Uncharted Territory

October 22, 2009

Lucky we had Lehman’s!

Filed under: Concepts, Credit crisis, Economics, Moral hazard, Regulation — Tim Joslin @ 5:28 pm

So banks are to be forced not only to hold more capital but also to make “living wills” in order to prevent another Lehman’s. Everyone seems to think this is a good idea. The arguments centre around the practicality of the measure.

But was Lehman’s collapse such a bad thing?

Let’s remember that the interbank money markets seized up in August 2007. Lehman’s collapsed in September 2008. It was only then that governments were galvanised into taking decisive action to recapitalise the banks.

What are the counterfactual scenarios?

Well, let’s not spend too long discussing what would have happened had there been no credit crisis at all. Remember that inflationary pressures were building. Oil might now be at $200 and we could be looking at another decade of 1970s style stagflation. Lucky we had all those sub-prime mortgages!

Let’s consider a little more, though, what would have happened had Lehman not collapsed. Maybe the investment banks would still be limping along after a few more ad hoc injections of Middle Eastern capital and a few asset sales. But the interbank money markets would still be dead. And mortgage defaults would have continued and would have continued to have knock-on effects. Likely we’d still have had a recession and banks around the world would be facing secondary losses.

The dominant paradigm suggests some banks should be allowed to fail. Otherwise we run risks of “moral hazard”.

But if lots of smaller banks do fail, as in the 1930s, how do we stop the cascade of bankruptcies? Every failure puts other institutions at risk. Where do you draw the line?

To look at it another way, consider the collective pool of bank shareholders’ capital. Ultimately this risk capital supports lending. Whenever banks collectively start to lose money this pool shrinks. Regardless of the structure of the banking industry. Inevitably positive feedbacks develop as banks reduce lending, in what has been termed the “deleveraging” process, causing further personal bankruptcies or loan defaults and business failures and the need to rein in lending still more…

What happened after Lehman’s was that a number of government steps and some private recapitalisations arrested the deleveraging process after a few months.

The question is how else would this have occurred had Lehman’s not failed? I strongly suspect that we would have had a longer, more drawn-out recession. This would have allowed more time for adverse economic and social consequences, such as protectionist steps and the rise of xenophobic extremist political parties.

I put it to you that we need to retain banks that are too big to fail, so that when they do fail everyone is scared shitless and overcomes the ideological obstacles to radical steps to solve the problem!


I add some codas:

(1) Market lore is that financial crises only bottom out when there is the failure of a systemically important institution. There’s a reason for this. It’s only then that governments take actions they would not previously have contemplated.

(2) We’d all be in a much better place if there were better ways of getting private capital into ailing financial institutions.

(3) We’d all be in a much better place if we abandoned the ridiculous idea that “moral hazard” is best applied to corporate entities. We don’t want any banks (or other public companies for that matter) to fail – because this simply propagates a bankruptcy cascade. What we want is for them to raise additional capital and for the shareholders to fire those responsible for destroying value.

(4) Having observed recent events closely, I’m highly sceptical that mandating banks to hold more capital “in the good times” is going to work. The problem is that no government will relax the capital limits as we head into a crisis. The 2008-9 recession has broken all records. When the next downturn starts, no-one will know how deep it will be. Governments will keep their powder dry and banks will reduce lending to restore their balance sheets. Again.


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