Column: Five years after Lehman

Madan Sabnavis | Updated: Sep 12 2013, 01:32 IST

The world financial order has opted for better regulation and stronger institutions
Indiscriminate household borrowing supported by banks (through sub-prime lending), with
repackaging from Wall Street (to spread the risk across institutions) after getting a nod from
credit rating agencies in an unregulated environment with tacit political support (as it led to
economic booms), was what constituted the Lehman crisis in 2008. Five years on as the
financial world looks back on September 15, which was more catastrophic than 9/11, are we in
a better state today?
There are ten pictures that meet the eye in the periscope as one looks back on how things have
turned out and how we have moved.
First, the concept of investment banking has changed and it is no longer sexy to be an
investment bank as it is now associated with all kinds of negatives. Several of them have turned
into commercial banks with better regulatory oversight. In fact, a recent estimate drawn on the
market value to book value for two top banksGoldman Sachs and Morgan Stanley show that
this ratio came down from 1.8 times to 1.11 times and 1.4 times to 1.02 times respectively
between the onset of the Lehman crisis and the first week of September 2013. The 12- month
forward EPS delivered a P-E multiple of less than 12 for both of them. Such has been the
moderation.
Second, the world of financial derivatives which came as part of the financial engineering
revolution has been looked at with circumspection. The ABS, MBS, CDO, CDS, etc markets have
all become less prominent than they were at that time when home loans were multiplied
through securitisation. Regulators are putting structures in place before going for them in a big
way.
Third, the regulatory world has moved ahead with Dodd Frank talking of single regulators and
the Volcker rule distinguishing client trading from proprietary positions. This, combined with
the Basel III version where focus is more on liquidity than capital, has meant that the financial
world is more cautious than before. The benefit of the crisis has been that we have started
putting systems in place before the markets.
Fourth, the credit rating agencies did come in for some criticism, and there has been a fresh set
of regulations in place to eschew conflict of interest in their operations. This has been hastened
with the sovereign debt crisis where similar questions have been raised. But more importantly,
the door appears to have been opened up for more rating agencies to join the fray as it has
been felt that oligopolistic structures may not be the best fit in such an industry.
Fifth, the three big names that have been associated with the crisis, who worked towards
saving and then reviving the system have or will move onEuropean Central Bank's (ECB) Jean-
Claude Trichet was succeeded by Mario Draghi, Bank of England's Mervyn King by Mark Carney
and Fed's Ben S Bernanke is likely to be succeeded by either Janet Yellen or Larry Summers.
These were the wise men that could not help the Lehman collapse but worked towards getting
others like AIG, Morgan Stanley, Fannie Mae, etc back on their feet. They will be known more
for their innovative minds and unflinching resolve to ensure that the crisis did not go out of
hand.
Sixth, the fiscal stimulus, which was the solution to the crisis, was pursued everywhere in the
world with mixed success. The USA ran into trouble with the debt levels reaching unsatisfactory
levels which required presidential intervention and came off with a downgrade by a rating
agency. Some of the euro nations which had been inflating their budgets ran into a crisis of
confidence which led to ECB and IMF action as they came close to default status. India had also
inflated its way out of trouble; but now it is believed that we have lost our way somewhere and
whatever was done was just too artificial and at the cost of high inflation which we are not able
to get out of.
Seventh, banks have become much stronger today with a lot of capital being infused across the
world. One estimate says that banks have raised as much as 60% risk-weighted capital in the
last 5 years to ensure that they are back on the prudential path. Clearly, banks have gotten
their bearing right this time. They have also written off a large proportion of their impaired
assets. Curiously, the market estimates that 6 of the largest US banks have become even bigger
today in the last 5 years and the old dilemma of too big to fail continues to haunt us.
Eight, banks have become more conscious of risk which has had unintended consequences.
They are shy to lend if they are not sure of the quality of assets which has put global growth in
jeopardy. Therefore, while liquidity has not been an issue, lending is. Central banks have
lowered interest rates across the world to ensure that lending takes place freely. But banks
have been more worried about their assetson and off the balance sheets.
Nine, following from the earlier point on risk aversion, banks had stopped trusting one another
after the crisis as no one was aware of how rabid the others portfolio was. This compelled the
use of non-conventional measures called quantitative easing which went under different names
such as QE, LTRO, and Abenomics, etc. This was probably the most significant fallout for the
rest of the world because buyback of bonds by the central banks meant more liquidity that was
not put to full use in these countries but invested in the emerging markets in a big way which
helped to spur the economies of the latter. Just while the analysts discussed the decoupling
hypothesis where global growth was largely due to the emerging markets, there has been a
reversal of fortunes with all these countries now under pressure from the fear of a withdrawal
of these programmes.
Last, while the US economic supremacy was questioned in 2007, and capitalism chided for
wanton greed, the cycle seems to have returned to the start with the US economy still calling
the shots. As much as central bankers have argued that domestic monetary policy is based on
local conditions and is not determined by the Fed, any action here has a deep-rooted impact on
such policy framework.
Quite clearly, the world financial order has moved on learning lessons, where the core is on
better regulation and stronger institutions. The easing programmes have had a lot of collateral
effectsboth positive and negativeand would probably be the last of the vestiges of the
sordid episode as we go ahead. Schumpeters creative destruction may have just struck the
right cord here.
The author is chief economist, CARE Ratings.