Bankers are great story tellers.  Perhaps their greatest self-serving story is the one they tell about contagion.  By definition, contagion occurs when one failing bank drags down others.  The mere possibility of this occurring is the financial regulators’ greatest fear.  It is such a great fear, financial regulators are willing to go before Congress and ask to have Wall Street bailed out.

But is contagion possible?  Wouldn’t the designers of our current financial system have thought about contagion and taken steps to prevent it?

To answer these questions, we need to turn to the last person who actually investigated Wall Street’s practices.  Ferdinand Pecora led the investigation into Wall Street that bears his name in the early 1930s.  He wrote about this investigation.  At the end of his book, Wall Street Under Oath, he observed:

It is certainly well that Wall Street now professes repentance. But it would be most unwise, nevertheless, to underestimate the strength of hostile elements. When open mass resistance fails, there is still the opportunity for traps, stratagems, intrigues, undermining-all the resources of guerilla warfare. These laws are no panacea; nor are they self-executing. More than ever, we must maintain our vigilance. If we do not, Wall Street may yet prove to be not unlike that land, of which it has been said that no country is easier to overrun, or harder to subdue.

This comment is amazing.  Based on his experience, Mr. Pecora was absolutely sure Wall Street would not be subdued.  He even pointed out the tools Wall Street would use.

Mr. Pecora didn’t stop there.  He recognized the disclosure laws, specifically the 1933 Securities Act, required vigilance.  These laws are not self-executing.  And the fact they are not self-executing is a flaw Wall Street has managed through guerrilla warfare to exploit.  Wall Street captured the process by which the government sets disclosure requirements.  The result were opaque securities like the subprime mortgage-backed deals that were at the heart of the Great Financial Crisis.  [Please note, the Transparency Label Initiative provides the vigilance Mr. Pecora thought was necessary, but it does so using a label to indicate where there is adequate disclosure to know what you own.]

Mr. Pecora explained why vigilance in enforcing the disclosure laws was necessary:

Had there been full disclosure of what was being done in furtherance of these schemes, they could not long have survived the fierce light of publicity and criticism. Legal chicanery and pitch darkness were the banker’s stoutest allies.

So what do the disclosure laws have to do with contagion?

By design, our financial system has an explicit tradeoff.  In return for the information needed to know what you own, investors assume all responsibility for losses on their investments.

The definition of investors is not limited to individuals.  It includes Wall Street.  Every asset a bank holds is an investment.  The bank is responsible for any and all losses on this investment.

When investors know they are responsible for losses, they limit their exposures to what they can afford to lose.

If banks limit their exposures to other banks to what they can afford to lose, then contagion cannot exist.  As each bank is able to withstand the failure of any other bank.

I can hear the bankers’ rebuttal already.  But what happens when there isn’t the disclosure needed to know what you own [after all, none of the Too Big to Fail banks qualify for a label]?  Can’t banks take on more exposure to each other than they can afford to lose and hence contagion exist?

Fortunately, the designers of our financial system handled the problem of contagion under this circumstance.  They designed a system under which banks like Goldman and JP Morgan need the US, but the US doesn’t need specific banks named Goldman and JP Morgan.

What do I mean by this.  The design of our financial system includes both deposit insurance and a lender of last resort.  The existence of deposit insurance means taxpayers become the silent equity partners for insolvent banks.  A lender of last resort means these insolvent banks have access to funding.  Together, they allow an insolvent bank to continue in business indefinitely.  Together, they allow regulators to take as much time as they need to resolve the insolvent bank.  Most importantly, together they allow the time needed so even insolvent banks can make the necessary disclosure so investors can know what they own.

Of course, part of the bankers’ story about contagion is the false claim the banking system would collapse immediately absent a bailout.  The fact this claim wasn’t challenged reflects the lack of understanding about the design of our financial system.  [In case you doubt I am right about deposit insurance and the lender of last resort, just look at the Savings and Loan Crisis where insolvent firms continued to operate for years before being shutdown.]