In this loop, we describe what has been termed a liquidity spiral, where an initially liquid bank’s concern about the solvency of its counterparty (or solvencies of its counterparty’s counterparties) or perhaps concern that itself may run into funding difficulty in the future, decided to forgo interbank interests and began to hoard liquidity. When enough institutions embarked on the  BIS Review 130/2009  3  same actions, a general freeze in liquidity ensued, leading to “unnecessary” defaults that further exacerbated doubts in the system. These examples of positive feedback loops were some of the interactions that took place in the amplification stage of the crisis, as market participants responded to specific problems and general distress. But while the feedbacks were important in themselves in setting off deleveraging and losses, it was also the interactions between these feedbacks that contributed hugely to intensifying the problem and multiplied the losses into a larger systemic problem. What we saw was the rapidly worsening crisis that spread beyond financial institutions into money and capital markets. On this aspect of loss intensification, a number of studies have pointed to joint exposures to common risk drivers and network linkages between financial institutions to be the two key propagation channels. Let me elaborate further on this point. First, propagation channel in the form of joint exposures to common risk drivers means that different financial institutions are becoming not so different. In other words, their investment strategies and methods for minimising regulatory capital were beginning to copy one another.

As a result, the whole class of asset backed commercial papers (ABCP) suddenly appeared risky to investors. Next, as the special investment vehicles (SIV), which essentially were virtual bank that financed mortgage/long-term lending by issuing ABCP, could no longer fund themselves as no new ABCP could be sold, the banks, who were the SIV sponsors, had to come to rescue for the fear that the reputation risk could harm their access to the interbank market. The rescue, as we know, led to large balance-sheet losses. Example C is the loss spiral linked to mark-to-market accounting and asset fire sales. In this feedback loop, we describe what has been termed a loss spiral, whereby some financial institutions, on suffering marked-to-market losses to their asset portfolios, were forced to conduct “fire sales” of assets. Maybe the fire sales were necessiated by an increasingly difficult funding environment, or by the need to comply with internal risk management limits and/or capital ratios, or because the original positions were so highly geared that a small percentage of loss triggered large asset sales merely to keep the leverage ratio constant. 2  BIS Review 130/2009  Whatever the main reason, the fire sales affected everybody. Other financial institutions with the same or highly correlated assets suddenly found themselves facing heavy losses from wholesale declines in asset values. They, in turn, for the same reasons, had to conduct their own “fire sales”, further depressing asset prices. Lastly, example D is the case of a positive feedback loop linked to liquidity.