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Wednesday, December 9, 2009

Lehman’s Fall: Lessons to be Learned

Markets may know better than regulators, but regulation of market behavior through effective supervision alone can preempt financial crises

It is a year since Lehman Brothers—one of the venerable investment banks from America’s Wall Street—collapsed, setting the global financial infrastructure aflame. Since then, it has destroyed trillions of dollars in public monies across the globe. Now, some are wondering, of course on hindsight, that if only the government had bailed out Lehman, markets would not have plunged into such a mess. A few are even questioning the wisdom of letting a bank of Lehman size fail, that too, in a globalized economy. Some, of course, comment that the US is right in letting Lehman Brothers fail, for capitalism squarely rests on the principle of “the lure of wealth and the fear of bankruptcy.” Even otherwise, the global imbalances in debt and asset prices have reached such a point from which there is no scope for soft landing, argue others. There are a few others who argue that the collapse of Bear Stearns should have alerted the Fed and treasury to take urgent steps to backstop such a collapse. But the political system being what it is, it may not always be easy to convince the Congress for deployment of public funds to guarantee private debts against ‘vulnerabilities’. However, for a better understanding of it, a relook at the origins of the crisis is in order here.

Origin of the crisis

A true analysis of the origin of the crisis should trace a bundle of reasons for the global financial meltdown rather than one that culminated in the fall of Lehman: one, low interest rates maintained by the Fed under the leadership of Alan Greenspan for too long; two, repelling of Glass-Steagall Act of 1933 that prevented the deposit-taking commercial banks from tying up their capital in risky bets on securities; three, relaxation in limits on leverage, granted by the Securities Exchange Commission during 2004, that investment banks can undertake; and, four, unbridled expansion of trading in complex, opaque derivative transactions to even systemically important financial institutions. Finally, it is, of course, the bonus-driven compensation structure that made them exploit the opportunities thrown open by the free markets to the hilt.

Above all, there is another important reason behind the global meltdown which silently crept into the rational decision making of investors: vanishing of equity risk premium from the US markets. A study carried out by the Federal Reserve Bank of Minneapolis revealed that in the last four decades preceding the collapse of Lehman, lenders made as much return as the equity investors. During 1926-1970, US equity investors received a return of 7 percentage points more than what bondholders had. But during 1982-1999, the same had fallen to less than 1%. Indeed, a study carried out by Credit Suisse revealed that equity investment in the US yielded almost close to zero return in real terms during 2000-08. This is quite contrary to the two centuries of expectations/experiences of the US investors: since 1802, they have been enjoying a return in excess of an average of 4% over government bondholders.

It is this missing equity-premium that had impacted the globe worse—individual investors started looking elsewhere for profits. The Asian crisis had only hastened people’s running away from investing in hard assets. Financial assets designed in the Wall Street had become the main attraction for investors. The net result was the credit bubble. And with the increased flow of dollars from the Chinese exporters and from the petroleum-exporting countries into the Wall Street, the credit bubble—converting even subprime mortgages into securities and selling them to gullible investors as though they were as good as treasuries, duly aided by dilution of standards in terms of rating, absence of prudence, and above all an environment of lax-regulations—had only inflated further to gigantic proportions. Thanks to the Fed, as returns on these instruments got squeezed further, even the risk-averse investors boarded the bandwagon.

As is natural, following such unruly growth in profits for even corporates from the Wall Street rather than from labor-linked assets, the credit bubble finally burst, making many penniless, while the governments and central banks across the globe got busy in pumping trillions of dollars—fiat money—into markets to first unfreeze the credit markets and then to offer a safety net to the collapsing financial architecture. All this has certainly given us immense comfort that we are no longer falling! And today, we are even being told that the worst is over and the shoots of growth are sprouting. But there are also a few questions: “Is this recovery durable?” “If not, does it then mean a fall into a long-term liquidity trap like the one Japan experienced in the 1990s?” Of course, finding answers to these questions certainly calls for new knowledge. But ironically, what is more disturbing is that we do not seem to be interested in learning even from the existing knowledge. To better appreciate this phenomenon, let us take a peek at the basics of financial markets.

