A particularly relevant source of systemic risk was the build-up of widespread financial imbalances – the second form of systemic risk I described – in the period of 2003 to 2007. The years prior to 2007 were characterised by low financial market volatility and risk premia, rapid financial innovation in credit markets, low interest rates across the maturity spectrum and ample liquidity conditions.
In particular, rapid financial innovation led to securitisation techniques with thus far unknown complexities and to long and uncontrollable chains of intermediaries between originators and final investors. Ratings agencies gained global power as the pricing of securitisation tranches was largely based on their assessment, while leverage mounted ever higher and a shadow banking system developed up largely unregulated.