Did Lehman Brothers die in vain?
Having once worked for Lehman Brothers and having championed financial reform long before it became fashionable subject, I have strong opinions on the issue. Just as I was about to write something for the 5th anniversay of Lehman's collapse, a Good Samaritan sent me this transcribed text of a keynote speech I had made at the 2nd anniversary of the collapse. After browsing through it, I decided it did not need any editing - so here goes… It is also a good précis of my book that you can download here. You might also want to read my recent FT op-ed on how financial reform is lagging behind and a piece I wrote on what a good banking system ought to look like. Enjoy!
The world has been rocked by the most major financial and economic crisis in recent history. This exposed several aspects of financial system dysfunction. These not only increased the instability of the financial markets, but also impeded their normal functioning as tools to allocate economic resources efficiently throughout the real economy.
The collapse of Lehman Brothers two years ago was at the heart of this crisis. This is not a Eulogy to Lehman Brothers. That having been said, Lehman in death managed what it could not do while alive – be more famous than its peers Goldman Sachs and Morgan Stanley. In death, Lehman may have performed a greater service for society than it did perhaps in the many decades of its existence – provided, of course, that we have learnt the right lessons from its failure and acted on them. Did Lehman die in vain?
Before continuing it is necessary to address an important myth – namely, that there was something more crooked or special about Lehman Brothers which did not afflict its peers that lived to tell the tale – Morgan Stanley and Goldman Sachs amongst others. Even though I worked briefly at Lehman, I had no love lost for it, so I say this purely as a neutral observer. There was very little special about Lehman that also did not permeate its peers.
It is true that in our version of history it was Lehman that went down, in another parallel universe it could equally likely have been Morgan Stanley or one of the other bulge bracket banks, or in fact all of them. Lehman’s death, paradoxically, allowed them to live. It was because of the panic that this demise caused that governments around the world came to the rescue of all survivors, so any time you hear representatives of Barclay’s, Goldman or Deutsche Bank talk about how they were somehow better run or that they did not need government assistance, you will know that they owe their life only to Lehman’s demise – and to the generosity of taxpayers who stood behind whole banking systems, at a great cost to themselves.
Why finance cannot be left alone
Financial systems are different from the real economy – when one of the three restaurants in the neighbourhood goes out of business it is good for the two remaining restaurants. When one out of three banks fails – it is bad for the other banks. First, because finance runs on trust confidence and a bank failure can result in the collapse of confidence and, second, because in banking, your competitors are also your counterparties. Two restaurants in a neighbourhood will seldom trade with each other. Banks, on the other hand, borrow and lend from each other sums that are sometimes larger than the ones they exchange with customers. So the collapse of a bank can inflict serious losses on other banks, i.e. have a systemic impact.
The financial system is so central to the functioning of modern economies that many have likened finance to being the brain of the economy. Disturbances in the financial system have a negative footprint on the real economy, as we have so drastically seen in this ongoing crisis. Given that individual financial institutions can have a systemic impact not just on the financial system, but also on the real economy comprised of the ‘little people’ such as you and me, the way that the financial system is run should be everybody’s business. This is not only about the money we deposit in financial institutions, but also about our taxes, which eventually backstop the financial system in times of crisis.
Those who bought the twin arguments that (1) finance is too complex for the ordinary folk to understand, and that (2) the smart people in the industry getting paid $10 million knew what they were doing are complicit in this crisis. And all of us bought it – civil society, NGOs, trade unions, regulators and politicians. We must not let this happen again. We were often also told, by the same industry that because it was so complex, if lesser mortals tried to regulate finance, the whole system would collapse. We did not, and it collapsed anyways. Finance is no rocket science and those getting 10 million do not always know what they are doing and, even when they do, do not care the damage that their actions will inflict on others, as long as they get their 10 million. These are some of the reasons why finance is far too important to be left alone.
Ever since Lehman failed there has been much talk of overhauling the financial system to prevent such a crisis from happening again. However, the debate has been far too narrow. The question has been what not to do rather than what we should do, or what we do not want rather than what we need. The next sections, therefore, deal with three questions: (1) Why this collapse happened, (2) what a better system would look like, and (3) a prognosis for the future.
