Game theory and balance sheets

What’s really the problem these days?

The single best thing that could happen would be for the true magnitude
of the losses suffered by banks and other exposed parties to be
revealed and put in the P&L. Until what happens, fear of getting
stuck with the hot potato makes banks unnaturally unwilling to extend
credit against the kind of collateral that they would not have thought
about twice accepting at the beginning of the year.

Here’s the source.  This is an important game to understand.  Think of bank managers as being collectively averse to admitting a loss, if only because they might be blamed for that loss.  So at first no one admits losses.  Even though the market knows the losses are there, the market just doesn’t know exactly where.  But then the market has no accurate valuations for some asset classes.  Those asset classes can’t serve as collateral because just about any result — relative to an unevaluated base — could count as a loss and we’ve already seen that managers are loss-averse.  Plus dealing with hard-to-value assets is difficult in any case.

The simple lesson is that bad news can be good news.  "Predictability of environment" is a public good across managers.  Once managers admit their losses, market liquidity can spring back to life and we can avoid a credit crunch.

Once managers admit their losses, that is.


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