Reading today once again about ECB's oposition to any kind of Greek deault in FT, one analogy from Lorenzo Smaghi strucked me - the one to Lehman Brothers and fairytale-like illusion that something like orderly default could exist. From my point of view we are having the pre-Lehman script replayed, but I take from it different conclusion. Ex-post, Fed was critized that in the period between Bear and Lehman it did not push banks toward recapitalizing. This, combined with the view that there will be another Bear-like solution, meant that neither Lehman acted to safe itself, nor the market participants were not prepared for something like this.
The theory of banking panics developed in past three decades tells us, that the problem is asymmetry of information. From this point of view the unknown amount and location of exposures to Lehman's demise were the key driver for the banking run in shadow banking sector (i.e. run on repo, CP etc.). If we compare it to our situation in Europe, we have the advantage of the fact, that we saved Greece once so we can decide when and if its going to fail. Therefore, before any such event would happen, we could device a recapitalization program undertaken by US governemnt under the auspicies of TARP. Thus in the event of default, market participants would know where the losses are located (due to stress tests, which would need to be published in their detail - I am not so sure how this is possible from legal point) and would also be assured that governments stand behind the weakest banks, or even better that governemnt already provided capital to this banks. Therefore there would be very little scope for market participants to go into havoc as in the post Lehman period, when neither the location of losses, nor the safety of institutions, could be taken for granted. The only risk of course would come from the possibility that markets would not trust assesment of the banks by governments.
This approach leaves out the biggest problem, and I think that all the talk about impossibility of organized default from ECB is result of this: the question of Greek banks. The default of Greek governemnt would mean that they are bancrupt, no doubt. In that event, ECB would either have to pull the plug on them, as it threatens, or greatly compromise its credibility by accepting the Greek bonds as collateral even after a rating event. And no doubt that they want to avoid this second possibility at any cost. However, there could be also another solution - that Greek banks' liabilities would be slashed. This would necessary include hit on ECB (which is provides great amount of funds to them), any remaining senior creditors, but crucially also depositors, depending on the size of losses from default of Greek government. With this a recapitalization would be possible.
Final possibility is that I am wrong, and the situation is much worse. Maybe ECB knows something more, maybe the losses from Greek default would be greatly concentrated, in a such way, that recapitaliztion of these institutions would be very, very costly creating further problems for ECB in terms of short term financing of these institutions. But the default of Greece would also have one very important advantege, which is not spoken about lately - that there would be less incentive for moral hazard behaivour by institutions in the future. With the real possibility, that country can default on its debts, betting and thus preventing country to run its debts to astronomic height would become more profitable. Right now we are punishing those, who were right in saying that Greek will be bankrupt. Lets see what the future brings.