Why did the financial crisis happen?
Years before Lehman collapsed we knew there was something wrong with our financial system. If someone said planet earth has an efficient and well-functioning financial system and we looked down at it from planet Mars we would expect to see
- a stable system
- that was at most garnering competitive rents of say 1-2%,
- which performed its job of taking money from where there is too much and returns are low to where there is too little and potential returns are higher,
- which pottered on in the background as a support system – a bit boring and invisible,
- and one that was sustainable in the long-term.
In reality, however, the global financial system is characterized by high volatility, strong procyclicality, and ever more frequent financial crises; financial institutions earning enormous rents of 20-25% compromising the efficiency of finance as a support system of the real economy; a massive net capital transfer from developing countries to financial centers like London or New York further perverting the function of efficient capital allocation; years of financial market news grabbing the headlines in newspapers around the world; and an unsustainable build-up of leverage and excessive risk.
Finance has changed drastically over the past several decades and the scope of this can change is best explained with a metaphor. The financial system, with its many institutions and channels for transfer of money closely resembles a road transport system. Well-managed roads enable people and goods to move where they need to go, quickly and without too many accidents; a good financial system efficiently allocates resources to where they are needed in the real economy without too many crises en route. Clearly we do not have such a system.
Imagine cars cruising down a road on a clear day: the occasional speed bump to slow them down, cameras reminding drivers they are being watched and the odd police patrol just in case. That is how finance in general and banking in particular worked for decades after the reforms triggered by the Great Depression. The world saw substantial economic growth in the decades following World War II and the financial system was fairly stable. Next think traffic, fuel tankers, racing down the road in thick smog. Sparser police patrols, spray-painted cameras, and dismantled speed bumps and barriers complete the picture. This was the new face of finance that first started to emerge in the 1980s.
Cars and finance have always crashed. But crashes have become more frequent, more severe and ever harder to clear up. We are still emerging from a financial pile up of unprecedented proportions that brought financial traffic to a near standstill. Even as the rescue operation was in full swing, with governments taking unprecedented action, too many inebriated drivers kept careening down the road out of control. Truck after truck kept crashing into the rescue operation. Bear Sterns, Lehman Brothers, AIG followed in quick succession and the flow of financial traffic is still blocked.
Given hazardous driving conditions, hysterical daily news reports of accidents and poor visibility, most prudent drivers stay at home. They keep their cars in the driveway, their money close to the chest. This is what led the economy to seize up.
Governments, regulators and central banks have been in action clearing up the debris of road accidents but the scale and scope of the accidents was so great that it will take a long time before drivers would venture out again with confidence. It is clear that going back to the old system is no longer an option. It was far too dangerous and failed to fulfill its purpose of directing funds where they would have best served the real economy.
Summing up the lessons learnt – we can see that
- We need to focus on the system, not just individual institutions;
- What you cannot see should concern you most;
- Incentives matter – in fact they are crucial;
- Just in time finance seems to work well but can be very dangerous;
- Whatever can go wrong, almost always will;
- Co-operation across network boundaries is essential;
- Individually rational decisions can be collectively disastrous;
- The pursuit of diversification in extreme leads to uniformity.
What would a better financial system look like?
The system would need to be much safer without being inefficient. At 1km/h, there are no accidents, but clearly this is bad for the economy. Some risk-taking is essential for the success of capitalism: it drives entrepreneurship and productivity gains. So we need measures that best increase safety and confidence without slowing down traffic to a trickle.
We need a top down perspective. First, we need to understand the concept of safety. You can test the safety of cars to death but the main danger on modern roads comes not from exploding cars and failing brakes but collisions with other cars.
Next, we need to tackle smog. Opacity in finance comes from 1) trading poorly understood derivative structures 2) the use secretive tax havens and 3) growth in the shadow banking system that lies outside regulatory reach. This has jeopardized safety and undermined confidence. These three aspects of finance pollute through secrecy and need to be tackled upfront. Furthermore, better road signs in the form of full disclosure will no doubt help increase public safety and restore confidence.
