European Central Bank - Hazardous Contagion & Adverse Feedback Loops

The ECB has issued a report which warns on contagion, the interdependencies when bailing out the financial institutions with public funds one doesn't have. The full report is here (large pdf).

Outside the financial system, the progressive intensification of market concerns about sovereign credit risk among the industrialised economies in the early months of 2010 opened up a number of hazardous contagion channels and adverse feedback loops between financial systems and public finances, in particular in the euro area. By early May, adverse market dynamics had taken hold across a range of asset markets in an environment of diminishing market liquidity. As a result, the prices of some securities tended to become detached from underlying fundamentals, and banks’ long-term funding costs were pushed to levels not seen since the time of the failure of Lehman Brothers. Apart from the pass-through of higher sovereign funding costs, this appeared to reflect growing concerns about the possibility of mark-to-market losses on banks’ government bond portfolios. Towards the end of the first week of May, the situation deteriorated very abruptly and extensively. On 7 May, the cost of insuring against credit losses on European banks soared to record levels, surpassing the heights reached after the collapse of Lehman Brothers in 2008.

They also warn on more write-offs, peaking in 2010, but also 2011 for €195 billion.

The main reason for the severe deterioration of public finances was the activation of automatic stabilisers – that is the loss of tax revenue and higher government expenditure outlays that ordinarily results from weaker economic
activity – as a consequence of the marked contraction of economic activity that followed the collapse of Lehman Brothers. Because the structural fiscal imbalances of a number of euroarea countries were sizeable before the financial crisis erupted, fiscal deficits in those countries expanded to very high levels. Added to this
were the discretionary fiscal measures taken by many countries to stimulate their economies following the agreement in December 2008 of the European Economic Recovery Plan.

The tally for write downs from 2007 to 2010 is €515 billion.

Ireland's FinFacts has a pretty good summary write up of the report.

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