In other words, these policies were excessively short-term and did not fully account for the knock-on effects (or negative externalities) on each other. The years prior to 2007 were characterised by low financial market volatility and risk premia across market segments and low yields across the maturity spectrum. In this environment, banks and other investors engaged in a “search for yield” spurring financial innovation.
The pace of financial innovation exceeded the supervisors’ and market participants’ capacity to solve a number of valuation, risk management and incentive issues. The result was a highly opaque system of credit risk distribution. The low-yield environment therefore played a key role in the accumulation of fragilities that led to the crisis.