sector, which can be relatively easily monitored through the supervisory process. i recognise that this emphasis on balance sheet management - which is especially important where a country is seeking actively to manage its exchange rate - may raise the cost of short - term capital inflows ; but that seems to me to be a price worth paying for greater protection against sudden capital outflows if confidence declines. finally borrowing countries are being increasingly encouraged to develop, in the current less febrile environment, an ongoing dialogue with their major external creditors in the expectation that this would help to identify emerging concerns and possible responses at an earlier stage and to promote a more constructive reaction on the part of those creditors when storms begin to gather. now, all of these steps are steps which countries themselves can take to reduce the risks of domestic or external macro - economic shocks leading to financial instability, which in turn would be likely to amplify the effects of the initial shock. but with the best will in the world such shocks will no doubt continue to occur. and alongside all this work on what countries can do to help protect themselves, a major review of the terms and conditions of the imf facilities is taking place, designed to increase the effectiveness of the financial help that the imf can give to its member countries when they do run into difficulties. this is not an easy issue on which, i know, people hold strong views. we have to try to strike a sensible balance between excessively onerous and excessively liberal conditions attaching to imf support. on the one hand, if imf conditions - whether preconditions attaching to quasi - automatic support in the event of sudden capital outflows or adjustment conditions attaching to the fund ’ s more traditional facilities - if in either case the conditions were too demanding, countries may be deterred from seeking the fund ’ s help. that in turn could result in unnecessary economic and financial instability. if, on the other hand, imf assistance were too readily forthcoming, both the member countries, and their creditors, might be encouraged to take excessive risks in the belief that the imf would in the end bail them out. this is a particular form of the familiar problem of moral hazard. it, too, could result in unnecessary economic and financial instability. what does seem clear is that, given the scale of private international capital flows today, the imf ’ s resources are certain to be limited in relation to the problems that could emerge. at some point therefore - depending

years. but one challenge is that, as for the authorities, it is hard for individual firms to gauge the likely “ systemic impact ” of particular shocks, which takes into account macro and financial system interactions and feedback effects. indeed, in practice, banks often model the effect of even severe macroeconomic shocks as if they were occurring to the bank in isolation. they thus may assume that they have freedom to readjust their balance sheets and lending practices in the event of an adverse shock, without considering whether other banks may be trying to do the same thing and the effect that these behavioural responses may have cumulatively on market liquidity and on the economy as a whole. an important implication is that many firm - level stress tests may consequently underestimate the possible impact of adverse shocks. as i have highlighted, some of the potentially missing effects should be captured in the proposed suite of models. but the proposed enhanced “ top - down ” approach outlined above may still benefit from additional insights gained from closer dialogue and interaction with major financial firms on their likely reaction to episodes of stress. i consequently think there is merit in more formal comparison of “ top - down ” and “ bottom - up ” stress testing exercises, and of seeking ways of integrating the two into more formal “ systemic ” stress tests, where the authorities present an initial scenario to firms and then modify the scenario in the light of feedback on the potential response by firms in an iterative loop. this approach has recently been pioneered by the dutch central bank. 6 it potentially offers a useful way of improving knowledge of key system - wide interactions, and thus could provide a valuable supplement both to improved “ top - down ” approaches and to “ bottom - up ” stress tests which are naturally targeted more closely at the major risks facing individual firms given their balance sheets and positions. 16 to conclude, there is a major programme of inherently difficult and challenging modelling work ahead for the public authorities and for financial firms. but this is very important. development of a more coherent and consistent framework for the analysis of financial stability is a major prize. ultimately this should improve the understanding and pricing of risk and support better targeting of public policy, focused more closely on containing systemic risk and on the maintenance of the public good of systemic financial stability. de nederlandsche bank ( 2006 ), financial stability : is the dutch financial sector stress - resistant? quarterly bulletin, december.