Sunday, June 26, 2011

The Treatment for Financial Contagion is Disclosure

The Economist magazine ran an interesting article on the Greek debt situation and contagion.  It supports this blog's conclusion that the only sure cure for financial contagion is disclosure.
CONTAGIOUS diseases are usually dealt with by isolating the patient, lest he infect anyone else, and then by trying to treat the illness. Isolation is not always possible with physical ailments; with financial ills, it almost never is.
Actually, the equivalent of isolation can be achieved if there is disclosure of all useful, relevant information in an appropriate, timely manner.

Under the FDR Framework, investors know that under the principle of caveat emptor (buyer beware) they are the beneficiaries of any gains and the bearer of any losses.  As a result, investors have an incentive to use disclosure to adjust their exposure to financial risk.  It is the adjustment of their exposure that creates the financial equivalent of isolation.
With the Greek government perilously close to default, investors and policymakers are wondering whether European banks have caught something nasty. Many are comparing the choices facing the euro zone and the IMF to those faced by the American Treasury and the Federal Reserve in the days before Lehman Brothers collapsed in 2008, causing a seizure in the global financial system. 
The comparison is not exact. The Greek government owes more than €300 billion ($435 billion); Lehman’s balance-sheet before its failure was $613 billion. The chief difference, though, lies in complexity rather than in scale. Wall Street’s fourth-largest investment bank was at the centre of tens of thousands of interconnected trades that were hidden from view and difficult to value. Its fall caused panic because others in the markets had no way of knowing who the counterparties to its trades were and whether Lehman owed them so much that they too might fail.  
That ought not to be true of Greece. It has far fewer creditors: two-thirds of its debt is probably held by about 30 institutions. And whereas Lehman’s exposures were hidden from public view, Greece’s are largely out in the open and are also reasonably easy to value. The more light has been shone into the dark vaults of banks holding Greek government debt over the past year, the more markets have been reassured that few, if any, foreign banks are dangerously exposed.
The chief difference lies in disclosure and not complexity.  Lehman's exposures were hidden from public view and therefore no one knew who was solvent and who was insolvent.

There is much more information available about the exposure to Greek government debt.  However, regulators and the markets still do not know where the real exposure to losses on Greek debt lies.  David Cameron and Mervyn King have said that banks should be required to publicly disclose their exposure, including their hedges.
... Holdings of bonds do not tell the full story of banks’ exposure to Greek government debt. By buying credit-default swaps (CDSs), which are essentially insurance policies against a default, banks are likely to have shifted some risk to insurers or investment funds that are less important to the financial system as a whole. Some banks, however, will have sold CDSs. 
Across the entire financial system these CDS exposures largely net off, Barclays reckons, and collateral and margin-calls should have reduced the outstanding exposures to relatively small amounts. However, not everyone will end up with a net position close to zero. It is reasonable to suppose that there would be some large losses (and some large gains) on CDS contracts if Greece stopped paying its bills. Quite where these would emerge is causing some worry in markets. 
Bank regulators have made progress in publishing information on exposures. Banks themselves have been giving quarterly or half-yearly updates on their ownership of Greek bonds. But weaker banks have been the most reluctant to come clean: public data on their holdings are a year out of date. Were panic to seize the banking system, regulators could do much to restore calm by releasing information they have collected in the past three months as part of “stress tests” of Europe’s banks. 
The Economist recognizes two themes that this blog has been discussing under the FDR Framework.

First, disclosure stabilizes the financial markets.  With disclosure, market participants can adjust their exposures based on facts.  Without disclosure, market participants adjust their exposure based on fear.

Second, the regulators' monopoly on the useful, relevant information is a source of financial market instability.  If they did not have a monopoly on this information, then they would have nothing to release that would calm the markets.
... The hard numbers alone thus suggest that a Greek default would do little lasting harm to the rest of Europe’s financial system. Yet investors act on fear as well as figures. 
What is more worrying for Europe’s policymakers is the thought that Greece’s affliction would spread not just to foreign banks but to foreign governments. Just as Lehman’s collapse told investors that a Wall Street bank could fail, a Greek default would tell them that a Western government could renege on its debts: Greece would be the first developed country to default for 60 years. 
This is why disclosure should not be limited.  The only way to understand the impact of restructuring the debt of Ireland, Portugal, Spain and maybe Italy is to know what the exposures are and to what extent the losses have already been recognized in the financial system.
... Another cause for unease is European banks’ reliance on short-term wholesale financing from outside the continent. Fitch, a ratings agency, reckons that roughly half the cash entrusted to big American money-market funds is lent on to European banks. This is skittish money that can be gone in a trice. 
Banks in vulnerable countries have already found money-market funding harder to come by, or at least dearer.
This is the modern day run on the bank.  When the portfolio managers of money-market funds do not know if a bank is solvent or not, they reduce their exposure as they are not compensated for taking solvency risk.
Worse than jitters in the money markets would be a loss of faith by depositors. The Bank of Greece thinks that in the first four months of the year Greek banks lost deposits at the rate of €2.8 billion a month. 
Greece is encountering the same run on the bank deposits that the Irish banking system is experiencing. Depositors do not know if a) the bank is solvent or b) the government has the resources to support any guarantees of their deposits.  Faced with this situation, depositors have an incentive to withdraw their money and try to find a safer place to put it.

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