The collapse of Lehman Brothers remains shorthand for the start of the global financial crisis and a period when the foundations of capitalism shook. A decade on the Western financial system is still struggling to move out of the shadow of the events of 15 September 2008.
Political events around the world today are still pegged on the crash a decade ago, while economists are still analysing the shockwaves that came in the aftermath – and the policies that came in response. Yet regulators insist the financial system is now a different, safer place.
Panic on Wall Street
Lehman, a bank with relatively humble origins more than 150 years earlier, had become the fourth largest investment bank in the US by assets by 2007 on the back of a spectacular boom in American mortgages, and the securitisation process.
The bank became one of the pioneers of a business model reliant on making loans and then packaging them together to be sold on as retail mortgage-backed securities. These products were then given top ratings by agencies and hoovered up by investors eager for supposedly safe securities – with the banks holding onto a significant chunk. Yet as the mortgage market soured and default rates on the underlying loans soared Lehman lost the confidence of the market.
We were stunned at the speed it went. The US regulators were genuinely as shocked as we were.
Lehman’s balance sheet was worth $691bn in 2007, of which half was funded by relatively short-term repo transactions (repurchase agreements in which the bank borrows money using US Treasuries as security), according to Adam Tooze in his epic history of the last decade, Crashed. The bank was eventually sunk as other banks refused to lend, draining its liquidity pool at an astonishing rate, with only $1.4bn left on the final Friday before its collapse.
Andy Murfin was a supervisor of US broker-dealers’ UK operations at the now-defunct Financial Services Authority, and now supervises international banks at the Bank of England. “We were stunned at the speed it went,” he says. Earlier in the week, the firm seemed to have sufficient funding but by Thursday it was dead. “The US regulators were genuinely as shocked as we were.”
The collapse when it came was a shock to observers across the world, and also to its employees.
Anil Stocker joined Lehman as a summer intern, before joining full-time as an analyst in a private equity fund investing in mid-market European firms. The bank had a “super-aggressive, high-achieving” culture, says Stocker. The bank’s reliance on short-term funding was not well understood even among its employees, he adds.
The firm carried out an “internal propaganda campaign” as its struggles became clear, with messages in the lifts insisting it was not the next Bear Stearns, an earlier failure, while it continued hiring.
The stunning growth of Lehman and other investment banks “all seemed to be the product of some financial alchemy which everybody just thought would work,” says Emily Reid, a financial services partner at law firm Hogan Lovells. “It was a bit like the emperor’s new clothes.”
The liquidity issue
The Financial Services Authority’s handbook at the time of the crisis had a chapter on liquidity that was yet to be written, but the drying up of lending did not come out of the blue – although it was fatally ignored by policymakers.
Geoff Coppins was one of only five people on the Bank’s financial stability team in 2008, barely two years out of university. Since the collapse of the UK’s Northern Rock under similar strains in 2007 the Bank had been in permanent “crisis management mode”, trying to work out who would be next.
What was becoming apparent was that those things were all related and were going to crystallise as one big risk, not separate risks
“We warned about the reliance on [wholesale funding], but what we did not see was the whole collapse in confidence that followed, or that it would lead to such dislocation in the financial system,” he said. “We spotted the underlying vulnerabilities without necessarily putting all the pieces together.”
When Lehman collapsed the fears were so great that credit essentially dried up in developed markets for weeks, presaging a giant recession.
Sarah Breeden, now executive director for international banks supervision at the Bank of England, remembers discussing six separate risks to the system with a colleague in early 2008, from turmoil in China, the reliance on wholesale funding, and the US subprime mortgage market. “What was becoming apparent was that those things were all related and were going to crystallise as one big risk, not six separate risks,” she says.
The experience of the crisis prompted a new way of thinking about risks to the system, and new institutions in the UK including the Bank’s financial policy committee, which explicitly examines how external shocks will spill over into the British economy.
On the global level it emphasised just how reliant the Western financial order was and still is on the determination of the Federal Reserve and the US government to underwrite it – a worrying thought under an “America First” President and ruling party. The reliance of the financial system on the dollar meant that the Fed had to step in to support banks in the UK and Europe, with massive swaps arranged with the Bank of England and the European Central Bank.
“We knew that the banking system that operated in London was short dollars and might need to borrow dollars from the central bank,” says Breeden, who personally signed the swap contract, arranged within three days of Lehman’s collapse. “We knew the vulnerability and had a plan to think about how to fix it. The only way for us to fix it was for us to lend the dollars, having got the dollars from the Fed. We knew about the vulnerability.”
The British banks
Lehman set off shockwaves through the global system, with the funding sources for banks essentially disappearing overnight. It soon became clear to the British government that the banking system would need extra capital as well to avoid becoming insolvent. £50bn was the number decided on by the Treasury. Royal Bank of Scotland is still 62.4 per cent owned by the government while Lloyds Banking Group only left government ownership last year.
Breeden says: “Until [insolvency] had been taken off the table in October in the UK and in the US in November, you really felt like the world could freeze tomorrow. Banks could stop working tomorrow. The need to make sure that they were there to serve the real economy, you felt it. I certainly did.”
