been made and, third, are being made in order to preserve financial stability. b. the three themes and financial stability past crises could give us some hints about what could also be important financial stability concerns in the future. one should not go too far back as the financial system is rapidly changing and one must always be prepared for surprises. often the new crises come as complete surprises. b. 1 the growing role of financial markets and volatility let me turn to my first theme - the growing role of markets. this development means that financial stability threats could increasingly stem from financial market problems. as i alluded to earlier, sudden and extreme shifts in expectations concerning the value of an asset and increased volatility could represent one major type of financial instability. in europe, most historical periods of financial instability have been linked to traditional loan losses by banks. however, if one looks at the longer - term perspective over the past 15 years or so, european financial markets have grown very rapidly. no doubt, the recourse to market - based finance in europe is still significantly below that of the united states, but the gap seems to be rapidly narrowing. as the markets have grown and have become more liquid - thanks also to the euro - investors have been moving from bank deposits to direct and collective securities investments. whereas sharp and large price adjustments may not necessarily have systemic implications, financial institutions with leveraged market positions may be directly affected. the russian crisis of august 1998 illustrates the point well, as mature markets experienced spillover effects through investors ’ leveraged positions in russia and other emerging markets. one such leveraged exposure was held by the ltcm hedge fund. prior to the rescue undertaken by private banks and aided by the us federal reserve, liquidity plunged and prices in many markets dropped to very low levels. an additional element threatening the stability of the global financial system was that virtually all of the leveraged treasury bond investors had similar positions, including major financial institutions. banks ’ direct exposures may be an important aspect of financial instability in periods of financial market volatility. in addition, banks may hold significant exposures with non - bank financial institutions, which themselves suffer from direct market exposures. the barings crisis in 1995 is an example of the first case, while the ltcm case is an example of the second. in my view, the eventual scale of a systemic crisis might depend on the magnitude of the deviation of asset prices from fundamentals. how, then, do asset price bubbles

get created in the first place? they may be created or exacerbated by some form of herding and overly buoyant investor expectations, as groups of investors imitate leading institutions ’ strategies. bubbles may be further boosted by a lack of adequate disclosure, problems of conflicts of interest, and destabilising trading or investment strategies. once bubbles burst, portfolio insurance strategies in the event of falling prices - or dynamic hedging might heighten the downward spiral. particularly in earlier episodes of equity - driven financial instability, such as the 1987 stock exchange crash, the initial wave of the sale of equity futures appears to have resulted in an accelerated decline in stock prices. however, the jury is still out on the role of tools such as portfolio insurance or automatic trading rules in exacerbating aggregate financial risk. less controversial seems to be the observation that downward spirals in prices can be magnified by the institutions involved in the selling wave of the crash, thereby generating contagion across markets and countries. in particular, the russian and ltcm crises demonstrate the important role of market liquidity as a potential channel of crisis contagion, as market price falls due to liquidity withdrawals could cause losses for many market participants. to summarise the lessons learnt from past experiences, it seems that volatility is in itself not necessarily a threat to financial stability. other elements are necessary before serious concerns arise over financial stability. one of the key elements is the risk faced by banks and other financial institutions, because this could be the channel through which the functioning of the financial system as a whole could be jeopardised. this view is supported by the recent episodes of market volatility in late 2002 and early 2003, when the sequence of substantial market readjustment was generally managed in an orderly manner by financial institutions across the globe. b. 2 progressing financial innovation let me turn to the second theme - the implications of progressing financial innovation. in fact, the reason why the latest episode of stock market adjustments did not cause systemic problems could be attributed to the contribution of financial innovation to the more even distribution of risks. however, some concerns have emerged regarding the securitisation and credit risk transfer markets, for instance. from the perspective of the public authorities, concerns have been expressed in particular about the lack of transparency on the identity of the ultimate risk holders and about adequate risk management by the institutions dealing with these instruments. in particular, financial innovations may be subject to problems when their