Contagion: A Wall Street term to remind regulators that they do not know what is going on

The Independent ran an interesting column discussing the fact that no simple deal can save Greece.  What made the column interesting is its explanation for why Greece had to be saved.

Contagion.

As described by Wall Street, contagion occurs when banks are required to recognize losses.  Once banks are forced to recognize their losses, there is a risk of a loss of confidence in these banks and that, like a disease, this loss of confidence will spread to other presumably healthy banks.

In short, contagion is Wall Street's term for reminding regulators that they do not know what is going on in the banking system.

Previously, this blog described the immunization against contagion.  This immunization was implementation of the FDR Framework.

Under the FDR Framework, governments ensure that market participants have access to all the useful, relevant information they need to make a fully informed decision.  Market participants, since they are responsible for all gains and losses under the principle of caveat emptor, have an incentive to use this data to assess the risk of any exposure.

It is the principle of caveat emptor that immunizes against contagion.  Since each market participant is responsible for the gains and losses on their exposures, they have an incentive not to take on any exposure that is bigger than they can afford to lose.

For banks who have to disclose their current detailed asset and liability information, market discipline acts to enforce adherence to not taking on any exposures greater then they can afford to lose.  Each bank has an incentive to limit its exposures to other banks to only those banks that limit their exposure to what they can afford to lose.

THE eurozone debt crisis rumbles on. To be more accurate the current impasse is the Greek debt crisis but the key issue is what impact the Greek default will have on the rest of the eurozone. 

Greece is going to default. What is needed is not another part-attempt at a resolution of the problem but a realisation that the Greek government cannot repay it’s debts....

The problem the ongoing EU summits are trying to address is to minimise the fallout when it is finally accepted that Greece cannot pay backs its creditors.... 

It is now accepted that Greece will also require at least a 60pc write down on its government debt. It is estimated that the losses that will be imposed on other European banks will be as high as €100bn. 

The sticking point in the current EU negotiations is where are the banks going to get the money to cover these losses .... The funds will have to be provided to cover the losses as many of these banks are retail banks that have huge connections with the real economy. These banks have billions on deposit from savers and also owe substantial sums to their own bondholders.

While it is reasonable to expect that depositors will have their money protected, the mantra of the crisis over the past few years has been that “bank bondholders will not be burned”.  If this is to be maintained public money will once again have to be used to cover for losses in banks. 

This policy has been adopted to try to avoid contagion and a loss of confidence in the European banking system. This policy has failed. No one has confidence in the European banking system, least of all the banks themselves. 

Why should they as no one has any idea of each banks exposure to the other banks or to sovereign debt?  As this blog has repeatedly said, the only way to restore confidence is through disclosure, specifically by making each bank disclose its current detailed assets and liabilities.

Usually, there are hundreds of billions of overnight deposits moving from bank to bank as banks seek and use liquidity. In recent weeks banks have been less and less willing to deposit money with each other.

Banks are now more willing to place excess liquidity on deposit with the ECB at very low rates, rather than earn a better return by lending the money to other banks. There have been occasions where the ECB has received nearly €250 billion of overnight deposits. This is the money that should be providing liquidity to the European banking system but doubts about the strength of all banks to handle the Greek default have meant that the money is warehoused in the ECB. 

EU leaders have to banish these doubts. At least now there is a realisation of the scale of the problem and the proposals on the table are based on realistic losses from the Greek default. 

Markets are likely to be indifferent between each solution but just want to see that something will be done.

This is an important point and needs to be re-read.

Markets are looking for a process that leads to resolution of the solvency problem at both the sovereign debt and bank level.  That is what has been proposed under the FDR Framework blueprint for saving the financial system.

Markets are not looking for a solution that just purchases a one to two year reprieve.