the risk that liquidity or solvency problems in a bank may cause liquidity problems or insolvency in other institutions. Thus, correlation and common exposures across institutions are important in the macroprudential approach. The second approach deals with risks originating from outside the financial system. This field has increasingly been recognized by researchers and policymakers in later years. Strong growth in debt and asset prices, as well as macroeconomic disturbances like a surge in commodity prices or the unwinding of large imbalances in the world economy, can ultimately affect financial stability in a negative way. To identify potential sources of instability, we need indicators that contain useful information.

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.