The Day The World Nearly Ended: Have We Learnt Any Lessons?

September 14th, 2008.  The day the that global financial system nearly collapsed under its own strain, the day that the fifth largest bank in the world, ceased to exist.

The day when Lehman Brothers, the fifth largest global financial services firm, was faced with a mass exodus of most of its clients, drastic losses in its stock, devaluation of its assets and an increasingly inward-facing financial market, forcing to file for bankruptcy protection under Chapter 11 of the United States Code.

Since that traumatic date, long, seemingly endless periods of volatility and unpredictability symbolized the global recession, with job cuts, a reduction in consumer spending and falling house prices being the hallmarks of the ‘credit crunch’.

Nevertheless, these periods of depression and desperation have slowly been replaced by cautious optimism and renewed growth in the financial markets and global economies – the loaded ‘green shoots’ term comes into effect here – but, this has arguably occurred only after significant government bailout strategies were hastily drafted into place.

In the wake of Lehman’s collapse, everyone seemed to agree that fundamental change was necessary.  Bailouts largely stabilized the financial system, but it became clear that regulatory reform was needed to prevent a similar crisis from happening again.

President Obama and Prime Minster Gordon Brown have since cautioned that regulators and companies should continue to step lightly as the economy and financial sector recover from the deep lows of 2008 – but evidently, stringent regulation is desperately needed in order to ensure that similar events never happen again.

Stricter rules are needed within respective economies and industries in order to prevent the domino effect if one large firm collapses.  While it may be inevitable that a certain institution collapses, or files for bankruptcy, at some point in the future, the dragging-down of other key organisations must be avoided at all costs.

Equally, as is the key motto in global economics, the overhaul of regulation must be done in a way that does not smother innovation.  Reckless behaviour, unchecked excess and the desire for ‘quick kills’ must all be limited, if not stopped completely, so that the entire banking system realises the consequences of its actions.

Obama and other members of the G8 have reiterated a number of proposals, including a new Consumer Financial Protection Agency, closing loopholes and gaps in the regulatory system, and putting an end to “too big to fail” by creating resolution authority for non-bank financial institutions. Obama also called on foreign economies to join the United States in its regulatory effort for a coordinated response to the financial crisis.  Nicolas Sarkozy, the French President, has even called for a reintroduction of the ‘Tobin Tax’, whereby a levy would be applied to every financial transaction.

The end of the ‘too big to fail’ motto is certainly one that strikes a chord with many executives.  It is widely agreed that regulators and lawmakers needed to impose rules so failing banks could be shut, rather than allowed to operate indefinitely with taxpayer support.

Nevertheless, other lawmakers and regulators have been resistant to some of the changes the administration has proposed. The surprise is not how much has changed in the financial industry, but how little.  Lawmakers have spent most of the last year trying to save the financial industry, rather than transform it.

For instance, Federal Reserve Chairman Ben Bernanke has opposed a new consumer regulator, arguing that it’s the Fed’s job to protect consumers.

Seemingly protected by huge federal and fiscal guarantees, the biggest, most influential banks have restructured only around the edges.  Surprisingly, only a handful of hedge funds have closed; employee salaries and bonuses are, in many instances, returning to pre-crash levels.  Goldman Sachs, for instance, are reported to be giving their workers an average of $700,000 each this year after earning over $3 billion in third quarter (July-September) profits.  This from a highly prestigious, highly trusted bank that was almost ready to fail twelve months ago.

J.P. Morgan, too, have released profits of $3.6 billion for the past quarter.  If anything, the hedge fund arm of this huge retail and investment organisation is performing better than ever before due to a lack of competition from its pusillanimous rivals.

There is an increasing separation from the healthiest and least healthy of the banks, both nationally and internationally, which is only adding to the feeling among the prosperous that there is no need for reform.  In the UK, it is clear that the Royal Bank of Scotland and Lloyds Banking Group are dragging the financial sector down.

These big banks have had their eyes opened, their books exposed.  They have been able to realise the fragility of certain trading and investment strategies before it is too late, with Lehman being the martyr in this particular financial battle.  By pulling back on risk and reducing leverage, the banks argue, there is no need to impose more regulation in the sector.

Yet critics of the industry argue that a reduction in risk will only produce temporary results, without the necessary deep, regulatory changes.  Many note that banks chronically underestimate their risks and must be managed more cautiously and deeply.  The assumption, too, that governments will always prevent major banks from collapsing so the banks can continue to execute risky trades knowing that the taxpayer will soak up any cataclysmic losses – the so-called ‘moral hazard’, or IBG, ‘I’ll Be Gone’ – only adds to the financial excess.

Economists who predicted last year’s fall, purely from noticing the danger of trading unregulated derivatives, warn that if longstanding issues are not addressed, they could cause an even bigger crisis — in years, not decades. Next time, they say, the credit of the United States government may be at risk.

So what else can be done?  A multitude of solutions have been raised, then quashed.

Principally, investors in financial institutions, especially bondholders, must believe that they will lose money if banks fail, but legislation that would allow regulators to close giant institutions in an orderly fashion has been consistently stalled.  So too have efforts to create a systemic regulator that would focus on the broader risk that might occur from the ripple effects caused by the failure of one major bank.

Another proposed change would require banks to list and trade derivatives through a central clearinghouse, just as stocks and options are traded through exchanges, but it has yet to go anywhere.  Requiring that derivatives be traded openly sounds like a relatively small change, but it could have important effects.  Banks could not hide negative equity positions; they would have to put up money as positions moved against them, since derivatives would be sold if they were not backed by adequate margin.  Showing the power of the banking industry, legislation to force derivatives trading onto exchanges has stalled for now, and banks are still writing contracts with limited regulatory oversight.

Reining in banker’s bonuses, another key media theme in the recession, is another colossal headache for lawmakers.  The bankers and the government are seemingly playing a game of cat and mouse, whereby each act of chasing seems to end in calamity rather than success.

Advocates of bonuses claim that it reinforces a healthy attitude in the City, an attitude that will ultimately bring benefits to the national economy as a whole, with many bonus pounds being put directly into the Chancellor’s tax treasure chest.

Nonetheless, the sheer abhorrence of the status quo to observers is clear to see.  George Osbourne, Shadow Chancellor, has suggested a dramatic reform in the shape of retail bankers being tethered to bonuses worth no more than £2k in cash, with the rest in shares.  The insistence of ‘new equity capital’ – i.e. shares in the banker’s own business – is a common theme from all areas of the political spectrum, both nationally and internationally.

Of course, there is scepticism too from the potential implementers of this system.  Many city lawyers have already been approached about the contractual arrangements of such a scheme, but a predicted consequence of any law would be that bankers will have their salaries doubled or trebled.  Once again, this could increase the risk-taking because the link between performance and profitability will be severed.

There are other complications in this proposal.  Employers could be put in a conflicted position, by trying simultaneously to obey the law and meet the contractual obligations to employees.

In the longer term, there are likely to be tax problems on these share handouts, not to mention the distress of existing shareholders as the value of their own shares diluted by these effective gratuitous giveaways.

There are two main streams of thought at work – deferral and clawback – yet no-one is quite sure what these terms would mean in practice, given the complications of remuneration on such a huge scale.  Nevertheless, with such a barrage of criticism levelled at bonuses it is likely that there will be some sort of change in the future, an ordered transparency and target-based structure.

Clearly, the insatiable hunger for profit and individual bonuses juxtaposed with the need for restraint and transparency is a complex puzzle to solve.  Plus it cannot be denied that the sheer power of the world’s biggest banks in determining fiscal policy suggests that there is no end, and no fundamental reform, in sight.  At least for now.

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