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The Lehman Crisis and the Unfinished Business of Financial Reform

With the collapse of Lehman Brothers in September 2008, a crisis in part driven by derivatives on subprime mortgages, a seemingly obscure sector of the financial market help fuel the worst economic crisis since the Great Depression.

Since the recent financial crisis, governments around the world have massively increased central bank balance sheets using so-called “quantitative easing” techniques and spending billions on bailing out bank and non-bank financial institutions. In the case of Ireland, the crisis brought the government itself to the brink of bankruptcy, with millions having lost their jobs in the context of a recovery that is weak at best. (In several European countries GDP is still at or below the level of 2008.) So what have we learned from the crisis and what should we have learned?

Has the financial sector been radically reformed to prevent similar crises in the future? The answer is no. Reforms have been timid and further watered down by the financial lobby.

Four issues stand out among the long catalogue of necessary reforms.

First, there needs to be strict regulation of the shadow banking sector, which includes hedge funds and offshore financial vehicles, but also more widely used institutions like insurance and money market funds. The modern financial system is so interconnected that regulating banks alone cannot guarantee financial stability. Indeed, Lehman Brothers was an investment bank that had not been part of the deposit insurance scheme or any other government guarantee. Still, its bankruptcy made financial markets freeze in panic. As a consequence several non-bank institutions had to be bailed out (e.g., AIG, an insurance company) and guarantees were extended to money market funds. Financial regulation must adapt to these changes. All large financial institutions have to be subject to oversight and regulation.

Second, banks have not yet been forced to recapitalize. While Basel III is a step in the right direction, the new regulations are completely inadequate, requiring banks to hold just 7% of risk-weighted assets as capital. Even worse, the banks are allowed to determine these risk weights themselves. And as the crisis has shown, they are not particularly good at it.

Effectively banks can get away with holding 3% equity. Moderate changes in asset prices can then push banks into insolvency. Banks should be forced to hold substantially higher capital ratios, say 25%. It is scandalous that banks were allowed to distribute dividends while taxpayers recapitalized them.

Third, institutions that are deemed too big to fail need to be broken up or nationalized. Private institutions of enormous size with an implicit government guarantee cannot be expected to play by the rules. This is an enormous challenge as many of the big banks such as Citigroup, JPMorgan Chase, and HSBC fall in this category. Indeed, this an area where things have become worse since the 2008 crisis, as many of the failed banks have been taken over by other banks, the way Bank of America bought Merrill Lynch or Lloyd’s picked up HBOS.

Finally, one wonders why none of the financial engineers behind the meltdown is facing criminal charges or has gone to jail. In this way, the fallout from the most recent crisis has been different from the U.S. savings and loans crisis of the 1980s, when scores of bankers were put before the courts.

It is not only that the financial industry has embroidered balance sheets and misled the public about asset values. Even more blatantly, a range of criminal activities in the sector has surfaced in recent years. Banks have been involved in aiding money laundering for drug cartels and tax avoidance. As the LIBOR scandal has shown, key monetary indicators have for years been manipulated in the interest of private profits. In the UK, mis-selling of payment protection insurance took place on an industrial scale. The examples go on and on.

Clearly, five years after the beginning of the crisis, serious financial reform still is urgently needed. It is clear that the forces against any such reform are powerful. Only a determined, informed, and broad-based political movement will be able to prevail over these vested interests. But if we want to get our economy back on track, we can’t leave this work unfinished.

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