Regulation key to preventing another financial catastrophe

ON SEPTEMBER 15th, 2008, Lehman Brothers filed for bankruptcy. The global financial system almost imploded in its aftermath. One year on and many trillions later, what are the lessons of the Lehman collapse?

Might we have been spared the deepest global recession since the 1930s if US authorities had bailed out Lehman rather than allowing such an inter-connected bank to fail? Should bondholders always be protected at all costs? Or does the implicit promise of government bailouts fuel further risky bank behaviour, thereby sowing the seeds of future crises? Ultimately, what should be done about banks that are “too big to fail”?

Former IMF chief economist Kenneth Rogoff categorises officialdom as adapting a “When in doubt, bail it out” doctrine. Bailing out Lehman, policymakers now believe, would have resulted in a “hiccup and not a heart attack”. Harvard professor Rogoff, who predicted in advance of the Lehman failure that a “whopper” bank was about to “go under”, argues that this “conventional postmortem on Lehman is wishful thinking”.

The US economy was heading towards a deep financial crisis for several years before the subprime crisis, Rogoff said recently. “Any economy that is excessively leveraged with short-term borrowing” is “highly vulnerable” to such crises. “Accidents that are waiting to happen usually do”.

Focusing exclusively on Lehman’s failure ignores the fact that the US had fallen into recession nine months previously. The housing bubble had already burst, with severe distress as a result of the subprime market meltdown evident well over a year before the fall of Lehman.

Despite this, Lehman’s demise tends to be talked of as a bolt from the blue that triggered unnecessary financial Armageddon. US policymakers certainly had a post-Lehman change of heart, subsequently bailing out AIG, Citigroup and Bank of America. Ireland’s Minister for Finance Brian Lenihan frequently cites the Lehman fallout as proof that bondholders cannot “take the hit” of bank failure. “It’s clear that governments have to prevent banks failing and stabilise them,” the Minister said in June.

But is it clear? Rogoff has argued that the problem with letting Lehman fail “was not the concept but the execution”. Government should have “moved in aggressively to cushion the workout of Lehman’s complex derivative book”, adding that there was “plenty of warning”.

Prof Willem Buiter of the London School of Economics has made the same point, noting that no regime was in place to deal with such a situation. A special resolution regime, such as was introduced in the UK last March, could have kept the “systemically important bits of Lehman” on government life support while letting shareholders and unsecured creditors meet their fate. Some sort of guarantee on money market funds, as well as soothing words from the US Fed on the extension of liquidity facilities, could have limited the fallout from a Lehman failure, critics argue.

The latter moves were belatedly given a week after the Lehman collapse. By then, all hell had broken loose. Having bailed out Bear Stearns six months earlier, markets were shocked by the US administration’s about-turn. When AIG was handed an $85 billion lifeline just days after Lehman had been allowed to die, the impression was given that authorities were reacting in an ad hoc and inconsistent manner. That impression was cemented by the hastily-constructed $700 billion bailout package designed to remove toxic assets from bank balance sheets, a plan that was soon rejected by Congress and subsequently revised.

With banks not nearly as healthy as had been believed and policymakers appearing panicky and hopelessly behind the curve, markets arrested. Accordingly, it’s easy to view the Lehman collapse as a symptom rather than a cause of the financial malaise.

The obvious objection to continued government bailouts of reckless institutions is that it encourages excessive risk-taking, the so-called “moral hazard” argument. Moral hazard was clearly evident in the months following the Federal Reserve’s bailout of Bear Stearns in March. In the months prior to Bear’s downfall, investors grew increasingly wary of dealing with the bank, with the amount of commercial paper bought from the bank dropping noticeably. The opposite happened in the months prior to Lehman’s collapse.

One person who has been warning of the dangers of moral hazard for some time is Thomas Hoenig, Kansas City Federal Reserve president. In 1999, he warned that the rise of “mega financial institutions” risked a “less stable and a less efficient system” due to the fact that governments would be reluctant to close failing behemoths, creating implicit guarantees in the process.

That was prescient. Approximately $185 billion has been committed to AIG to prevent its collapse. $45 billion has been pumped into Citigroup, with the US taxpayer also committing to guarantee more than $300 billion in potential losses. Bank of America received a taxpayer guarantee of $118 billion in potential losses. Despite this effective nationalisation of financial losses, the taxpayer owns a mere 36 per cent of Citigroup while Bank of America has escaped the government taking common equity in the company.

Ten years on from his initial warnings, Hoenig cautions against such bailouts, advocating that government should instead declare failing institutions insolvent, replace management, liquidate bad assets and reprivatise as soon as possible. Certainly, the “too big to fail” problem diagnosed by Hoenig is worsening. JP Morgan, Bank of America and Wells Fargo each hold more than $1 out of $10 on deposit in America, a practice that was prohibited until recently. The same three banks, plus Citigroup, issue one out of every two mortgages and two out of every three credit cards.

More worryingly, banks with more than $100 billion in assets are borrowing at interest rates 0.34 per cent lower than the rest of the industry. That’s more than four times 2007’s 0.08 per cent differential. Creditors recognise that the government implicitly stands behind the largest institutions.

However, banks are again making profits and share prices have rebounded substantially, causing the question of reform to fade from political agendas. This indifference is “somewhere between maddening and tragic”, says Princeton economist Alan Blinder.

Treasury secretary Tim Geithner insists that serious regulatory reform will ensue. Not everyone is convinced. Despite high-profile regulatory gatherings in the coming months, “nothing meaningful” will be achieved, according to Simon Johnson, chief economist with the IMF until August of last year. “Unless and until our biggest financial players are brought to heel, we are destined to repeat versions of the same boom-bust-bailout cycle.”

What Lehman’s fall shows, Rogoff maintains, is that the financial system was “totally unprepared” to deal with the “inevitable collapse of the housing and credit bubbles”. The “right lesson” is not that governments must bail out institutions ad infinitum, but that the global financial system needs changes in regulation and governance. That was echoed this week by money manager Richard Bernstein, former chief investment strategist with Merrill Lynch. “Designating certain institutions as too big to fail, and not having a thorough regulatory process to match”, Bernstein warned, “practically invites another catastrophe.”