When a group of investors led by Australia's Macquarie Bank sought to raise €1.5 billion to fund a buy-out of Yellow Brick Road, a European telephone directories publisher, many financiers gulped. The planned total debt was 8.4 times the group's gross annual earnings - a record ratio of leverage for this type of deal, both in Europe and the US.

But when debt syndication closed last Friday, bankers had further reason to gasp. Investors had flocked to the deal, allowing part of the finance to be raised far more cheaply than expected.

The tale illustrates a much wider phenomenon: an extraordinary volume of money is swirling around Europe's financial system awaiting a sufficiently rewarding home.

Why are banks, hedge funds and other financial players in Europe awash with funds and what are the consequences of this state of affairs?

The pattern is global but it is arguably made starker in Europe because - unlike the US Federal Reserve - the European Central Bank is not raising interest rates (and the Bank of England has just cut them). Europe's sluggish economy is meanwhile creating little mainstream demand for loans - forcing banks and other financial players to seek other outlets for surplus cash that can produce reasonable returns.

This makes some policymakers uneasy. The ECB, for example, has repeatedly warned that excess liquidity could hold longer-term dangers for the region's economy, by creating a destabilising boom in inflation and asset prices - and a subsequent bust.

There is still little evidence of bubbles forming - at least not in areas of the economy usually associated with financial excess. However, while investment-grade companies are exhibiting debt restraint, riskier borrowers - particularly in the private equity world - are more than compensating for this by taking on higher and higher levels of debt.

Though this has recently fuelled a boom in buy-out activity in Europe, it also risks sowing the seeds for future problems - particularly if financing costs head upward.

Data currently emanating from that sector are startling. In recent years, US buy-out specialists have crossed the Atlantic on a striking scale. In 1998, total private equity activity in Europe was just $32 billion (€26.3 billion); deals announced so far this year have totalled $123 billion, according to Dealogic, the research group.

The factor that has recently given the sector the greatest boost is the ease of raising finance.

Another - arguably just as important - factor is the changing structure of European debt markets. A decade ago, the European leveraged loan sector barely existed, but it has sharply expanded in recent years, largely centred around private equity, adding more liquidity to the pot. This has made it possible for buy-out groups to chase ever-larger deals.

It has also allowed private equity firms to refinance themselves repeatedly, to take advantage of falling funding costs. Fitch, the ratings agency, calculates that a record €63 billion of leverage finance was raised in the first half of this year, of which €25 billion was devoted to leveraged buy-outs - and nearly half of that was used simply to let private equity firms pay dividends to their investors.

This benefits the private equity groups, since their managements can pay their own shareholders back fast while keeping control of the companies in which they have invested. "Money is coming out of these deals - and coming out very early, often in less than a year," says Fitch analyst Rachel Hardee.

Extracting cash can saddle deals with more debt and higher levels of leverage. That means the investors who are financing these deals, via bonds or loans, are being exposed to more risk.

Little evidence is so far on hand to suggest that banks, hedge funds or other investors are getting cold feet.Most bankers insist, in public anyway, that the picture can last. The default rate for companies is very low and there is little expectation that liquidity is about to dry up.

The money markets are not projecting an imminent ECB rate rise and developments in Asia could push even more finance into Europe soon.

Nevertheless, as the levels of leverage become more extreme, some industry players are becoming uneasy. "Operating risk must be tied closely to the financial risk. But the two are divorcing," warns Mr O'Grady of 3i. "Some [ investors] will get caught with egg on their face."

There is no sign yet of such a funding shock occurring. And some policymakers argue that, even if it did hit the sector, its impact on the broader economy would be limited.

However, history suggests that when credit bubbles emerge, these rarely deflate smoothly - or without creating unexpected casualties.