Role of financial markets

Financial markets are essential for the efficient allocation of scarce capital to the most productive uses. The financial institutions/markets collect the savings of households and businesses and reallocate to households, businesses and government to finance additional consumption or investments. The usage of capital is, of course, many and diverse. Obviously, they do vary in expected outcomes and the risk thereof. But the market mechanism—competition among alternative users of funds via prices offered and bid—is more likely to allocate capital to its best uses, taking into account both risk and return. In the process of allocation, markets also pool up the incongruent information about various market participants—of course, none of which depicts the full picture of the available investment opportunities. These two functions are highly interdependent.

That said, market experiences indicate that markets do not perform these two functions perfectly—there are limitations to aggregation of individual motivations behind their transactions and also about the range of financial products being offered by the markets. What it obviously means is that trading on risks and rewards under such limitations will not give the same results that would have been achieved from a fully informed market—a hypothetical model of an economist. Indeed, it is this constraint on information that motivates the varied behavior of market participants and the varied market features. All these imperfections would only mean: there is hardly any way to improve on market outcomes.

Amidst such market imperfections, if a financial safety net is offered by governments, as is being done now to restore confidence in markets, it would only further vitiate the pricing of risk by the creditors to banks and banks’ very management of their own risks. It also makes financial institutions less averse to seeking greater leverage than it otherwise would, and such high leverage by large institutions that are systemically important makes outcomes more catastrophic. Therefore, it is essential to have a matching regulatory supervision to arrest the inherent tendency of these institutions to take excessive risk.

Way forward

Common sense, gained from the recent experiences, also tells us that a market-based approach has failed in safekeeping the financial institutions and it needs to be replaced with tougher regulatory constraints. Yet some argue that tight regulations would only stifle financial innovation, which, while being detrimental to growth, may not be of great help in stemming a future crisis, for an element of risk-taking is the very core of financial intermediation. But Kenneth Rogoff of Harvard University rightly asserts that such an argument is dangerous. He argues that the financial system needs fundamental reforms in regulation and governance, sooner and not later. He is categorical in declaring that ‘restoring confidence’ through the safety net approach is all right, but what ultimately the system needs is “a system of global financial regulation and governance that merits our faith.”

Lord Turner, Chairman of the UK’s Financial Services Authority, too raises quite a few unpalatable issues: one, that the responsibilities of FSA be shifted to the Bank of England; two, the excessive size of financial sector; three, the level of capital to be maintained by banks, particularly against their trading activities, to cushion themselves from vulnerabilities; four, imposition of global tax on financial transactions; and, five, bankers’ pay.

Even Ben S Bernanke, observing that the governance system of the financial infrastructure owes the public “near-term, concrete actions to limit the probability and severity of future crisis,” stressed the need for “stronger supervisory and regulatory systems under which gaps and unnecessary duplication in coverage are eliminated, lines of supervisory authority and responsibility are clarified, and oversight powers are adequate to curb excessive leverage and risk-taking.” Another important issue that he raised, which merits utmost attention, particularly from G20 countries, is: the “world is too interconnected for nations to go it alone in their economic, financial, and regulatory policies. International cooperation is thus essential if we are to address the crisis successfully….”

It is also essential to take note of what Satyajit Das, the renowned author of textbooks on derivatives said: “The sheer importance and size of derivative profits means that it will continue to attract the best and the brightest who will continue using derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails.”

The summum bonum of all this argument is, financial institutions must be regulated—regulated they must be, but how, is an issue that needs to be sorted out through diligent intra- and intercountry political discussions. At the same time, America and China should learn a better way of managing the fundamental imbalance in the global economic system, which in fact has been dubbed by many as the prime cause behind the global meltdown—America needs to realize that it cannot merrily borrow forever from the rest of the world to consume, and China must reform itself to encourage domestic consumption instead of stacking huge surpluses abroad. The biggest lesson that becomes obvious from the crisis is: finance capital works wonders only when complemented by the real economy, and this can be ensured only through prudent regulation of markets. If this learning does not reflect in our future behavior, we sure will be heading for another crisis.


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