Lower interest rates have encouraged risk-taking and higher leverage as investors have wanted to secure high rates of return. A case in point is insurance companies, which have to service guaranteed rates of return, and pension funds that have agreed to specific benefits. As the return on risk free bonds has declined, investors have been increasingly led to search for yield and increase the share of risky assets, including credit derivatives, in their portfolios. This contributes to the compression of risk premia. This can continue as long as long-term interest rates stay low. But there is some circularity in the situation. On the one hand, institutional investors are “victims” of low long-term interest rates. On the other hand, they help to maintain this situation as they continue to look for even longer-dated bonds. Therefore, if the pricing of long-term government bonds, which is the reference for the pricing of many other assets, remains distorted, credit risk premia may be based on shaky foundations. Second, risk transfer mechanisms contribute to a certain opacity in the distribution of risks. Most transactions are conducted on OTC markets and are not recorded in a centralised manner: there is therefore a “knowledge gap” in the financial system as regards CRT exposures. More fundamentally, risks are usually transferred by banks, which are regulated and transparent, to entities that are unregulated and are not required to disclose their positions. It is therefore impossible for market participants and regulators to identity the situation of the ultimate risk holders.

Third, the atomisation of risk has been accompanied by higher leverage embedded in the instruments themselves, making it hard to assess which of these countervailing effects prevails. While atomisation of risk mitigates the impact of a shock, leverage amplifies it. For instance, “singletranche” collateralised debt obligations (CDOs) substantially increase “embedded” leverage: a singletranche CDO is generally leveraged 5 to 10 times, meaning that potential losses are 5 to 10 times greater than the losses on the underlying portfolio. This is a type of leverage that does not show up in lending figures. Assessing the extent and effect of embedded leverage on a system-wide basis is therefore a real challenge. Lastly, market liquidity can be very fragile. Indeed, it is now much easier to trade credit exposures thanks to standardised credit derivative indexes. However, liquidity remains very uneven among CRT markets and cannot be guaranteed under stressful market conditions. Many institutions are also vulnerable to “runs”. Market liquidity dry-ups therefore constitute one of the risks to be assessed. 3. What are the implications for central bankers and supervisors? I would like to suggest three approaches: First, remind market participants and investors that benign times, such as the current credit environment, should not be the benchmark for assessing risks. Credit risk transfer markets remain untested in stress situations. The US subprime mortgage market is a bellwether reminding us that excesses in credit growth and relaxation of lending standards are paid for sooner or later by much higher risk premia.