European Commission cites risk of financial contagion to defend not restructuring Greece debt earlier

The Guardian reports that the European Commission is defending its failure to restructure the Greek (Irish, Portuguese, Spanish, ...) debt at the outset of the financial crisis citing the risk of financial contagion.

And what is financial contagion?

In theory, financial contagion is a domino effect through the banking system where the failure of one banks triggers the failure of other banks.

But does financial contagion exist in our global modern banking system?

No.  Banks have the capacity to absorb significant losses as they are designed to be able to operate with low or even negative book capital levels and still support the real economy.

Banks are able to do this because of the combination of deposit insurance and access to central bank funds.  With deposit insurance, taxpayers effectively become the banks' silent equity partner when they have low or negative book capital levels.

But don't banks need to be recapitalized immediately after they have absorbed the losses on the excess public and private debt?

No.  Again, the taxpayers are effectively backstopping the banks, so it is as if the banks had unlimited equity.  As a result, the banks can rebuild their book capital levels over several years by retaining 100% of pre-banker bonus earnings.

But won't depositors get nervous if the banks have low or negative book capital levels?

No.  There are two types of core depositors.

One type holds deposits that are below the deposit guarantee level and they trust that the government will honor its guarantee.

The second type of depositors is a business that has a reason, like making payroll, for holding deposits with the banks.  They too are insensitive to how much capital the bank has unless policymakers and financial regulators plan on seizing these excess deposit a la Cyprus to bail-in and recapitalize the bank.

So why are policymakers citing the risk of financial contagion to defend themselves against not restructuring excess public and private debt sooner?

Because policymakers were following the advice of the bankers advising them.  As shown by the European Commission, it was easy to succumbed to the irresistible temptation to push the losses onto the taxpayers and "protect" the banks.

In reality, all putting the losses on the taxpayer did was to protect the bankers' bonuses and shift who suffered as a result of the losses from the banks to the taxpayers.

The IMF criticism and the commission's defence of its performance boil down to a dispute over whether Greece's staggering debt level should have been restructured early in 2010 when the troika was fixing the terms for the bailout. 

While the IMF takes the view now that it was a cardinal error not to restructure, the commission argues strongly that there were too many unknowns, the risks were huge, such a move could have unleashed a rollercoaster of panic across the eurozone, and there was not yet any real eurozone firewall or bailout funds in place.

Actually, all the necessary firewalls have been in place for decades.

It would have been armageddon for banker bonuses, but this seems like a reasonable outcome given that the bankers were the ones who took on the risk in the first place.

"Even assuming it was inevitable and the only solution, the risks associated with an early Greek debt restructuring were huge," according to the commission. 

The European Commission is confirming that it knew what the only solution to end the financial crisis was (adopt the Swedish Model and require the banks to recognize the losses upfront) and that it instead chose to protect bank balance sheet and banker bonuses at all costs (the Japanese Model).

"The whirlpool in the financial markets in early 2010 was only beginning to subside, the banking system was extremely fragile and it was not possible to estimate financial and psychological effects of the largest bond restructuring in history or its potential ripples to the real economy of the euro area. Against this background, later restructuring allowed for time to build firewall capacity. An earlier restructuring would have also entailed risks of systemic contagion."

By 2010, governments around the world had put the financial system on life support.  Recognizing the losses that everyone knew were on the bank balance sheets would not have triggered panic.  In fact, it would have triggered relief.

Later restructuring allowed the banks time to offload their losses onto the taxpayers while the bankers continued to pocket their bonuses.  Not a good outcome for the taxpayers.