The regulatory legacy of Lehman Brothers

The collapse of Lehman Brothers in September 2008 produced an immediate and obvious disaster. The aftermath was a global financial meltdown whose intense phase lasted for over six months, and which led to trade and output declines as rapid as those of
the Great Depression

Top 5

It is obvious that there should be an intense discussion about which policy or policies might have provoked the collapse.

Most commentators assumed that the US authorities had made a mistake in allowing Lehman to fail. It was not as if the failure was a surprise; it was a slow-motion collapse that was regarded as increasingly likely in the week before September 15. Since the financial markets seemed to be already recovering in the summer of 2008 from the turbulence surrounding the rescue of Bear Stearns, it was plausible to think that then-Treasury Secretary Hank Paulson wanted to make a dramatic illustration of the unwillingness of the authorities to enlarge moral hazard.

The alternative view was that the Treasury and the Federal Reserve knew that the banking system was deeply problematical, and contained a plethora of unknown risks. It threatened to explode sooner or later, and would require a massive restructuring involving a large amount of public money.

But such money would only be made available by Congress after a dramatic crisis. Allowing Lehman to collapse was just the easiest way of making the politicians aware of the seriousness of the situation.

The exposure of Lehman’s accounting practices in the court-ordered report by Anton Valukas makes it clear that both the previous prevailing interpretations of the Lehman collapse are mistaken.

The Lehman problem was in reality a much simpler and rather old-fashioned one. Lehman had adopted accounting practices (the use of Repo 105 to shift property exposure off the balance sheet) that New York law firms had been unwilling to endorse.

If the Lehman crisis had been recognised at the time as the result of such accounting, it could have been allowed to collapse without implicating the banking system. The strategy of containing moral hazard might have worked.
In a similar way, the collapse of Enron after fraudulent accounting strengthened rather than weakened American corporate life. No one assumed that all American business simply replicated Enron.

The problem of 2008 was that there was no mechanism to work out what had gone wrong with Lehman, or to recognise the extent to which the Lehman problem was an idiosyncratic one rather than a generic issue.
The Lehman problem would have been avoided by a common set of accounting practices and international regulation of banking.

The problem looks exactly like the collapse in 1991 of the Bank of Credit and Commerce International. BCCI had been legally based in Luxembourg and in the Cayman Islands, but had extensive operations in Africa, the Middle East and the Far East that were managed out of London. The Bank of England had not concerned itself with BCCI, as it did not appear to be a London institution.

But the systemic consequences of BCCI were never enunciated. In the early 1990s, BCCI was seen as a unique case that did not require the institution of a genuinely international system of regulation and supervision.

By the 2000s, however, the international banking system was full of opacity, largely because of the extent of a globalisation of finance that took place at the same time as banks evolved their own trading platforms.

Megabanks had internalised activities that were once performed by individuals and institutions in large part legally independent of one another, or of public markets.

Nearly all of these new mega-institutions were public companies, which are better placed than separate institutions, especially those conducting business on public markets, to keep their transactions off the radar screens of regulators.

Banking is inherently competitive, but is not an industry where competition ever worked very well. Banks essentially depend on information (about the quality of their lending) that is not available to their depositors.

When banking was stable and regulated in a national setting, three or four leading banks tended to form an oligopoly in each country: Barclays, Lloyds, Midland and National Westminster in the UK, Bayerische Vereinsbank, Commerzbank, Deutsche, and Dresdner in Germany; Credit Suisse, SBC, and UBS in Switzerland.

There were always suspicions of either a formal or an informal cartel. Regulators generally turned a blind eye to these suspicions, but there was an obvious framework for regulation.

Over the last 20 years, the oligopoly became international rather than national. In the 1990s and 2000s internationalisation promised a new landscape in which a handful of banks would divide up not national markets, but a single global market.

Banks manoeuvred to take advantage of financial globalisation. That usually meant locating themselves in the most lax and least restrictive regulatory regime.

From the point of view of regulators, there was an unwillingness to take on the potential systemic consequences of regulatory arbitrage. The US assumes that it can regulate banks on its own. It negotiated the Basel II agreement, but was unwilling to implement it. The UK also assumed that it could provide the framework for a more effectively competitive financial industry.

Coming as it does at a moment when the discussion about banking regulation looks as if it is stymied by the clashes of national champions, the Lehman report is a valuable reminder. Unless regulators are in a position quickly to work out whether a failed institution is an example of particular misconduct or of a systemic risk, banking regulation will not be able to produce more stable financial markets.