Claire Jones The ECB on the eurozone’s vicious circle

In its financial stability review, out today, the European Central Bank acknowledges that the vicious circle between a sovereign’s finances and the health of its banks has become far more pronounced in recent months.

Ultimately, what became painfully clear in the autumn of this year was that bank and sovereign vulnerabilities are inseparable in several countries. At the aggregate euro area level, partial solutions were no substitute for a comprehensive approach to stem contagion and the interplay between fiscal and banking sector vulnerabilities. These two factors needed to be considered in tandem – as two sides of one and the same coin.

The central bank also warns of another facet to this negative feedback loop: the deterioration in the growth outlook.

This from the review:

The first key risk, arguably the most important, concerns the potential for a further intensification of contagion and the negative feedback between the vulnerability of public finances, the financial sector and economic growth…

…The vulnerability to further contagion remains highest for those countries that are perceived to exhibit a combination of vulnerable fiscal positions, weak macro-financial conditions, and the potential for further significant losses in the banking sector.

One might well ask if the ECB’s championing of fiscal austerity is doing much to dampen the growth outlook.

But it is, of course, not one of the four events that the central bank lists as a trigger for a further intensification of the crisis:

A first trigger could relate to negative news on euro area banks’ profitability and solvency. A second would stem from any further deterioration of the credit ratings of euro area sovereigns and banks, or from the activation of higher margin calls or collateral requirements. A third trigger concerns the potential for any lingering uncertainties about details relating to private sector involvement in respect of Greek sovereign bonds when implementing the decisions taken by the Heads of State or Government. A last trigger relates to implementation risk with respect to the new fiscal compact and the effective size of the EFSF.

The second of the four is particularly interesting and, given that downgrades of France and other eurozone sovereigns are a possibility, rather frightening.

Many had assumed that, because investors and bankers have expected Paris to lose its triple A rating for the past few months, the impact of a downgrade on both the sovereign’s funding costs and those of its banks had already been priced in.

The ECB, it seems, is not so sure.