Syndicate content

Ten Years after Lehman: Where are we now?

Asli Demirgüç-Kunt's picture

The tenth anniversary of the collapse of Lehman Brothers is a good opportunity for us all to reflect on the global financial crisis and the lessons we have learned from it. By now, there is widespread agreement that the crisis was caused by excessive risk-taking by financial institutions. There were increases in leverage and risk-taking, which took the form of excessive reliance on wholesale funding, lower lending standards, inaccurate credit ratings, and complex structured instruments. But why did it happen? How could such a crisis originate in the United States, home to arguably the most sophisticated financial system in the world? At the time, my colleagues and I argued incentive conflicts were at the heart of the crisis and identified reforms that would improve incentives by increasing transparency and accountability in the financial industry as well as government. After all, if large, politically powerful institutions regularly expect to be bailed out if they get into trouble, it is understandable that their risk appetite will be much higher than what is socially optimal.

So, where are we now, after ten years of reform? There has been progress in some dimensions: banks have stronger capital positions, and there is emphasis on higher-quality capital. Reliance on wholesale funding instead of deposits has decreased. There is greater oversight of the largest institutions, with stress tests and requirements to submit living wills (resolution plans). Derivative markets are smaller. Bank governance and pay policies have received greater scrutiny.

But much has remained unchanged. The crisis was resolved in a way that bailed out large institutions, which inevitably makes them more willing to risk insolvency in the future—the so-called “moral hazard” problem. Safety nets and deposit insurance coverage expanded in countries all around the world. It is particularly difficult to resolve insolvent banks, especially across borders. This “too-big-to-fail” subsidy not only makes banks more eager to take risk in the future, but also gives them incentives to become larger and more complicated to maximize the subsidy. It is possible to observe in the data how market participants valued this subsidy for large international banks after the crisis, but also by observing simple trends in bank size: From 2005 to 2014, the total asset size of the world’s largest banks increased by more than 40 percent. This greater concentration and market power in the banking sector is likely to be associated with lower levels of systemic stability. Our research also shows “good” corporate governance of large banks—defined in terms of their board composition, compensation, and independence—is associated with higher risk and lower capital in countries with more generous safety nets, to be able to better exploit them. This suggests that well-managed institutions simply take better advantage of the subsidies for excessive risk-taking, further underlining the severity of the problem.

Another unintended effect of the crisis was the populist reaction. While banks were supported in dealing with the excessive risks they took, insolvent households with subprime mortgages received much less support. It is not surprising that many observers place the blame for the populist backlash we see today against globalization, international finance, and big business on the crisis and the way it was resolved.

What about capital regulations? Did we learn the right lessons from the crisis? Partially. Bank capital is important because banks that hold more capital should be able to absorb losses with their own resources, without becoming insolvent or necessitating a bailout with public funds. In addition, by forcing bank owners to have some “skin in the game” minimum capital requirements are expected to counterbalance incentives for the excessive risk-taking that limited liability and safety subsidies generate. However, many banks that were rescued during the crisis were actually in compliance with minimum capital regulations shortly before and even during the crisis.

In our research we see that these regulatory capital requirements set as a proportion of risk exposure were mostly dismissed by market participants at the time of the crisis, since the risk exposures did not reflect actual risk. The stock returns of large banks were actually much more sensitive to a simple leverage ratio than risk-adjusted capital ratios. This highlights an important principle when it comes to regulation: complex regulations are not always better and in fact may lead to manipulation and regulatory arbitrage and are difficult to supervise and enforce, particularly in developing countries where supervisory capacity is lacking. And one size certainly does not fit all. Our recent research shows that greater capital indeed reduces system-wide fragility, and this link is stronger in countries with weaker public and private monitoring of risk. Hence, we would expect developing country banks to hold higher levels of capital to compensate for this weaker monitoring.

Overall, our research supports the view that the emphasis on strengthening capital requirements and introducing leverage ratios was appropriate. But, properly measuring risk-exposure is very difficult, particularly for large and complex organizations, which puts into question the usefulness of emphasizing the risk-weighted concepts of bank capital that remain at the core of Basel regulations. In our next Global Financial Development Report, we are going to explore how new capital regulations have been adopted around the world, drawing upon the latest round of the World Bank Regulation and Supervision Survey currently in the field.

Finally, there are important trends that make it even more challenging to provide effective oversight of banks. Technological change, globalization, and the resulting concentration of market power are making us rethink regulation in banking and industry alike. With the crisis fading from our memories, the industry pressure on regulators to once again reduce transparency and accountability will intensify. The fintech revolution since the crisis has already greatly increased the pace of financial innovation, making it ever more difficult for regulators to catch up with the industry. (For example, Quicken Loans has already become America’s largest home lender, fast expanding mortgage lending for-low income households.) The crisis experience has surely increased the confidence of large banks in their ability to socialize their future losses, making them more creative in seeking new risks. 

We cannot be sure when and how the next crisis will strike, but it surely will. Finance is risky business and crises cannot be eliminated. The ultimate goal of public policy is to minimize the frequency and severity of the crises. This is a difficult task that necessitates incentive reforms, which is difficult precisely because existing defects reflect the political preferences of regulated institutions and other politically powerful market participants.

Sources:

Anginer, D. and A. Demirguc-Kunt, 2018. “Bank Runs and Moral Hazard: A Review of deposit Insurance.” Forthcoming in Oxford Handbook of Banking, Third Edition, A. N. Berger, P. Molyneux, and J.O.S. Wilson editors, Oxford University Press, Oxford.

Anginer, D. and A. Demirguc-Kunt, H. Huizinga and K. Ma. Forthcoming “Corporate Governance of Banks and Financial Stability,” Forthcoming, Journal of Financial Economics.

Anginer, D. and A. Demirguc-Kunt, D. Salvatore Mare. “Bank Capital, Institutional Environment and Systemic Stability,” Forthcoming, Journal of Financial Stability

Anginer, D. and A. Demirguc-Kunt, M. Zu, 2014. "How Does Competition Affect Bank Systemic Risk?," Journal of Financial Intermediation,  23 (1):1-26; Also see blog post on AAF “Is Bank Competition a Threat to Financial Stability” on 4/10/12.

Ayyagari, M., A. Demirguc-Kunt and V. Maksimovic, 2018 “Who are America’s Star Firms?” World Bank Policy Research Paper

Bertay, A., Demirguc-Kunt, A. and H. Huizinga, 2017 “Are Internationally Active Banks Different? Evidence on Bank Performance and Strategy,” World Bank Policy Working Paper

Caprio, G., Demirguc-Kunt, A. and E. Kane, 2010. “The 2007 Meltdown in Structured Securitization: Searching for Lessons, not Scapegoats.”  World Bank Research Observer, 25:125-155.

Demirguc-Kunt, A., E. Detragiache and O. Merrouche, 2013. “Bank Capital: Lessons from the Financial Crisis,” Journal of Money, Banking and Credit, 45(6).

Demirguc-Kunt, A. “Bank Capital Regulations: Learning the Right Lessons from the Crisis.”  Blog post, AAF. 12/17/2010.

World Bank, 2017/2018 “Bankers without Borders” Global Financial Development Report, World Bank. Washington DC.

World Bank, 2019/2020 “Bank Regulation and Supervision – Ten Years after the Crisis” Global Financial Development Report, World Bank. Washington DC. forthcoming

Add new comment