##ies which have provided credit risk protection. if these counterparties were found not to be in a position to sustain the losses, credit risk “ insurance ” might not be available when claims are ultimately made. on the other hand, if the functioning of the credit risk transfer market were impaired, for instance if financial market volatility rose unexpectedly, this could have an adverse impact as banks might not then be able to lay - off their credit risk in the way they have become accustomed which could, in turn, induce greater caution in their lending to lower quality borrowers in particular. iii. 3 euro area corporate and household sectors turning to developments in the euro area corporate sector, over the past six months there have been mounting signs that an adverse turn in the credit cycle seems increasingly likely, driven by factors such as rising leverage ratios, a further tightening of monetary conditions and expectations of a future slowdown in the pace of profit growth. a favourable economic environment together with the persistently low cost of issuing corporate sector debt and greater investor appetite for lower quality credit have created conditions that have been conducive to a surge in global merger and acquisition ( m & a ) activity [ see chart on the left of slide 8 ], and in particular of leveraged buy - outs ( lbos ). such transactions have become an important source of growth in leveraged loans. 1 [ see chart on the right of slide 8 ] the rapid growth in the value of lbo transactions has taken european leveraged loan issuance beyond levels last seen at the height of the telecom boom of the late 1990s. at the same time, the average degree of leverage in these loans – measured by debt - to - ebitda ratios2 – has increased substantially. as a result, the credit quality of different market organizations and lenders define leveraged loans in different ways ; however there are two broad ways to classify loans as leveraged or nonleveraged. the first is based on credit ratings, and the second is based on a loan ’ s initial interest rate spread over libor. the extent to which a credit is leveraged reflects, other things being equal, the leverage ratios of a borrower with higher ratios resulting in higher spreads or lower credit ratings. ebitda stands foe earnings before interest, taxes, depreciation, and amortization. issuing companies has deteriorated. it cannot be excluded that certain features of the leveraged loan markets, such as debtor - friendly re - payment structures and an increasing

related to very low risk premia. it should also be noted that several demand - related factors, such as bond purchases by euro area insurance corporations and pension funds, might have played some role in keeping long - term bond yields at low levels, although it is difficult to quantify the impact with precision. as already noted, the bout of volatility across a broad range of financial markets during may and june 2006 was comfortably absorbed both by markets and institutions. however, to the extent that the “ search for yield ” in a low interest rate environment has led to this “ pricing for perfection ” in other financial markets, long - term rates and risk premia could have been driven too low especially in credit markets and those of emerging market economies [ see chart on the right of slide 4 ]. this means that valuations in these markets could prove vulnerable to several potential unanticipated adverse disturbances including a renewed spike in oil prices, a pick - up in the demand by non - financial firms for external funds should profitability weaken, or a change in global asset allocation. such triggering events could have the potential to bring about possible abrupt increases in bond yields, spreads and risk premia across mature and emerging capital markets. if a triggering event of sufficient severity were to occur, it could bring about an abrupt increase in longterm yields, and credit and equity risk premia across mature capital markets and emerging market economies. this would imply significant asset portfolio losses for banks and other financial institutions. more importantly, it could also raise the counterparty risks some banks face vis - a - vis hedge funds in case it would trigger a cluster of hedge fund failures. as to the second issue for financial markets, credit derivatives markets have been growing at an exponential rate over recent years, not only in terms of size but also in terms of the complexity of products. [ see slide 5 ] the development of these markets is undoubtedly contributing to the efficiency and stability of the financial system by allowing financial intermediaries to measure and manage their credit risks more efficiently and effectively, primarily by buying protection in the credit default swaps ( cds ) market. at the same time, there have been concerns that rapidly increasing credit risk transfer ( crt ) activity may be leading to concentrations of risk among agents who might not be able to bear it in a more challenging environment, particularly in the case of the more complex structured credit products where investors may have been attracted by high short - term returns. in 2003, the banking supervision committee