The financial system is strong enough to weather the dramatic recent sell-off in government bonds and the resulting increase in the cost of corporate borrowing, the European Central Bank (ECB) signalled on Friday.

But the ECB used its latest financial stability review to warn of the “increasing vulnerability” of the financial system to an “abrupt” loss of the liquidity on which private equity and hedge funds in particular have thrived.

Despite higher bond yields upping the chances of companies hitting financial constraints, ECB vice-president Lucas Papademos said he “would not derive any unfavourable conclusions regarding financial stability”.

Government bond yields, benchmarks for the cost of corporate borrowing, surged this week as investors priced in central bank rate rises in Europe and a steady rate in the US following indications of solid economic growth.

Mr Papademos said there was “no evidence” that the bond-market sell-off had been triggered by fears of inflation. It reflected a positive shift in perception about the US economy and “the likelihood of the path of interest rates.”

The ECB was less sanguine about the abundance of capital that, it said, has made financial markets “very liquid” since 2004. That was probably due to new instruments such as credit derivatives but also “excessive risk appetite.”

It warned that markets allowing creditors to sell their credit-risk might have seen some institutions become “overly reliant” on such transactions, many of which seemed to be “based on very favourable [economic] expectations”.

Should investors suddenly become more risk averse – as a result of a big corporate bankruptcy or an oil-price shock – a sharp drain of liquidity could put highly leveraged institutions such as hedge funds in difficulty.

This could force funds to stop buying banks’ credit risks on the credit-derivatives market, affecting the ability of these institutions to lend to companies and families – what the ECB calls “the triangle of vulnerability”.

While there was only a “low probability” of problems that could trigger such a systemic crisis, the ECB vice-president said risks had risen since the bank last issued a report on financial stability in late 2006.

Potential problems “might have a high impact if they occur”, Mr Papademos said. There was thus “no room for complacency” on the part of financial players.

The Group of Eight most industrialised nations has called on hedge funds to be more transparent. Mr Papademos said this would help enforce indirect regulation through the “market discipline” of other players.

The ECB said “adverse disturbances” endured by the markets, most recently the market-turmoil of February and early March, had shown the global financial system to be comfortingly resilient to harder knocks.

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