Then we need to limit the size of ‘too large to fail’ financial institutions by breaking them up. These fuel tankers of the financial system have threatened the safety of whole countries such as Iceland and Switzerland. More speed bumps are also needed in the form of financial circuit breakers and transaction taxes that slow the speed of finance.
Traffic cameras in the form of more regulatory oversight would ensure financial institutions know they are being watched and discourage reckless behaviour. More patrol cars i.e. more regulatory power for greater deterrence, faster rescue services and sharper punishments for offenders will help ensure that the smooth flow of financial traffic is not interrupted by dangerous driving.
Seat belts and airbags for the ordinary driver are also needed. These can come in the form of better deposit insurance and social insurance clearly increase safety in the event of a crash and help restore confidence to drive amongst the prudent.
These measures will need to be part-financed by a differentiated road toll scheme with those driving big or dangerous vehicles which endanger financial safety and erode the road being asked to pay higher insurance, tax and capital levies. This could take the form of a levy on the balance sheet of large financial institutions.
Barriers need to be reinstalled. Regulators will fall asleep again – we need proximity sensors and circuit breakers.
Traffic management incentives, which ensure that traffic does not ‘herd’ too much at peak times, translate into what are commonly known in finance as counter-cyclical’ policies. These ensure that regulation and fiscal policy lean against the wind to prevent the build up of bubbles or busts. It was the absence of such policies that inflated the recent asset price bubble in the first place.
No traffic system is complete without public transport that connects areas under-served by private vehicles. Similarly, governments need to support small and medium enterprises, green investments and infrastructure provision critical elements of a sustainable economy that the private financial sector almost always under serves.
A prognosis for the future
There are four possible corner solutions to try and make the financial system fail-safe, which can be illustrated by the Child Minding Metaphor.
1. Guarding against failure. Capital and liquidity buffers plus resolution authority – metaphorically speaking, you let your baby run around but put cushions and have a first aid kit handy. This approach is not failure proof.
2. Changing the incentive system. Discouraging banks’ excessive risk taking by changing remuneration schemes in the financial sector – you reward and punish the child. This is the least cost and first best option, but obviously not foolproof either, because thrill seekers and those who take risks for the pleasure of it will act against incentive structures.
3. Inoculation. Separating the more risky parts (e.g. proprietary trading) from the more boring parts of banking (retail and commercial banking) – you make a safe Children play area. However, just as children can sometimes climb over the fenced off play area, a decline in confidence can spread out from fenced off parts of the financial markets, so this strategy is not fail safe either.
4. Improving financial supervision. Child minding – you make sure someone is always babysitting your kid. However, even the best babysitter can get charmed or fall asleep, so this solution is not fail safe either. Regulators were asleep at the wheel up until the time the crisis hit.
In order to make sure that the crisis does not happen again, what is needed is ideally a combination of all such strategies. It will also allow reform efforts to be more measured so unintended consequences of reform are minimized at the same time as stability is ensured.
For example, if we merely focused on inoculation, you could put the child in a cage but that would not be healthy. Or an extreme version of incentive reform is to start giving children mild electric shocks every time they come close to the edge of the bed- obviously not a healthy solution either.
The point is that none of the corner solutions are good in themselves and it is a combination of some movement on all which constitutes the right balances between efficiency and safety.
In the regulatory discussion we have focused primarily on building up cushions and stricter supervision, with both the separation of commercial and investment banking and changes to bonus and incentive systems having been ignored by policy makers. This will lead to a less efficient and a less safe system and these measures need to be addressed.
In order to make sure we do not end up here again, four broad sets of financial reforms are required.
- Changes to supervisory structures and approaches so as to supplement current local bottom up approaches with international and top down regulators who have a system-wide view.
- Changes to the structure of the financial system to tackle the too-big-to-fail, too-interconnected-to-fail, and too-complex-to-fail institutions that are able to gorge on implicit subsidies during peacetime and significantly increase the possibility of a systemic meltdown.
- Changes to regulations to build up capital and liquidity buffers, tackle procyclicality and lean against the build up of systemic risk.
