not always clear where the risk exposures ultimately lie ; and third, rapid re - leveraging in some parts of the euro area corporate sector, partly induced by a surge in leverage buy - out activity, makes a turn in the credit cycle increasingly probable. the global financial market turbulence of late - february and early - march of this year vividly highlighted the existence of some of these market vulnerabilities. it seems to have reflected an abrupt reappraisal and re - pricing of risks in response to a combination of triggering events, especially a rising concern about rapidly deteriorating credit quality in the us sub - prime mortgage market and, more generally, increased uncertainty about the macroeconomic outlook in the united states. this temporary increase in financial market volatility served to illustrate how an abrupt decline in risk appetite, when asset prices may have departed from intrinsic values, can result in very sharp changes in asset valuations, even when changes in the economic fundamentals are relatively small. looking ahead, in this context of what we have called “ pricing for perfection ” – in the sense that some asset valuations appear to be based on highly optimistic expectations about future economic outcomes and very low risk premia – some markets could continue to prove vulnerable to adverse disturbances and changing market sentiment. added to this, there is uncertainty about how markets for innovative and complex financial instruments ( in particular, structured credit derivatives ) will perform and how lightly regulated and highly leveraged financial institutions will behave in a more challenging macrofinancial environment. that said, financial innovation and the growth of alternative investment vehicles, such as hedge funds, have had, in our assessment, an overall positive effect on financial markets in europe, contributing significantly to enhanced market liquidity and greater pricing efficiency, portfolio diversification and a better distribution of risks within the financial system. however, hedge funds ’ activities are also associated with potential operational and systemic risks. moreover, the monitoring and management of these risks by their counterparties and investors have become more complex. an appropriate level of transparency is therefore important for effective market discipline and for the assessment and management of risk by the counterparties of such institutions and by investors. a final point i would like to stress with regard to the activities of the eurosystem in the field of financial stability concerns its ability to cope with a possible financial crisis affecting the euro area. to this end, the eurosystem carried out a comprehensive financial crisis simulation exercise in may 2006 which confirmed its preparedness to deal with potentially systemic events that

positive response of the supply side of the economy to the reforms implemented over the past few years. employment has risen significantly, by more than 12 million people since the launch of the euro, and the unemployment rate has steadily declined to the lowest level since 1993, although it is still unacceptably high. moreover, we have recently witnessed an increase in productivity growth. although this seems to be mainly associated with cyclical factors, there is some evidence that, in certain sectors of the european economy, and in a number of euro area countries, efficiency gains of a structural or permanent nature are being achieved. for the euro area as a whole, however, it is too early to reach definite conclusions. in order to foster higher and sustained economic growth and job creation and enhance the capacity of euro area countries to adjust to shocks, further reforms are needed that can contribute to improving the efficiency, flexibility and adaptability of product, labour and financial markets. financial stability outlook i would now like to address a number of issues concerning financial stability and integration in the euro area. as you know, the ecb monitors and analyses risks to financial stability in order to assess the financial system ’ s shock - absorbing capacity. at the end of 2006, our assessment suggested that the main scenario for euro area financial stability remained broadly favourable. various considerations underpinned this judgement, including : first, global economic activity was expected to remain robust and become more evenly balanced ; second, the credit quality of banks ’ key counterparties – households and firms – generally remained high ; and third, euro area banks ’ profitability was anticipated to strengthen further, their solvency ratios comfortably exceeded regulatory requirements and risk management methods had greatly improved. against the background of the positive macroeconomic outlook and benign financing conditions, and in the light of the latest information on the euro area banks ’ performance, that assessment has been confirmed. at the same time, several pre - existing sources of risk and vulnerability remain and some of them might even have grown in importance. among the vulnerabilities in financial markets, i would like to highlight the following three : first, the low levels of long - term yields and credit spreads in some markets make them vulnerable to a reappraisal of risks ; second, unabated growth in the volume and complexity of new financial instruments, combined with the increasing presence of lightly regulated and highly leveraged financial institutions in the same markets could have made them vulnerable to disruptive adjustments with possibly unforeseen consequences as it is