Lesson of Lehman collapse: maybe we need a new version of the Glass-Steagall Act

16 September, 2009

The media are full of stories marking the first anniversary of the collapse of Lehman Brothers.   This one in the Telegraph  is worth reading, and contains a section which caught my attention (to say the least).

Until Paulson let go of Lehman, the markets implicitly believed that no big bank would be allowed to fail. “All financial assets were priced on the belief that there was a state ‘put’ in the system,”  [Danny Gabay] the former Lehman director says. “After abandoning Lehman, governments had to prove that ‘put’ still existed to restore confidence in markets. The cost of proving it has been $9 trillion.”

Banks had been making vast profits because that $9 trillion guarantee had been effectively granted for nothing. As Pete Hahn, a fellow in finance at Cass Business School, puts it: “In effect, banks have been taking a free profit off society.”

This is the crux of the financial disaster that unfolded: we cannot have banks that are too big or too systemically important to be allowed to fail.  There is a hidden subsidy in that situation that all taxpayers ultimately pay for.  The incentive is for bank executives to take big risks:  if they work, they get huge bonuses; if they don’t, then too bad, Joe Schmoe will pick up the tab for putting the pieces together.

John Gapper covered this issue back in July in the Financial Times.  He criticised George Osborne, the shadow chancellor, for backing down on “a genuine structural reform – the separation of retail banking from investment banking by creating a British version of the 1933 Glass-Steagall Act.”  He went on to write:

……..I have argued here before for some form of Glass-Steagall separation and, if this cannot be done by fiat because the detail is too difficult, then it ought to be engineered through financial incentives…..

….Now, big investment banks not only have economies of scale on their side and an implicit government guarantee that lowers their cost of funding, they are also treated for regulatory capital purposes similarly to smaller and less systemically important banks.

Of course they will carry on ramping up trading and paying their employees handsomely. As Mervyn King, the Bank of England governor, said in a recent speech: “It is not easy to persuade people, especially those who are earning vast sums as a result, that what looks successful in the short run is actually highly risky in the long run.”…

…..The UK Treasury made some half-baked arguments this month about why small institutions can be just as risky as large ones to the system. But our intuition is true: it is necessary to have strict limits on banks deemed “too big to fail”.

Here in Ireland, we would need a different approach to ensure that banks involved in small business and personal lending, as well as running the payment clearing system, are not “betting the shop” in risky big-business lending or investments in derivatives.  But isn’t that what the Financial Regulator is supposed to do?

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