The International Swaps and Derivatives Association (ISDA) has estimated that the notional amount of credit derivatives outstanding globally was USD 3.78 trillion at end-2003. By mid-2004, this figure had grown to USD 5.44 trillion. While the market has been rapidly expanding, it is useful to put its size into perspective: OTC traded credit derivatives only represent around 2-3% of the more than USD 200 trillion total notional amounts of OTC derivatives outstanding. Prepayment risk is a risk that banks can face if they grant homeowners the option to take advantage of lower mortgage interest rates by refinancing their mortgages on more favourable terms. This Box examines the prevalence of prepayment risk in the European mortgage markets, and examines how such risks are typically managed. Shocks can be quickly transmitted within the banking system through the interbank market. This is why financial stability analysis requires regular monitoring of interbank linkages. For this purpose, non-consolidated data on interbank assets and liabilities of euro area banks aggregated at a country level can provide useful information. It is important to note that mapping of interbank relationships is not sufficient to measure contagion risk in interbank markets, as proper measurement of contagion requires detailed consolidated data on each bank’s interbank exposures, also taking into account the different risk mitigation measures (such as collateralisation, netting, hedging, etc.). Financial stability is an important economic policy objective. Financial stability analysis requires a broad view on the economic environment. It draws upon a large pool of data in order to measure the condition of the macroeconomy and its sub-sectors, and it links this with information on the functioning of financial markets and the financial condition of key financial intermediaries. A comprehensive framework is especially necessary as the weight attributed to different sources of financial instability changes and new sources may appear over time. Banks have continued to broaden their potential sources of income growth, especially in light of declining margins on traditional retail lending. One possible effect of these attempts to diversify income sources might be an increase in the share of non-interest income in banks’ total income, which could in turn reduce cyclical variation in banks’ overall income. This Box examines whether this has occurred for a sample of 140 large euro area banks by looking at the changes over the period 1999-2003. The latest ECB Bank Lending Survey (BLS) of October 2004 shows that the net percentage of banks tightening credit standards to enterprises and households declined further in the third quarter of 2004 (see Chart B10.1). This is the second time since the BLS was started in January 2003 that a net easing in credit standards has been reported, and it continued a downward movement in the net percentage of banks tightening credit standards to enterprises. Among the factors explaining changes in credit standards, competition from other banks and from market financing contributed to the stronger net easing. At the same time, more negative perceptions regarding the industry or firm-specific outlook as well as higher costs related to bank capital positions slightly favoured a tightening in credit standards. Expectations regarding general economic activity remained broadly unchanged. Regarding the terms and conditions of credit, there was a decline in the net percentages of banks tightening credit standards via the size and maturity conditions of the loan as well as via margins on average loans. This box provides an assessment of performances in the euro area area banking sector during 2004 based on information provided in the published accounts of 50 large euro area banks. Historical data for these institutions also serve to complement the analysis in the main text. The 50 institutions were chosen because they represent a significant share of the assets of the domestic banking systems in individual euro area Member States. A broadening of alternative sources of bond finance can contribute to financial stability by enhancing the diversity of financing options available to agents in need of funds. For instance, the coexistence of corporate debt securities markets and bank financing is beneficial to the stability of corporate financing. Likewise, the development of markets for bonds that are tied in some way or another to mortgages – such as covered bonds and mortgage-backed securities – can help banks to match their assets and liabilities more successfully; they can also facilitate a wider dispersion of the interest rate risks that are associated with mortgage lending (see also Box 14 on the distribution and management of prepayment risk in European mortgage markets). Moreover, as liquidity in bond markets improves, issuers benefit from enhanced flexibility. This means that funding needs can be quickly and easily satisfied. This Box highlights some key structural developments that took place in the euro-denominated bond market between 1999 and 2003 and which are relevant for financial stability. A recent study of the euro money markets undertaken by the ECB, based on data for the second quarter of 2003, sheds some light on structural developments in different segments of these markets. This Box reports on the main findings of this study and particularly highlights two important trends that were identified. First, the relative importance of unsecured deposit markets continued to decline, which benefited secured products. This might reflect a growing preference on the part of market participants for limiting credit risk exposures. Second, euro money market derivatives continued to grow in importance. Improving depth and liquidity in these markets can contribute to financial stability by facilitating the transfer and broader dispersion of interest rate risks from those who would rather not bear them to those who are able and willing to do so.