Lehman Brothers Plus Five: Have We Learned from Our Mistakes?
Is the US financial system in better shape today than it was five years ago? Finance professors Victoria Ivashina, David Scharfstein, and Arthur Segel see real progress—but also missed opportunities and more challenges.
In September 2008, Lehman Brothers went under—the largest bankruptcy in American history. But that was just the beginning of the story. What followed was the Great Recession, a gargantuan financial crisis that affected the entire world economy. Five years later, we're wondering if the US financial system is in better shape. Professors Victoria Ivashina, David Scharfstein, and Arthur Segel, all members of the Harvard Business School Finance Unit, examine the current state of affairs.
Is the US financial system in better shape today than it was five years ago? The short answer is yes.
The safety of the financial system depends on financial institutions' risk exposure, their ability to absorb losses, their reliance on short-term wholesale funding, transparency, and understanding the interconnectedness between large financial institutions. In 2008, each one of these points was a source of stress for the system's stability. Today, banks are better capitalized, rely less on short-term wholesale funding, and make available much more detailed information about their portfolios, while the amount of "shadow banking" has shrunk dramatically. In addition, a considerable amount of high-quality research has been done regarding financial stability.
Some of these steps were prompted by regulatory changes—or anticipation of such changes. But perhaps the biggest force in stabilizing the financial system has been greater public scrutiny and market retrenchment from risk-taking activities. However, since market forces were shown to be an unreliable mechanism for ensuring the soundness of the financial system over the long term, there is real pressure for making fundamental changes in the way we deal with the risks embedded in the financial system.
Hence the understandable frustration voiced by many about the slow progress in writing the rules required by the Dodd-Frank Act. That said, we need to be aware not just that 40 percent of rules have been finalized in three years, but that this process involves a delicate balance between not unnecessarily weakening the conditions of credit supply (especially in a slowly recovering economy) and improving the soundness of the financial system. The interaction between regulators and the private sector is a crucial ingredient in getting these rules right, something that is clearly not captured by the hard statistics.
In an environment often eager for simple answers, many reflections surrounding the fifth anniversary of Lehman's collapse suggest that the financial system is riskier today because it is more concentrated. Indeed, there are fewer banks, and asset concentration among the top 100 banks has increased slightly compared to pre-crisis levels. However, the three largest US banks—JP Morgan, Bank of America and Citigroup—represent about the same fraction of these assets that they did before the crisis.
More important, we must acknowledge that we now understand far better (albeit not perfectly) how these institutions affect one another. This expertise—combined with better institutional transparency and the banks' new lower—risk practices-leads to a more stable system than the one that existed five years ago. But for the financial system to be safer five years from now, more substantive actions to fend off the accumulation of systemic risk are both expected and needed.
The financial crisis revealed significant problems in our financial system and its regulation. Five years later, although all these problems haven't been solved, we've made some progress. The Dodd-Frank Act, which was passed by Congress in 2010, created a mechanism to deal with many of them, alongside Basel III the most recent iteration in global banking regulations. Important details of both are still being hammered out.
The most progress has probably been made in enhancing the capital positions of large banking institutions. "Systemically significant" banks are now required to hold an extra layer of capital and undergo regular and more extensive stress tests to see if they can withstand a significant economic and financial downturn.
Banks are also being pushed to rely less on short-term debt financing, an attractive source of funding in good times but an accelerant of financial crises when things go bad. And we're getting closer to adopting a "resolution regime" that could enable regulators to wind down a financial firm without the sort of havoc created by the Lehman failure. None of these reforms is perfect, but they are improvements over where we were five years ago.
Unfortunately, there are other areas in which we've made little or no progress since 2008. Housing finance is still basically a government program, as the government guarantees the lion's share of mortgages through Fannie Mae, Freddie Mac, and the Federal Housing Administration, and the Federal Reserve buys most of the securities guaranteed by these entities. Congress has not yet agreed on a system with a better balance of private and public capital and a set of regulations that will ensure that the excesses of the 2000s aren't repeated.
"Shadow banks"—the non-bank entities such as money market funds, hedge funds, and insurance companies that provide banking-like services—still need more regulatory oversight, given their collective importance to the financial system. For example, recent SEC proposals to reform the regulation of money market funds, which were a major problem during the financial crisis, don't go far enough. [For more details on what I think we should do in these areas, see my paper on housing finance reform with Adi Sunderam and my paper on money market reform with Sam Hanson and Adi Sunderam.]
Many are frustrated with the slow pace of regulatory reform, including President Obama, who recently urged regulators to move things along. Indeed, the pace has been slow. Agencies are understaffed, industry lobbying has been intense, and many of the solutions aren't straightforward. Some reforms are surely not as strong as they should be, and current events in Congress should remind us that risks can escalate beyond the control of even the best regulations. But overall there is progress on the regulatory front, and with more work, we'll end up with a healthier and more robust financial system.
It seems remarkable that we have progressed as far as we have since the crash in 2008. Stocks, which had fallen 59 percent by March 2009, have all but regained full value. Consumer debt as a percentage of disposable income is below eleven percent—the lowest in over 30 years. Home prices are perking up, and the number of home mortgages with negative equity is down. Balance sheets have recovered to their 2007 highs. While the United States represents only 19 percent of the world economy with only 5 percent of the population, we constitute an impressive 49 percent of the world's capital markets.
But the job picture is bleak, with over four million people unemployed for more than 26 weeks. Productivity growth has been negative for four years. Compared to the other ten downturns since World War II, this has also been the slowest recovery by far (by at least 16 months), and we are still shy of our predownturn employment peak by 1.5 million. The levels of inequality in our country are the worst since 1929, and some indicators suggest a lot worse than even then. Real incomes, except for the very rich, have been pathetically stagnant since the 1970s.
We now worry about government-caused asset bubbles. Governments must avoid doing this because asset bubbles benefit virtually no one and harm nearly everyone. Cleaning up the mess is a deadweight cost to society even as it dangerously expands moral hazard. There are no effective tools to deal with asset bubbles after they form, and no regulator wants to act promptly and spoil the fun. Thus the need to avoid them.
No one really knows what the future entails during the Great Unwind. We do know that most likely we will continue to debase our currency to pay down our debts and probably witness higher inflation. We also know that our entitlement policies are unsustainable, that our unfunded pension liabilities take their toll on millions of retired workers, and that those on fixed incomes are being clobbered by artificially low interest rates.
Bank balance sheets are still opaque, and banks are more concentrated than ever. Derivatives, though largely ignored, are somewhat more transparent. Rating agencies, with all their blunders, were left untouched. Between the Dodd-Frank Act and Basel III, capital requirements are getting clearer and higher. And while our financial system is still fragile, it is definitely better. The banks have more capital, are making loans again, and have regained the trust of depositors. Company boards and management are asking more questions.
On the other hand, although we did begin to seriously reregulate both the real and shadow banking sectors with Dodd-Frank, we have failed to execute the new regulations, due largely to a dysfunctional Congress refusing to appropriate the funds needed to write the new rules and have them enforced.
We may have missed the once-in-a-70-year-Kondratiev-cycle opportunity to break up our banks and deconcentrate our risk. We may have also missed the chance to put a much bigger stimulus into the system (one-and-a-half to two times more than we did) to fix our broken infrastructure, fund R&D and basic science, address climate change, pump up growth, and create jobs.
All this must be considered in the context of what's happening around the globe. The good news is that a billion people—mostly in China but also in India and increasingly in Africa—have come out of poverty during the last 20 years. That seems to have created a momentum of its own that over time will create new sources of demand and growth for the future of our ever shrinking world.