Learning the lessons of the financial crisis

Five years after the collapse of Lehman Brothers, the Forum:Blog will be publishing a number of personal views by key figures on the event and its implications. The views expressed are those of the author, not necessarily the World Economic Forum. 

As we look back at the causes and consequences of the collapse of Lehman Brothers – an event that was emblematic of a broader failure of large complex financial institutions – we continue to ask questions. What caused the calamity? Did it leave any lasting damage to the financial system? What have we learned about the American political economy from this episode and its aftermath?

Simply speaking, the credit avalanche surrounding Lehman Brothers’ bankruptcy was the result of excessive leverage and the opacity of complex financial instruments. How that leverage and complexity came to fruition was a combination of hubris and “heads-I-win-tails-you-lose” incentives. It was also in large part related to the adverse feedback process in American politics, where making money allows the purchase of favorable legislative and regulatory laxity, which begets more profit and more lobbying and more political intervention.

All of this was made to appear legitimate by so-called “rocket scientists”, who had convinced executives that they knew how to slice and dice and price these complex securities and that their statistical wizardry enabled their portfolios to run on razor-thin safety margins.

The crisis did appear to shake a lot of hubris out of top management about their ability to control market risk. It demystified the experts. As a result, the private sector is in a more sober and cautious posture than it was in late 2007.

Other major concerns were related to the perverse incentives created by the awareness that some large complex financial institutions were too intertwined to resolve. The logic of knowing ex ante that firms cannot be closed down because of the threat of cascading default created a toxic environment where banks deemed too significant to be allowed to fail were afforded funding that was cheaper because it wasn’t priced to reflect the possibility of default.

But cheaper funding enabled these firms to take more risk and leverage. Cheaper funding allowed them to outcompete those firms that had no such conjectural guarantees. Their balance sheets blossomed and their market share increased. The over-the-counter (OTC) derivatives books of the top five banks had this embedded guarantee and as a result they controlled 95% of the derivatives markets.

The lack of progress in the realm of companies deemed “too big to fail”, derivatives regulation and most any other constraint that would hypothetically be placed upon a large complex financial institution is a reflection of the toxic incentives that politicians face in America and around the world. In Europe, the idea of restructuring sovereign debt has fallen behind other adjustments, including the propensity to cut spending in a depression or so-called austerity, in lieu of acknowledging that the existing debt overhang is nearly impossible to overcome.

A close study of the Eurozone crisis also would reveal that it was large-scale distortions in private credit allocation intermediated by European banks that was at the core of the problem. And still, no banking union is forthcoming in Europe. As Andrew Haldane of the Bank of England and the Institute for New Economic Thinking’s Advisory Board has shown, the financiers have been banking on the state in myriad ways, and they do not want to give it up for the sake of systemic integrity or legitimacy.

From the vantage point of five years out, we see a demoralized populous told that big banks are too systemically important to govern or punish. We see little or no progress on TBTF or bringing OTC derivatives out of the dark. We see a rule making process dominated by the lobbyists and lawyers for the financial institutions. And we see money politics still dominating in Washington. This is not a healthy state of affairs.

Looking back five years out, we did, it seems, learn that some of the received wisdom in financial theory was not true. But we have yet to capitalize on these insights. There is still a long way to go.

Read more blogs on Finance.

 Author: Robert Johnson is the Executive Director of the Institute for New Economic Thinking.

Image: A sign for Bank Street and high rise offices are pictured in the financial district Canary Wharf in London October 21, 2010. REUTERS/Luke MacGregor