15 years on from the Lehman bankruptcy, James Athey, investment director, abrdn, considers how the banking system was allowed to fail and why more banks collapsed in 2023.
“Light-touch regulation” was the watchword back in 2008. Politicians had seen the benefits of having a highly profitable banking system and the lack of crises in recent years, along with the pronouncements of economists and central bankers, had allowed them to believe that the system was robust and self-regulating.
Traders and bankers in profitable banks received big bonuses. The CEOs of those profitable banks receive gargantuan bonuses. If regulators were not there to spoil the party, then who was? The answer – nobody.
History shows that when the financial system organises this kind of multi-year party unchecked, it gets out of hand and hangovers are severe. What we should have known then, and what we certainly know now, is that though the perception of risk has fallen, that risk itself has not gone away. In fact, what economist Hyman Minsky astutely observed decades ago was that during times of apparent risk decline, risks are often building to dangerous levels. Looking back at the hubristic comments from politicians, policymakers, economists and bankers, the extent to which everyone was singing from the same song sheet really beggars belief.
The problems started decades before Lehman Brothers imploded, in the aftermath of the Great Depression. In 1933, to protect Mr and Mrs Main Street from the irresponsible behaviours of Mr and Mrs Wall Street, the US Congress passed the Glass-Steagall Act – a piece of legislation forcing the separation of commercial and investment banking activities. By the mid-1990s, however, the Great Depression was a period of historical curiosity, not a genuine foundation for regulation in the modern and sophisticated financial system. The act was abolished by President Clinton in a continuation of the post-Reagan regulatory bonfire, and the economy just kept booming.
The financial system’s response was swift and dramatic. M&A activity went through the roof as Wall Street names snapped up the competition and built financial Goliaths offering every financial service. The Mega-Banks dominated.
A small number of huge banks isn’t necessarily the problem. However, the prevailing wisdom was that the sophisticated hedging and risk management techniques, assisted by assumptions based on a small sample of historical data, meant these banks were stable and completely secure. Pride cometh before the fall.
The approach to regulation was almost akin to marking one’s own homework, as the amount of capital a bank needed to hold (to ensure it could pay its short-term liabilities) was related to how risky the bank’s assets were (“risk-weighted capital”). It was the bank’s job to decide how risky its assets were. Through the magic of modern financial theory, complicit rating agencies, and a heap of spurious assumptions, it turns out that many of these assets weren’t very risky at all! The result was a huge amount of leverage. Capital positions of 4 or 5% of assets were the norm, levering the big banks by up to, and over, 25 times. Under such conditions, a bank’s capital can be wiped out within days.
However, governments liked banks because they employed lots of well-paid people who paid lots of tax. So, there was no desire to step in and regulate. Economists and central bankers liked banks because their modern, quantitative approach meant risk had been all but defeated. Bankers and CEOs loved this environment because their ability to become wealthy was almost unimpeded. Asset prices were rising and everyone was getting rich.
By mid- September 2008, this entire edifice was in tatters. Many of the assets held by banks were not worth the proverbial paper onto which they had been securitised. The leverage and toxic assets in the system meant the collapse was swift and brutal. Governments had to step in with taxpayers’ money to bailout banks. Some of that money was used to pay further bonuses to the very architects of the downfall, leaving the public furious. The politics of banking turned on a dime.
The regulatory response was severe. The main piece of post-GFC regulation was the Dodd-Frank Act, passed in 2010. Over 2,300 pages long, perhaps not many Congress members read it all, but it marked a sea change. Globally coordinated efforts, such as the Basel Banking Committee, proposed further changes. Provisions for risk-weights became more prescriptive; leverage and liquidity were tightly controlled; individuals became directly responsible for the behaviours and policies of their departments; the interactions between banks and their clients were monitored and controlled. Banking was almost unrecognisable and due to the limits on leverage, far less profitable. To prevent any future need for a government bailout, banks were forced to issue capital designed to take losses in a default (“bail-in capital”).
Despite all the post-crisis regulation, in March 2023, the US banking system suffered the second and the third largest bank defaults in history. Plus, the government deemed it necessary to backstop the system by providing deposit guarantees over and above those available through the Federal Deposit Insurance Corporation. Meanwhile, the bail-in capital of Credit Suisse worked so effectively that its newly acquiring parent company, UBS, reported massive profit on the transaction and investors in the now wiped-out CS bonds sought redress through the courts, arguing the government had illegally upended the long-accepted seniority within the capital structure.
The cause of this, and other, default events in 2023 was not excess leverage, nor investment in toxic assets. Rather it was the unrealised losses on those safest of assets – US treasuries, which had plunged in value following the Fed’s aggressive rate hikes. Regulators, it turns out, had been fighting the last battle.
