A decade ago, in the year 2008 on the 15th of September Lehman Brothers filed for bankruptcy. This bankruptcy was considered as the biggest ever in the history of finance since the company had assets that were worth USD 639 billion and debt of value USD 619 billion. The asset value was way above the other two giants – WorldCom and Enron, which too became bankrupt previously. During the crisis, Lehman happened to be the fourth largest investment bank in the US. It had almost 25,000 employees spread across the globe (Sraders, 2019).
It was figured out that financial innovation was the root cause for the demise of this giant financial institution. During the 1990s, new methods of conversion of assets especially loans to marketable securities had allowed to put together large portfolios of loans and sell a small portion of those. However, there were two aspects that turned things into a financial weapon of mass wrath – the first one was the lack of clarity of expression and the second was uncertain incentives. Apart from the above, there were other factors as well that financial experts claimed were also responsible (in part or in full) like the absence of trust, substandard investments for the long term, unsteady funding and excess leveraging (Sraders, 2019).
One of the prime factors, as pointed by intellectuals, for the downfall of the company was overzealous lending that took place during the period 2003 – 04. The company had decided to take over 5 lending firms that were into sub-prime lending. There was an enormous profit in 2008 of around USD 60 billion. However, this investment turned out to be a very risky one and soon things came crashing down. It was investigated that this financial disaster was due to excessive loan defaults. The situation was so bad that Lehman was over leveraged. At the same time, the worth of the mortgage profile was not an impressive one (Sraders, 2019).
Another concern was the assurance given by the federal government that Lehman was way ‘too big to fail’. If that was true, then the simple question was – if it really happened to be the biggest business house around, then why it wasn’t big enough not to fail.
In the case of Australia, it did not go through a huge economic crisis. However, the speed of economic growth did suffer to an extent. This was evident when the unemployment rate went up considerably followed by a phase of uncertainty. The reasons why the Australian economy was not that much affected as the others were:
* Domestic lending was doing well. The banks of Australia had very less exposure to their US counterparts (Reserve Bank of Australia. 2019).
* The lending comprised of very little of high-risk loans.
* Australian economy was linked to the export of resources to China. China bounced back quickly after the Lehman collapse and so did Australia.
* Also, the APRA (Australian Prudential Regulation Authority) had already adopted conservative measures for the regulation and the supervision of the financial sector like the banks had to cover much of their capital needs through equity. The banks were not allowed to have large trading books nor were they allowed to get into off-balance sheet matters compared to the international institutions (Chadha 2016).
However, the crisis did reveal quite a few limitations in the practices that were followed by the financial institutions and the supervisory agencies. These limitations included:
* Insufficient financial institution holdings and management of liquidity risk.
* Inadequacies in micro-prudential supervision and risk management.
* Under-evaluation of trading banks and financial institutions operation especially those having multiple jurisdictions (Chadha 2016).
The reform agenda primarily constituted a balance between imprudent risk allocation and facilitating adequate risk-taking necessary for the growth of the Australian economy. The reforms centred around four main areas:
- Setting up of robust financial setups especially banks – Banks were not holding sufficient capital to counter the losses that they were taking in spite of meeting the minimum monetary requirements. Introduction of reform measures for strengthening the supervision, regulation and risk management of the banks (Forbes.com. 2019). This basically strengthened the bank’s ability to absorb losses. The minimum capital ratio was also raised. To make the liquidity management of the bank stronger, liquidity coverage ratio was developed so that banks were able to hold adequate liquid assets for a predicted period of one month financial stress.
- Understanding the ‘too big to fail’ syndrome – SIFI (Systematically Important Financial Institutions) to ensure the stability of systematically important banks. SIFI is the last resort in case the viability is threatened by any means by using public funds. Developments in the regulation of SIFI were done to ensure that the chances of their failure are almost nil (Reserve Bank of Australia. 2019).
- Understanding the shadow banking risks – These are non-bank financial intermediaries like finance companies, money market funds, etc. Policy recommendations were introduced to ensure that the regulation of the shadow banks was strengthened. The approach is to dampen the risk while ensuring that there is no effect on non-bank entities that do not pose any risk(Reserve Bank of Australia. 2019).
- Safety of the derivative markets – Amendments were done in the Corporations Act of Australia. This gave the government the authority to implement platform based execution needs, trade reporting or compulsory central clearing. As per this, the concerned minister was authorized to impose a determination that compulsory formalities should apply to a particular class or classes of derivatives (Reserve Bank of Australia, 2019).
Apart from the above, other initiatives were also undertaken like
- Protection of the superannuation fund members, policyholders or depositors so that they don’t encounter any loss or minimum loss as possible.
- Ensure that the stability and the faith of the financial system remain intact.
- Quick resolution of any crisis in an effective and practical way.
- Confirm that the directors, owners or the stakeholders of an affected or failed entity take sufficient responsibility.
- Maintain the required market discipline and ensuring that the fiscal and the economic influence of any financial distress resolution method is least (Reserve Bank of Australia, 2019)
Chadha, P., (2016). What Caused the Failure of Lehman Brothers? Could it have been Prevented? How? Recommendations for Going Forward. International Journal of Accounting Research, s1.
Forbes.com. (2019). Lehman Brothers And The Financial Crisis: What Went Wrong?. [online] Available at: <https://www.forbes.com/sites/miltonezrati/2018/09/17/lehman-and-the-financial-crisis-what-went-wrong/#2423db467790> [Accessed 19 February 2019].
Reserve Bank of Australia. (2019). The Global Financial Crisis | Explainer | Education. [online] Available at: <https://www.rba.gov.au/education/resources/explainers/the-global-financial-crisis.html> [Accessed 19 February 2019].
Reserve Bank of Australia. (2019). The Regulatory Response To The Global Financial Crisis | Submission To The Financial System Inquiry – March 2014 | Financial Sector | Submissions | RBA. [online] Available at: <https://www.rba.gov.au/publications/submissions/financial-sector/financial-system-inquiry-2014-03/regulatory-response-to-the-global-financial-crisis.html> [Accessed 19 February 2019].
Sraders, A., (2019). The Lehman Brothers Collapse And How It’s Changed The Economy Today. [online] TheStreet. Available at: <https://www.thestreet.com/markets/bankruptcy/lehman-brothers-collapse-14703153> [Accessed 19 February 2019].