Another Lehman will come — and should fail too

September 14, 2010

The blind self-belief of financiers can’t be abolished. Neither can cycles in the industry. But two years after the disastrous failure of Lehman Brothers, regulatory shifts have the potential to reduce the impact of a repeat. The challenge for politicians and watchdogs is not to go soft.

That’s what happened before. A munificent Federal Reserve helped stoke a leverage bubble that masqueraded as “the Great Moderation.” Meanwhile, financial regulators of all stripes dozed off, encouraged by lawmakers too cozy with Big Finance.

Then there was the costly bust. The swing of the pendulum from greed to fear has produced useful results. One is an effort to create powers for the orderly closure of a firm like Lehman. Tougher capital standards, imposed by market forces and regulators alike, also make sense. New rules and greater scrutiny for the over-the-counter derivatives market, one source of the interconnectedness that made Lehman’s failure so painful over and above its size, were overdue, too.

Yet supervisors didn’t use their already existent powers energetically enough to crimp the activities of institutions later deemed too big to fail. For all the Basel III talk of building capital buffers in good times, today’s response to the financial crisis — not to mention what little penitence there is on the part of banks — looks pro-cyclical.

Only the next Lehman will show whether lessons have been learned. Restructured bank pay mechanisms could make excessive risk slightly less rewarding, but bankers won’t stop their boundless quest for riches. If Son of Lehman has more capital and a better match between its assets and liabilities, failure will be less likely. And if financial euthanasia becomes an option as intended, the repercussions won’t spread as far.

But authorities must remain vigilant and skeptical, over and above enforcing new rules. After all, in mid-2008, Lehman would have comfortably exceeded new Basel III capital standards.

The Fed will have to lead the way. Invested with more supervisory clout than ever, it needs to show a clear willingness to shutter failing institutions, even if it means eliminating perceived major providers of liquidity. For watchdogs insulated thinly, at best, from politics, this will be the real test. Flunking will only confirm the morally hazardous idea that the government, armed with taxpayers’ money, will always blink first.

One comment

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Isn’t this why we have Audit boards and external auditors to review and report on the financial health of banks and companies they audit.

Why were auditors not taken to task for obvious oversight.

What possible use do auditors have when their opinion cannot be counted on or even believed.

Posted by tradingdaze | Report as abusive