What, from the sidelines, we have observed is striking innovation in ways of taking and distributing risk, against a background of strong asset-price performance in recent years and a presently benign macroeconomic environment. Over the past few years and currently, this has, perhaps, been most obvious, and most topical, in the structured finance markets. These are the markets in which portfolios of loans to households and companies – or synthetic versions of such loans created via credit derivatives – are bundled up into, for example, collateralised loan obligations (CLOs) and collateralised debt obligations of asset-backed securities (CDOs of ABS). The slicing and dicing of credit portfolios into different risk tranches can give end-investors access to assets more finely tailored to their particular demands and risk appetites. In most circumstances, that should distribute risk more effectively, buttressing the stability of the market and of the financial system as a whole. Looking ahead, a few questions are nevertheless posed by market participants. One is whether the CDO factory has amplified the compression of credit spreads. The argument advanced goes roughly as follows: that, as credit spreads have fallen, the returns have become unattractive unless leveraged up; that the new technology for acquiring leverage 6 has drawn new sources of capital – including hedge funds – in to the credit markets; and that this increase in demand has fed through to a lower price for credit risk – ie lower spreads, easier convenants, etc – in the underlying loan markets, including for financing LBOs.

Source: IMF  BIS Review 47/2006  9  Chart 7: Contributions to growth in UK non-financial company sterling deposits Other Legal, Accountancy & Other Business Activities T ransp ort, Storage & Communication Wholesale & Retail T rade Real Estate Construction M anufacturing Utilities & Primary Industries T otal  Percentage p oint contributions to change on a y ear ago 12 10 8 6 4 2 0 -2 -4  1998 Source: BoE  1999  2000  2001  2002  2003  2004  2005  Chart 8: Employer pensions contributions Per cent of gross corporate savings 50 40 30 20 10 0 1990  1992  1994  1996  1998  2000  2002  2004  Source: ONS  Chart 9: Employer pensions contributions £ billion, 2005 prices 60 50 40 30 20 10 0 1992  1994  1996  1998  2000  2002  2004  Source: ONS; dat a shown are expressed in 2005 prices using RP I inflat ion  10  BIS Review 47/2006  Chart 10: One-off and regular employer pension contributions  £ billion 35  Regular contributions Special/one-off contributions  30  Total employer contributions  25 20 15 10 5 0  1992  1994  1996  1998  2000  2002  2004  2005  Not e: Covers self-administ ered occupat ional schemes only Source: ONS  Chart 11: UK business investment Per cent of GDP, constant prices  14 12 10 8 6 4 1990  1993  1996  1999  2002  2005  Source: ONS and BoE calculations  BIS Review 47/2006  11  Chart 12: UK business investment recoveries  percentage difference from trough in I/Y ratio 30 25 20  Average of past recoveries  15 10 5  Current  0 -8  -6  -4  -2  0  2  quarters relative to trough  4  6  8  Source: ONS and BoE calculations  Chart 13: Revisions to UK business investment Percentage change on a quarter earlier  Initial Estimates  12  Suse que nt Estimate s  9 6 3 0 -3 -6 -9  Late st Data  -12 1993  1995  1997  1999  2001  2003  2005  Source: ONS  Chart 14: Long-maturity real sterling forward rates Per cent 6 5 4 3 2 1 0 1986  1991  1996  2001  2006  Source: Bloomberg and BoE calculat ions  12  BIS Review 47/2006  Diagram A: Stylised effect on equity returns of a fall in risk premia  One-period ex-post equity returns Time T  Time T+x  Premium falls by Y% each period Preshock steady state returns  Post shock steady state returns  time  BIS Review 47/2006  13