The consequences on both sides of the Atlantic if governments had not pulled off the rescues would have been catastrophic – a Wall Street exec joked to Murfin that had the US not pulled off its rescue “the next time we met we’d be sitting there in blue woad and wolf skins”.
We’ve had 10 years of new rules fighting the Lehman Brothers banking problem, but the world has moved on
Breeden is confident the solvency of the financial system will not be threatened in the same way again.
“We've put more financial resources in the firms to make sure they are better placed to withstand shocks like US subprime and so it shouldn’t cause such catastrophic effects,” she said. Meanwhile, bank ringfencing means regulators are more comfortable with the UK continuing to be a global financial centre, even after standing on the edge of the abyss a decade earlier, because the money of retail customers and smaller businesses will be stored in far less risky arms of the banks.
Fighting the last crisis
While a repeat of the same freeze in wholesale funding a decade ago is thought to be unlikely, many in the City doubt whether we have escaped the possibility of a Lehman-style event in the future.
“We’ve had 10 years of new rules fighting the Lehman Brothers banking problem, but the world has moved on,” says Michael Thomas, a partner at Hogan Lovells. The Bank has said it expects a period of regulatory stability, but rapid innovation, particularly around algorithmic trading, means watchdogs are constantly in catch-up mode. Either way, the lack of punishment for wealthy bankers has played out in the “undermining of popular support” for the institutions which govern our lives, says Thomas. “There are fewer and fewer institutions that people put their trust and faith in.”
Yet genuine progress has been made, says Peter Bevan, global head of regulation at Linklaters. “Regulation became altogether more political,” he says. The Senior Managers Regime has prompted, he believes, a “sea change in organisations in response… an acceptance of those responsibilities”.
The balance of power
And the effects of Lehman are still playing out in unexpected ways which are changing the financial world.
“It gave me the impetus to start my own company,” says Stocker, who founded Marketinvoice, a platform which allows small businesses to sell their invoices to free up working capital.
Nik Storonsky was a trader in Lehman’s London office - playing an online helicopter game with colleagues at 25 Bank Street as they awaited their fate - but he has since gone on to found Revolut, the fast-growing fintech firm which has targeted another part of the traditional banking business model, focusing at first on foreign exchange payments.
“A generation of entrepreneurs rose from the ashes, but were pretty disillusioned with the financial system,” Storonsky says. He joined Credit Suisse after the collapse, where he met Vlad Yatsenko, Revolut’s co-founder and chief technology officer.
“We were both frustrated with the fees charged to send money abroad and launched Revolut in July 2015 as a way to rebuild the industry from the ground up using technology.”
The fintech wave sweeping across the industry may itself be a sign that the ascendancy of Lehman and its ilk is coming to an end, despite the investment banks’ best efforts. Tech firms are seen by the post-Lehman generation as the most glamorous hirers. As tech firms boom, many household name banks are still struggling to escape the inertia of the last decade.
“The big investment banks thought they were so powerful, they lost sight of their customers,” says Stocker, but the “balance of power has shifted”.
What regulators have done since:
Senior Managers Regime: Even Lehman’s chief executive Richard “Dick” Fuld escaped any formal censure for the crisis. In the UK Royal Bank of Scotland’s Fred Goodwin received one of the worst punishments – although all he lost was his knighthood. Under the SMR, British regulators can now hold senior bankers directly responsible for their actions, even if they profess ignorance.
Basel III: The crisis made regulators around the world wake up to the inadequacies of the risk weightings (under the second accord of the Basel committee) used to decide how much capital banks must hold. The updated third round raised capital requirements and also aimed to ensure systemically important banks have adequate long-term funding, rather than relying on shorter-term loans.
Ringfencing: Ending the idea of “too big to fail” has been a key part of post-crisis regulation. An important part of that move in the UK has been ringfencing, a legal separation of personal deposits from the riskier investment banking “casinos” so that government does not have to step in to protect retail customers. The massive operations to complete the splits by 1 January 2019 are still ongoing.
US bank holding companies: Goldman Sachs and Morgan Stanley are two of the iconic investment banks on Wall Street, but until the aftermath of Lehman neither was regulated as a bank. As the liquidity crisis struck the Federal Reserve pushed them to become bank holding companies, allowing access to discount window lending facilities – ensuring they could access the lender of last resort.
Clearing: After Lehman regulators realised the massive and difficult-to-value market in derivatives traded over the counter (OTC). Yet while derivatives have been used by speculators, they also play a key role for firms who need to hedge against exchange rate or interest rate movements. Regulators have tried to push as much of the derivatives market on exchanges as possible, and have introduced rules to make it less attractive to trade outside an exchange – with the upshot that risks are more concentrated.
Bankers’ bonus cap: Public outrage at the size of bankers’ pay led to the introduction of the EU bonus cap in 2014. The UK fought bitterly against the rules, which limit payouts to 200 per cent of salary. The bonus cap has been earmarked for removal after Brexit.