Five Years After Lehman, We’re Much Safer

Martin Neil Baily and Douglas J. Elliott

It is almost five years since the worst phase of the financial crisis began with the collapse of Lehman Brothers, and the ensuing market panic. We are much safer now, and will be safer still going forward, but this is not the message that the public hears.

It is fashionable and easy to claim that the fundamental risks remain and that the efforts of regulators and politicians are simply rearranging the deckchairs on the Titanic, or perhaps even counter-productive. This ignores how markets and regulation really work and the major improvements that have been made through the Dodd-Frank Act, the Basel III global agreement on capital and liquidity, and safety improvements forced by market participants acting in their own interest.

The most important single improvement is probably the dramatic increase in bank capital. In particular, regulators are now demanding that a bank’s common shareholders fund about a tenth of a big bank’s assets, adjusted for their riskiness, whereas the earlier rules required only 2% be funded by common shareholders. Banks generally employed more common equity than the minimum, but a five-fold increase in required capital is a huge change, and actual levels have risen quite sharply as well. Depositors, and ultimately taxpayers, are further protected by additional forms of capital, such as preferred shares, and by long-term debt that would take losses before them. Higher capital directly adds to safety by providing a buffer to absorb losses, and indirectly helps by reducing the likelihood of market panic that can spread to other institutions and sectors of the economy.

Liquidity has also improved sharply. This is mostly through voluntary market reactions so far, but global agreements that will be incorporated into regulations in the U.S. and elsewhere will ensure that markets do not reduce these buffers significantly if over-optimism strikes. Liquidity is crucial. In the financial crisis, many banks and other financial institutions counted on being able to fund loans and other longer-term investments with cheap, short-term borrowing, relying on financial markets to supply whatever funding was needed. When this approach failed, the Fed and the U.S. Treasury were forced to infuse massive amounts of cash into the markets until the panic eventually subsided.

The Dodd-Frank Act tackled a myriad of other market flaws that were made evident by the crisis. Most derivatives are moving onto exchanges and central clearing houses, where risk is more transparent and can be managed better. Securitization procedures are being improved, although there is more work to do there. Regulatory powers over bank holding companies and affiliates are enhanced, so that the ability to take action against a bank is not stymied by regulatory weakness in regard to the rest of the banking group.

Although there is much talk about how large banks are still too big to fail, a lot of progress has been made on this issue too. The FDIC has developed a plan under which the holding company of a large failing institution is put into bankruptcy or FDIC-supervised resolution, while the subsidiaries are moved to a bridge institution and can continue to operate. The plan is complex and more work is needed on it, especially for banks operating in many countries. But a solution is in sight where large banks are allowed to fail without requiring taxpayer bailouts, and without massive market disruption.

We will certainly not claim that regulatory and market structures are now perfect. They never are and never will be, and we do support further actions, but the economy functions well in the real world despite a myriad of imperfections across many sectors. The point is that the level of safety will be much higher once all the regulations are in place, and the financial system is already quite considerably safer.

Why do many argue that things are no safer? First, there are those who believe that the repeal of Glass-Steagall was a significant factor in the crisis; they call for investment banking to be separated completely from commercial banking. This is impractical in the modern world, where loans and securities offerings are such close substitutes and derivatives have so many useful functions tied to both types of activities. Further, separating the activities may easily increase the risk in the system, not decrease it. Just look at the types of firms that failed spectacularly in the crisis; they were almost all nearly pure investment banks (Bear Stearns and Lehman) or nearly pure lenders (Countrywide, Washington Mutual). The repeal of Glass-Steagall clearly was not a driving force in the recent crisis.

Second, there are those who argue that the “too big to fail” banks were largely responsible for the financial crisis because they had an incentive to take excessive risk. These commentators argue the “moral hazard” problem still applies to large banks, which are able to make money in good times and pass their losses on to taxpayers in bad times. They are skeptical of the FDIC’s plan to deal with large banks if they fail in the future. Concern about moral hazard is legitimate but a striking fact about the financial crisis is how widespread the excessive risk taking was. Both small and mid-sized regional banks took on too much risk. Small banks in Germany bought risky U.S. mortgage-backed securities. Small state-regulated non-bank institutions originated a large proportion of the mortgages that subsequently failed. And recall that the Savings and Loan crisis of the 1980s, which triggered the largest federal bailout prior to the recent crisis, involved many small banks taking excessive risks.

If the big banks had been broken up before the crisis, the resulting smaller banks would all still have faced the same pervasive over-optimism about housing and commercial real estate, the same compensation incentives to take risk and to create overly complex derivative and securitization transactions, and the same federal encouragement to make home loans. For their part, the rating agencies and regulators would have still acted the same way. It is difficult to see why the recent terrible crisis would have been much different in scale.

Further, Dodd-Frank and regulatory changes, especially about capital, offset any remaining economic benefit of large size by forcing big banks to operate in a more expensive and safer manner than smaller institutions.

There is also an argument made that capital levels should be far higher than the recently enhanced levels. The immediate direct effect would indeed be to make the banks safer, but it would also make their loans and other activities much more expensive and would drive activity into the shadow banking sectors where they are less regulated and riskier. Thus, overall risk to the economy could easily increase. We favor higher capital requirements, such as those now going into place, but we believe the economic costs of substantially higher levels than those outweigh the benefits, and very significantly so at the extreme levels sometimes proposed.

All in all, we judge that the changes brought about under Dodd-Frank and Basel III have been substantial and are making the system much safer. We do not support the arguments for additional radical changes, which would be costly to the economy, and likely would not ultimately result in a safer system.  Indeed, financial activities would simply migrate out of regulated institutions to shadow banking or overseas.