The Lessons from the Bankruptcy of Lehman Brothers

Joint Research Conference of Institute for Banking and Financial History, House of Finance and SAFE on "Lehman - 10 years after" at Goethe University

Lehman Brothers - like no other, the name of the former US investment bank, which filed for bankruptcy in September 2008, is linked to the financial crisis. More than 25,000 employees lost their jobs and bankruptcy cost billions of dollars. Even more serious, however, were the consequences of the bankruptcy: the financial market crisis intensified, global stock prices plummeted, confidence in the markets and among banks was shaken. Why could the bankruptcy of a relatively small bank lead to such consequences? What lessons have been learned from the biggest financial and economic crisis after the Second World War? These questions were the focus of the conference "Lehman - 10 Years After", organized by the Institute for Banking and Financial History (IBF) and the House of Finance together with the Research Center SAFE at the Goethe University in Frankfurt at the beginning of June.

Harold James of Princeton University, who is the visiting professor of financial history at the House of Finance this year, opened the conference with a historical classification of the Lehman bankruptcy. This has shown that even relatively small events can have great effects. In fact, it was not so much the size of Lehman Brothers that was decisive, but rather the legal and financial complexity of the investment bank. This made a reasonable rating impossible in a crisis, James said. In the US and Europe, bankruptcy has been interpreted differently: in the US, the Troubled Asset Relief Program (TARP) has been launched in response to support troubled banks. In Europe, on the other hand, the central conclusion was different: "That is, no insolvency of a Member State could be allowed to develop into a second Lehman Brothers," James said.

The economic historian added that there were three main public narratives about the Lehman bankruptcy. First, the bankruptcy was a so-called "Minsky moment". This phase, named after the economist Hyman P. Minsky, marks the moment of a crisis when lenders reduce their lending so much that even solid money houses get into trouble - a situation that makes state intervention mandatory. Second, the Lehman bankruptcy has always been associated with the Great Depression of the 1930s. The third interpretation, however, points to the geopolitical effect: According to this interpretation, the United States has lost its status as a superpower in the global financial system.

James said that he only agreed with the third view. "The bankruptcy of Lehman Brothers brought with it a huge shift in economic power," James said. Also, the rise of populist movements in many countries is in his view a reaction to the economic and financial crisis. With regard to the United States and the United Kingdom, James said that populists were characterized by a mistrust of experts and the fight against globalisation. "It's about smashing a system they find too complex and dangerous," James said.

Too little financial competence on the supervisory boards

Joerg Rocholl, Professor of Finance and President of the European School of Management and Technology, spoke in his talk about the 2007 subprime crisis as a forerunner of the Lehman bankruptcy. He recalled an agreement between the European Commission and the German Government in 2001, according to which the latter should no longer grant guarantees to the Landesbanken after a transitional period of four years. In fact, this decision had the unintended effect, said Rocholl, that the Landesbanken initially expanded their balance sheet sums, bought bonds from other Landesbanken, and started looking for high-yielding investments. That's how much capital flowed into the US, Rocholl said. At the same time, new, complex financing instruments were created there, which received very good ratings from the rating agencies by a large majority. As a result, the Landesbanken in particular were heavily involved in the US subprime market.

Corporate governance also played a role in the development of the crisis: "There was too little competence in the supervisory boards," said Rocholl. Lehman Brothers, for example, was an example of a board that had a high degree of diversity but little financial expertise. This can also be proven for the Landesbanken, Rocholl said: their Supervisory Board had been significantly worse off with regard to financial competence, as those of private banks. Why the still relatively manageable losses in the US subprime market ultimately caused a historic economic and financial crisis, in the view of Rocholl is related to the fact that it was a debt-driven rather than equity-driven bubble. These would endanger financial stability far more, said Rocholl.

Macro-financial links of great importance

The economic historian Tobias Straumann of the University of Zurich compared in his lecture the Great Depression in the USA from 1929 to 1933 with the economic and financial crisis in continental Europe in the years 2007 to 2012. "The differences between these crises are huge but with a bird´s eye view you can see similarities," Straumann said. In his view, these exist, in particular, in the macrofinancial links between the real economy and the financial sector. In this way, shocks in the financial sector can affect the real economy, and vice versa. "The most important lesson is that macrofinancial linkages matter way more than we thought," said Straumann.

Tamim Bayoumi of the International Monetary Fund then analyzed in his speech the reaction of banking regulation after the economic and financial crisis in the US and the Euro Area. Before the crisis, the banking market in the US had been under-regulated. In the US this was recognized and acted accordingly, for example by stress tests and higher capital requirements. "The post-crisis reforms have delivered," said Bayoumi. As a result, the US banking market shrank, but banks are still very large. With regard to the euro area, he said that mega-banks manipulated their internal risk models before the crisis and thus held less capital than necessary. Today, the leverage ratio is in an acceptable range, but there are still problems, such as the business models of the banks or the sheer size of the banks. Still, too-big-to-fail is a problem. This must be tackled at European level: "The problem is that responsibilities are still at the national level," said Bayoumi.

Aurel Schubert of the European Central Bank spoke about the objectives and activities of post-crisis macroprudential policy, which aims to monitor and secure the stability of the financial system. Schubert recalled that the G20 states have established the Financial Stability Board to make financial players more resilient and solve the too-big-to-fail problem. So far, macroprudential policy has been very active, but above all focused on the banking sector. There are still gaps, for example in the data on real estate markets or the shadow banks. "History will tell if this is enough," said Schubert.