authorities in this area and the need for strengthened governance structures. financial contagion and public policy since the writings of walter bagehot financial contagion has become an issue that is discussed widely in policy, market and academic research circles. 2 taking a broad w. bagehot ( 1873 ), lombard street – a description of the money market, pp. 129ff. emphases by the speaker. see, for example, the following surveys on the issue : g. kaufman ( 1994 ), “ bank contagion : a review of the theory and evidence ”, journal of financial services research, 7 ; e. p. davis ( 1995 ), debt, financial fragility and systemic risk, clarendon press, 2nd ed. ; o. de bandt and p. hartmann ( 2000 ), “ systemic risk : a survey ”, ecb working paper, no. 35, november ; s. claessens and k. forbes ( eds., 2001 ), international financial contagion, kluwer academic publishers ; ecb ( 2005 ), “ financial market contagion ”, financial stability review, december ; ecb ( 2009 ), “ the concept of systemic risk ”, financial stability review, bis central bankers ’ speeches perspective embracing different views and studies, contagion could be defined as a situation in which instability in a specific financial market, institution or country is transmitted to one or several other markets, institutions or countries. a first characteristic of contagion is that the spread of instability would usually not happen without an initial trigger event – which often appears to be a relatively contained event. a second characteristic is that the transmission of instability is in some way abnormal, for example, in terms of its speed, strength or scope. though spillovers are to be expected in an interconnected financial system, contagion is distinct in that it often reflects a market failure and a dangerously amplified transmission of instability. the underlying market failure consists of the fact that contagion often involves externalities. 3 as a result, the private costs of the initial financial market failure, that is the costs to the actor triggering contagion, are lower than the social costs. in the specific case of the sovereign debt crisis in europe, the trigger could, for example, be that a country in a precarious fiscal situation does not seriously implement the necessary fiscal consolidation measures. this could lead interest rates on this particular country ’ s government debt to rise

jose manuel gonzalez - paramo : sovereign contagion in europe speech by mr jose manuel gonzalez - paramo, member of the executive board of the european central bank, at the distinguished speaker seminar of the european economics and financial centre, london, 25 november 2011. * * * ladies and gentlemen, it is a great pleasure to speak to you here in london and discuss some key issues relating to the ongoing crisis in europe. for centuries the city of london has held its position as a leading international financial centre. few other places in the world exhibit such a high density of expertise in financial matters. at the same time, where financial activity tends to be concentrated experiences with financial contagion during crises are often also pronounced. let me cite a few excerpts from walter bagehot ’ s “ lombard street ” : 1 “ mercantile bills are an exceedingly difficult kind of security to understand … in years like 1871 many active men make so much money at the end of the year they are worthy of altogether greater credit than anyone would have dreamed of …. on the other hand, in years like 1866 a contagious ruin destroys the trustworthiness of very many firms … persons who buy and sell again soon are often liable for amounts altogether much greater than their own capital ; and the power of obtaining those sums depends upon their “ respectability, ” their “ standing, ” and their “ credit, ” … and more simply upon the opinion which those who deal with them have formed of them. ” whilst not directly applicable to the present times and taken out of the historical context of the financial panic around the failure of overend, gurney and co. in 1866, there are still a number of thought - provoking passages that sound so familiar in comparison with what we have been experiencing over the past four years of financial crisis. this is not only the case because the offices of overend in lombard street were only a few miles away from where we are meeting today. so, let me dedicate my speech to the issue of contagion, and more specifically to the experiences with sovereign contagion during the european debt crisis and the related policy responses. i would like to start out by discussing why contagion needs to be addressed by policy and how. next, i shall review recent evidence of contagion phenomena across european sovereigns. the third part of my speech will deal with how the european central bank has responded to these developments ; and the fourth part with the ultimate key responsibilities pertaining to domestic fiscal