A year after Lehman

The ability to prevent a recurrence is in question

To many, the collapse of Lehman Brothers was the defining moment in the trajectory of the Great Recession. At one level, it demonstrated the malignant force of excessive risk-taking. At another, though, it persuaded a great many people that an economic crisis was at hand and there was no time to lose in initiating a massive response. One year later, there is little question that the bottom of the trough has been reached and a slow crawl out is under way. Massive infusions of liquidity, the shoring up of the balance sheets of fragile financial institutions and, in some cases, fast-acting public spending combined to arrest and eventually reverse the post-Lehman slide. Now, the focus has begun to shift to exit strategies. Beyond that concern, a fundamental concern persists: Has the world learnt enough from the Lehman episode and the broader financial crisis to prevent a recurrence?

The lessons are simple enough on paper. Three kinds of vulnerabilities have been brought to light. First, hopelessly under-capitalised financial institutions were able to invest in assets whose risk was hugely under-estimated and, consequently, underprovided for. Second, this risk was spread through the global financial system in the form of both securitised transactions and credit default swaps. Distributing the risk was, under normal circumstances, a logical way to minimise the vulnerability of individual institutions. But, if it was significantly underestimated, quite obviously, every institution that took an exposure became vulnerable and thereby the risk became magnified, not reduced. Third, when it comes to rescuing failing institutions, it is now obvious that many financial players have grown to a size that makes it difficult for their home governments to save them, even if they want to.

But, will these prove too difficult to act on? The regulatory response to these lessons, as reflected in the G-20 positions, for example, is generally in the right direction. A convergence to common standards of disclosure and a collective emphasis on transparency is not an unrealistic goal. Institutions that have exposures in several countries in any case need to provide their investors with a reasonably comparable picture of their assets. Regulatory emphasis and self-interest may be aligned in this instance. Beyond this, the prospects for concrete regulatory solutions become murky. Risk is difficult to quantify in a dynamic setting in which new asset classes regularly emerge and the combination of assets and geographies grows more complex. If risk cannot be measured, it cannot be hedged against with any sense of comfort. Second, even if risk is quantified, providing efficient ways of hedging against it will be a challenge, particularly in the emerging economies which are becoming increasingly important in global finance. Third, monitoring and setting workable prudential norms for large, global institutions requires an order of cross-country co-ordination which has never been attempted before. The bottom line is that, a year after Lehman, policymakers, law-makers and regulators may have understood what caused the crisis, but are not sure that they can prevent a recurrence.