source of funding on a large scale. more traditional and stable sources of funding, such as retail deposits, declined in importance ( chart 1 ). in addition, many banks saw opportunities to generate new sources of revenue and fee income by developing and deepening their activities in international capital markets. innovation has provided banks with greater opportunities to hedge and diversify risks. for example, a regionally - based bank in country a can easily lower its geographical concentration, for example by selling credit risk to other investors who had not previously been able to access such exposures, and / or by purchasing exposure to credit risk elsewhere. the resulting dispersal of risk allows banks to diversify their risk profile as well as their sources of revenue. providing that the gain from diversification outweighs the increased cost of credit assessment, as banks take on exposure to entities where they have no banking relationship, and that risks are priced fully and appropriately, such innovation should improve market efficiency and lower the cost of intermediation and of capital. these changes in the financial environment, however, resulted in banks increasing their exposure to liquidity risk. banks originated large volumes of long - term loans in the expectation that they could be quickly and readily sold on, but leaving them with additional funding risks if they could not. contingent liquidity lines to securitisation conduits and special purpose vehicles rose rapidly with little expectation that they would be drawn. exposures to higher yielding complex structured products rose, with market participants failing to recognise sufficiently that the high yields offered by such products were in part compensation for higher liquidity and market risk and that prospective risk - adjusted returns were much lower than might first appear from their short historic track record. moreover, in buoyant market conditions, the compensation for liquidity risk itself was bid down to negligible levels by early 2007 ( chart 2 ). by that stage, many market participants recognised that compensation for risk - taking was too low, but judged that the business risks of exiting lines outweighed the financial risks of continuing to write new business. 1 firms became over - confident in their ability to hedge or exit positions if conditions changed, failing to recognise that many participants would be attempting to do the same and that market liquidity would then evaporate. indeed, given a change in sentiment, the increased integration of financial markets transmits risks just as much as it disperses them. see bank of england financial stability reports july 2006 and april 2007. banks ’ funding thus became increasingly vulnerable to

high growth rates relative to that of economic activity as a whole. in corporate finance, the fund - raising environment has not changed significantly, that is, the environment for firms, particularly with high credit risks, remains severe, although the issuing environment of corporate bonds and cp continues to be favorable on the whole, especially for firms with low credit risks. developments in the financial and capital markets, the 2 / 3 behavior of financial institutions, and the situation of corporate finance continue to require close monitoring. 3 / 3