How Lehman collapse changed the way financial systems are governed globally

Lehman Brothers, a name now used synonymously with everything to do with the financial crisis of 2007-08, has become a watershed in the world of finance. It is significant not only because it turned out to be the only institution which was allowed to fail even as the others were merged or provided support by the US Federal Reserve, but also because the way the financial systems governed changed drastically after its fall.

Four things stand out. First, regulation has become the buzzword and the range of activities outside the banking system has now been regulated in all mature markets. Investment banking in particular, which was the epicenter of the crisis, is no longer unregulated, while the banking systems have come in for closer scrutiny of the central banks. 

Second, BIS has come with Basel-III, which is now focused also on the liquidity of banks. This was not the case earlier; the earlier versions were stuck on capital norms and the accompanying risk weights.

Third, central banks have become more open to stepping in immediately and lowering interest rates and providing recourse through finance, which was one of the blemishes on the Fed in the 1930s, when the action was not taken. The mantra now is that in times of crisis the central bank should provide liquidity and lower interest rates. This also meant that for the first time central banks used unconventional methods to reflate their economies; these were in the form of quantitative easing. In fact, never before had central banks gone outside the realm of government securities as they provided finance against MBS and ABS. This became necessary as there was a major trust deficit where banks and FIs did not trust one another in the market and were not willing to lend.

Lastly, the concept of financial engineering which gained currency in the heyday has no longer the same gleam, as there has been a rising suspicion on the concept of structured products, which are now being closely monitored by central banks to ensure that bubbles are not created.

What has been the result of these so-called waves? The world economy seems to have got back on its feet after a decade and this can be seen from the fact that several central banks have started increasing interest rates after unwinding on the monetary space provided by the buyback of assets programmes. Banks also seem to be better placed under the new umbrella of regulation and now look more resilient than before. Therefore, there is more comfort in the world economy.

In case of India, the Lehman impact has been different. To begin with while we did take pride in the fact that we were not affected by the sub-prime crisis, it was probably due to less global integration as well as conservatism on our side where the concept of securitisation was very much restricted and, more importantly, regulated. To the credit of RBI, the institution has been gradual in its approach which has meant that any new concept that is introduced is not allowed before creating a regulatory structure. That is very important in today’s world. In fact, even in case of cryptocurrency the RBI has not permitted it and has so far been against this concept. This is important because if such products are launched and fail they can engender a crisis. In turn, the cost of correction becomes high and the time taken to revert to an equilibrium exacerbates the pain. Further, in terms of Basel-III, RBI has been ahead of the curve, with the transition being faster for India than what has been prescribed.

Also, on the capital market side, there has been regulation in place on credit rating agencies. That was not so in the US. This is where the Securities and Exchange Board of India (Sebi) has been ahead of the curve. This has ensured that there has been some modicum of insulation received from the regulatory side. It may be recollected that the rating agencies in the west were blamed for the financial crisis as there was an inherent conflict of interest where they gave AAA ratings to all pools of assets which were sold in the CDO market.

Have we slipped anywhere? In the broader sense, yes. Following the financial crisis, we had also gone in for a stimulus on both the monetary and fiscal sides. In retrospect, one might say that we had gone overboard. For one thing, the fiscal deficit had slipped quite sharply and the struggle to get it to 3 per cent of GDP is still on. More serious is the issue of monetary stimulus where there were excessive lending and low interest rates. This went with the theory that the Indian economy, like China, was decoupled from the west and in a superior position – also loosely termed as ‘sweet spot’ with a touch of hubris. This was an egregious fault because the non-performing asset (NPA) issue of today is a creation of excessive lending which went in the range of 20 per cent growth, mainly for infrastructure and heavy industry. Although the reasons for failure were governance issues at the government level, the process of kicking the can and not recognising the NPAs and rechristening them as restructured assets and so on has taken gigantic proportions today. One is still not sure if the worst is over or not as every quarter springs a new surprise.

The main lesson learnt is that whenever there is a boom, central banks need to continuously study and monitor if there is a bubble somewhere in the financial sector. While money, being a means of funding, only facilitates growth, any distortion in the system has cataclysmic effects that are long-lasting and shake the course of future growth. This should be the message that should be taken.

The author is the chief economist, CARE Ratings

Views expressed are his own