The outlook for financial stability had deteriorated, particularly in light of heightened uncertainty about how, and when, euro-area risks would be resolved. Official policy measures, including the ECB’s longer-term refinancing operations (LTRO), had led to improved bank funding conditions and reduced market volatility in 2012 Q1. But underlying concerns about sovereign indebtedness, banking sector resilience and imbalances across the euro area had persisted and the improvement in sentiment had proved temporary. For example, spreads on Spanish sovereign debt relative to German bunds had increased to historically high levels and bond yields of several other euro-area governments remained elevated and volatile.Nothing we don't already know, but a good overview of the last 6 months. At the end of the last year, the ECB opened up a massive credit facility. This stabilized the financial markets for some time, as it gave market participants hope that a "floor" of sorts was being set under the market. However, the overall financial situation in the EU region continued to deteriorate, largely because more countries (Italy and Spain) saw their respective bond yields increase to unsustainable levels.
Market strains had re-emerged reflecting rising financial distress and political tension in the euro area, particularly regarding Greece and concerns that the country might require further debt restructuring and/or leave the euro area. A number of developments had reinforced perceptions of strong links between the creditworthiness of European sovereigns and euro-area banks, such as the efforts of the Spanish authorities to recapitalise the Spanish banking sector. Increasing concerns about sovereign balance sheets had manifested themselves in a sustained redistribution of international capital, with growing evidence of capital flight from some euro-area banks and capital markets and a reluctance byinvestors to hold some euro-area assets.
The Committee noted that major UK banks’ exposures to the most vulnerable euro-area economies’ sovereigns and banks were not high, totalling 6% and 14% of core Tier 1 capital respectively. But UK banks had significantly larger exposures to private sector borrowers in many of these countries. And, although some banks had made sizeable provisions, the risk of further significant losses persisted while the macroeconomic backdrop remained adverse. BanksI believe this is the real concern many central bankers have: another large and wide-spread credit event which would essentially freeze the financial intermediary system of the region. This would almost always lead to a recession, as credit would essentially dry up. However, considering the precarious nature of the overall economic situation right now, such a development would be disastrous.
in other EU countries were also exposed to vulnerable euro-area countries, leading to the potential for indirect losses for UK banks. If contagion were to spread, there would likely be significant disruption through secondary channels, such as increased counterparty risk and stresses in funding markets, with adverse feedbacks to the macroeconomy
These concerns prevailed against a backdrop of deteriorating global growth prospects. In particular, some larger emerging economies had experienced rapid credit growth and there were signs of overvaluation in some Asian property markets. A disorderly unwinding of asset prices could result in direct losses on UK-owned banks’ exposures to the region, which for some banks were significant
This is really proverbial icing on the cake of the problem. Over the last six months, we're seen a continued deterioration in the growth prospects of several regions of the world. A world wide credit event -- on top of an economic slowdown -- would lead to a very bad situation.
The above paragraphs highlight the overall macroeconomic environment very well, and clearly explain the overall problems faced by all policy makers.