For All Obama's Talk of Overhaul, the US Has Failed to Wind in Wall Street

What went wrong? Have the right lessons been learned? Could it happen again? The anniversary of the Lehman Brothers' bankruptcy
and the freezing of the credit markets that followed is an occasion for
reflection. I fear that our collective response has been mistaken and
inadequate - that we may just have made matters worse.

The
financial sector would like us to believe that if only the Federal
Reserve and the Treasury had leapt to the rescue of Lehmans all would
have been fine. Sheer nonsense. Lehmans was not a cause but a
consequence: a consequence of flawed lending practices, and of
inadequate oversight by regulators.

Financial markets had lent on
the basis of a bubble - a bubble in large part of their making. They
had incentive structures that encouraged excessive risk-taking and
shortsighted behaviour. And that was no accident. It was the fruit of
vigorous lobbying, which strived equally hard to prevent regulation of
changes in the financial structure, new products like credit default swaps
- which, while supposedly designed to manage risk, actually created it
- and ingenious devices to exploit poor and uninformed borrowers and
investors. The sector may not have made good economic investments, but
its political investments paid off handsomely.

Lehmans was
allowed to fail, we were told at the time, because its failure did not
pose systemic risk. The systemic consequences its failure entailed, of
course, were used as an excuse for the massive bailouts for the banks.
Thus the Lehmans example became at best a scare tactic; at worst it
became an excuse, a tool, to extract as much as possible for the banks
and the bankers that brought the world to the brink of economic ruin.

Had
more thought gone into how to deal with Lehmans, the Treasury and Fed
might have realised that it played an important role in the shadow
banking system, and that it was important to protect the integrity of
the shadow system which had come to play such an important role in the
US and global financial payments system.
But many of Lehmans' activities had no systemic importance. The
administration could have found a path between the false dichotomy of
abandonment or bailout. That would have protected the payments system,
providing the minimum amount of taxpayer money. Shareholders and
long-term bondholders would have been wiped out before any public money
had to be put in.

Bailing out the US banks need not have meant
bailing out the bankers, their shareholders, and bondholders. We could
have kept the banks as ongoing institutions, even if we had played by
the ordinary rules of capitalism which say that when a firm can't meet
its obligations to creditors, the shareholders lose everything.

Unquestionably
we should not have allowed banks to become so big and so intertwined
that their failure would cause a crisis. But the Obama administration
has created a new concept: institutions too big to be resolved, too big
for capital markets to provide the necessary discipline. The perverse
incentives for excessive risk-taking at taxpayers' expense are even
worse with the too-big-to-be-resolved banks than they are at the
too-big-to-fail institutions. We have signed a blank cheque on the
public purse. We have not circumscribed their gambling - indeed, they
have access to funds from the Fed at close to zero interest rates, and
it appears that "trading profits" have (besides "accounting" changes)
become the major source of returns.

Last night Barack Obama
defended his administration's response to the financial crisis, but the
reality is that a year on from Lehmans' collapse, it has failed to take
adequate steps to restrict institutions' size, their risk-taking, and
their interconnectedness. Indeed, it has allowed the big banks to
become even bigger - just as it has failed to stem the flow of
profligate executive bonuses. Obama's call on Wall Street yesterday to
support "the most ambitious overhaul of the financial system since the
Great Depression" is welcome - but the devil, as ever, will be in the
detail.

There remain many institutions willing and able to engage
in gambling, trading and speculation. There is no justification for
this to be done by institutions underwritten by the public. The
implicit guarantee distorts the market, providing them a competitive
advantage and giving rise to a dynamic of ever-increasing size and
concentration. Only their own managerial competence, demonstrated amply
by a few institutions, provides a check on the whole process.

The
Lehmans episode demonstrates that incompetence has a price. That there
would be serious problems in our financial institutions was apparent
since early 2007, with the bursting of the bubble. Self-deception led
those who had allowed the bubble to develop, who had looked the other
way as bad lending practices became routine, to think that the problems
were niche or temporary. But after the fall of Bear Stearns,
with rumours that Lehmans was next, the Fed and the Treasury should
have done a serious job of figuring out how to manage an orderly
shutdown of a large, complex institution; and if they determined that
they lacked adequate legal authority, they should have requested it.

They
appear, remarkably, to have been repeatedly caught off-guard. They
claim in the exigency of the moment they were doing the best they
could. There was no time for thought. And that explains how they veered
from one solution to another: after saying that they did not want to
bail out Lehmans because of a concern about moral hazard, they extended
the government's safety net further than it had ever been. Bear Stearns
extended it to investment banks, and AIG
to all financial institutions. Perhaps they were doing the best they
could at the time; but that is no excuse for not having anticipated the
problems and been better prepared.

Lehman Brothers was a symptom
of a dysfunctional financial system and regulatory failure. It should
have taught us that preventing problems is easier, and certainly less
costly, than dealing with them when they become virtually intractable.