DEBT VULNERABILITY PRIOR TO THE GREAT RECESSION

DEBT VULNERABILITY PRIOR TO THE GREAT RECESSION 

While remaining broadly stable between 2001 and 2004, corporate sector indebtedness rose markedly in the euro area and in many advanced economies in the years preceding the financial crisis, as documented . Such debt accumulation was primarily in the form of bank credit, while debt issuance remained broadly stable. As is often the case, such a build-up of bank credit was preceded by, or went together with, a process of financial innovation in the banking industry.This process was characterised by a rapid expansion of securitisation and increasing reliance on market-based funding, which allowed banks to offload risk and increase their leverage.

 At the same time, the heterogeneous pattern across euro area countries suggests that country-specific developments did play an important role in fuelling credit expansion and, hence, led to excessive debt levels. These excessive debt levels are illustrated in Chart for the year 2008 by means of three alternative indicators: the deviation from the historical average, from the euro area median, and from the long-term trend, as estimated by applying the Hodrick-Prescott filter. 

As noted above, theoretical insights and narrative evidence on fi nancial crises characterise the expansionary phases preceding periods of financial instability as times of subdued uncertainty and low pricing of risk, in which there is a certain euphoria with regard to real and fi nancial asset prices, and over-optimism with regard to income and wealth prospects, which again fuels the provision of credit and investment. Some of these aspects appear to be confi rmed by evidence from the latest euro area fi nancial crisis. 

In the years leading up to the crisis, volatility in financial markets was particularly subdued both domestically and internationally, by historical standards . The euro area implied stock and bond market volatilities plateaued at a low level between the end of 2004 and the beginning of 2007, before following a fl uctuating upward trend thereafter. Similarly, in the United States, the implied stock market volatility declined from mid-2002 to a historic low at the beginning of 2005, and remained broadly constant until the bubble burst. 


US implied bond market volatility lagged stock market volatility. Such subdued fi nancial market volatility was accompanied by low-cost debt issuance for the euro area corporate sector; between 2005 and the second quarter of 2007, euro area corporate bond spreads remained, on average, at around basis points. This was substantially below the average of 100 basis points recorded between 2001 and 2004, and below the level prevailing during the fi nancial crisis