Opinion | A look back at the Lehman Brothers’ collapse

The 10th anniversary of the collapse of Lehman Brothers has unleashed a predictable flood of reflections on what caused the crisis, whether it was handled well, and what we have learned from it.

Most of what has been written treads familiar ground, except for one completely original thought from Christine Lagarde, managing director of the International Monetary Fund (IMF), which deserves special mention. She has said that there would have been less reckless risk-taking if there had been more women at the top of financial institutions. As she put it, things may have been different if Lehman Brothers had been Lehman Sisters!

The case for gender balance is strong on its own merits, but the idea that alpha male behaviour promotes risk-taking has deeper implications. It actually suggests gender imbalance in favour of women in risk mitigation areas. Right on Christine.

Did the international community really play much of a role?

When the crisis broke, UK Prime Minister Gordon Brown talked about the need for a “new Bretton Woods”, implying that we needed a new international financial architecture with a restructured IMF. Reform of the international financial architecture was put on the agenda of the new G20 at the summit level.

It is logical to ask how much did the strengthening of the international institutions do to save the world? The short answer is that it did very little. The dominant factor in stabilizing the US financial system was (a) Ben Bernanke’s decision to flood the system with liquidity, keeping interest rates low and (b) the decision of the US Treasury to pump in $800 billion into the system by buying up troubled assets. These decisions were not taken through any international consultation. IMF was not even consulted. Had consultations occurred, there would have been many warnings against moral hazard.

Europe was less willing to fix its banking sector problems. European stress tests were much weaker than in the US and that explains why the European banking system continued to face problems. Continued weaknesses in European banks also explain why the European sovereign debt crisis built up from 2010 onwards. IMF had been strengthened with $500 billion as additional resources, and much of this was used at the time of the Eurozone crisis to assist smaller European countries. However, IMF’s resources were too small to meet the needs of countries like Portugal, Greece, Italy and Spain, etc., and it generally acted in concert with the European Central Bank (ECB). In the end, it was ECB that made the big difference. The system was stabilized only after Mario Draghi, president of ECB, assured markets in 2012 that ECB would “do whatever it takes to save the euro, and believe me it will be enough”.

Reform of the international institutions

Some reforms did take place. There was a quota increase of $500 billion for IMF, and also changes in quota shares, in which the emerging market (EM) countries gained at the expense of Europe. European seats on the IMF board were reduced by two, to give greater representation to EMs. These were steps in the right direction. However, there was no change in one important dimension.

The US retained its 16% vote share, which enables it to veto structural changes, which under the articles, require a super majority of 85%. For one country to be able to veto changes is not reasonable. A real reform would be to reduce the super majority required for structural change to say 75%. However, this requires an 85% vote at present, which can only happen if the US agrees!

The conversion of the financial stability forum into a more permanent Financial Stability Board (FSB), on which all the important EM countries including India, are represented, was an important change for the good. FSB is only a consultative body, in which central bank governors and senior finance officials meet to review developments in financial regulation and reach broad agreements, which are then pursued in the sectorally relevant fora. Membership gives us an opportunity to have our views heard, and equally important, to hear the views of others.

Financial regulation

A good deal has happened in this area. Banks are much better capitalized, thanks to Basle III, and there is better prudential oversight on leverage in the system. There is also greater understanding of the importance of building capital buffers, though how that will operate in practice is not clear. However, some important areas have seen very little progress. The “too big to fail” problem is still with us, and the system is as dominated as it was earlier by the big institutions. Cross-border resolution also remains an area with little progress. The incentive problems facing the credit rating agencies, which depend on the fees of those they rate, remains unresolved.

The new regulations have implications for India. Basle III capital adequacy norms were scheduled to be put in place by March 2017, but was postponed to March 2019. This date is likely to pose problems for our public sector banks, which are burdened by large non-performing assets (NPAs). Making provisions for these NPAs will lead to capital erosion. The full extent of the capital shortfall as of March 2019 is not known, but it will be substantial.

Since the government is not willing to let the government equity go below 50%, it will have to choose between (a) contributing the capital needed to meet capital adequacy norms from the budget, or (b) accept the triggering of prompt corrective action provisions by the Reserve Bank of India (RBI), which would restrict the expansion of commercial lending. There is always the option of regulatory forbearance, but this has a reputational risk for RBI. We will be carefully watched to see what actions we take and continued postponement of compliance will erode credibility. A clearer statement of intent will help, especially since it will be difficult to make announcements nearer March, when the election will be round the corner.

Accountability

An interesting feature of the 2008 crisis was that no one was held criminally responsible even though the excessive risk-taking and imprudent behaviour led to enormous losses and pain, especially for those in the lower and middle rungs of the income ladder. IMF’s Lagarde has said that rising inequality combined with the complete absence of punishment, have led to a loss of trust in expertise, and a general discrediting of the elite, leading to the rise of populism. I am not sure whether punishment would have made a big difference. The economic trends were probably sufficient to trigger a populist upsurge. There is no doubt that there has been an upsurge of aggressive, nationalistic populism in many countries and it certainly weakens the commitment to multilateral action. We can see evidence of that in the area of trade.

The problem of accountability in banking is very relevant in India, in the context of the build-up of NPAs in public sector banks. Some of these NPAs were undoubtedly due to fraud, with or without collaboration of the banks, and these should be pursued, to their logical legal end. However, as Raghuram Rajan has pointed out, not all NPAs are due to fraud and criminal collusion. Many are due to poor banking practice. This means criminal prosecution is not appropriate, but accountability still needs to be fixed.

It has been said that public sector banks were simply not equipped to undertake project financing. We need to know whether this was indeed so. Were managements not aware of this and was this issue ever flagged to the boards? The boards have representatives of both RBI and the finance ministry. Did they ever raise these questions? They must have been aware of market gossip about imprudent lending.

Most importantly, what are we planning to do to overcome this weakness? If public sector banks are going to remain in the public sector, we need to consider how these problems will be avoided in future.

Can we be sure there won’t be another crisis?

The history of the financial sector shows that crises occur with surprising regularity. This means we can be sure there will be another crisis. However, the chances are that it won’t be the same sort of crisis because if it is, it will be caught much sooner. The financial press is full of dire warnings about the extraordinary build-up of total (government plus households plus corporate) debt in many countries. We need to anticipate whether this build-up of debt could morph into a crisis, and how it might affect India. Even if it does not lead to a crisis, an orderly deleveraging will have a strong deflationary effect. We need to consider how that might affect India. These are issues the G20 should examine and we should do our own homework on them.

Montek Singh Ahluwalia was the deputy chairman of erstwhile Planning Commission.

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