- Tackling endemic incentive problems in the financial sector that encourage excessive risk-taking and short-termism.
At the time of making these changes, it is worthwhile to ask ourselves what sort of a financial system we need to support the real economy and work backwards from that to make sure that the changes we make to finance are not just reactive to the crisis but also proactive in terms of anticipating and fulfilling the needs of the 21st century economy. The reform process is still in full swing, so it is useful to consider how what is being discussed compares with what needs to be done.
A glaring omission in ongoing discussions is the complete absence of proposals to set up a global financial supervisor. While the International Monetary Fund and the Financial Stability Board are expected to be financial watchdogs of some kind, the global financial system needs a global regulator.
At a regional level in the European Union and the national level in major economies such as the United States, progress is indeed being made in setting up both systemic risk top down regulators, as well as better more holistic supervisory authorities but the efforts are unlikely to go far enough.
While there is a near universal agreement that tacking systemic risk is the new mantra, there is far too little being done to address the root cause of this risk. There is little serious discussion of breaking up too-big-to-fail institutions, even though the business case for them remains unproven, while their contribution to systemic risk is widely acknowledged.
The too-interconnected-to-fail problem is not being tackled by limiting the scope of activities of firms, but only by introducing mandatory clearing for derivatives that addresses only part of the problem. It is hoped that the too-complex-to-fail problem will be mitigated through the implementation of strict and credible ‘living wills’ that allow for failing institutions to be shut down quickly - but this is by no means assured.
The immense lobbying power of large financial institutions, as well as the tendency of politicians in some countries to see their banks as national champions, means that the likelihood of progress on tackling the problematic structure of the financial system is low.
Changes to capital and liquidity regimes are being coordinated through the Basel Committee on Banking Supervision and are likely to be decided by the end of 2010. Here again, while the initial proposals put on the table seemed robust lobbyists working for the financial sector are chipping them away. While it is clear now that both the quality and quantity of capital is set to increase, it is far from clear that the actual changes introduced will go far enough. A long overdue liquidity regime has finally been proposed and is likely to be introduced gradually over the next few years. Here again, while the direction of reform is clear, its scope remains a matter of much debate.
As supplements to the basic capital and liquidity regimes, discussions are ongoing about the introduction of leverage ratios, countercyclical overlays and systemic risk charges. These will be critical defining features of the new regulatory regime though the parameters continue to be the subject of intense discussions.
The incentive mis-alignments at the heart of the financial sector are scarcely being addressed. While reforms have been introduced at the margin to tackle conflicts of interests in securitization and credit rating agencies, the asymmetric payoffs faced by financial sector employees and institutions will continue to drive them to take excessive risks.
Compensation issues, which drive micro as well as macro behaviour in the financial sector have been successfully labeled as a ‘sideshow’ by financial sector lobbyists keen to preserve their ‘heads I win, tails you lose’ exorbitant and unfair bonus structures. The rules on compensation proposed by the Financial Stability Board are very weak and in danger of being watered down even further. The only sensible option of reducing the asymmetry of compensation by capping the relative and absolute amounts of bonuses is not even on the table.
Other incentive problems that drive the financial system to be excessively short-term oriented, highly opaque and needlessly complex are also not being tackled.
The financial system failed the test of the market and has left taxpayers to foot the gargantuan bill for its failure. Hopes that this would lead to robust corrective action have so far not been met. While the window of opportunity remains open, it is critical for all of us to engage with the process and the substance of financial reform since our failure to do so is likely to land us with another even bigger bill in the future.
Civil society actors and those outside the financial sector should no longer be content with the ‘it is too complicated for you to understand’ or the ‘relax, I know what I am doing’ messages from the financial sector and regulators. Financial system reform is much too important to be left to the regulators and politicians alone.
The financial system remains fragile and highly vulnerable to another crash. Let me conclude by saying that until the public is ready to hold finance, which is too important to be left alone, to account, we are condemned to seeing a repeat of crises on ever larger scales. Let us act now…Let Lehman Brothers' death not be in vain!