The Legacy of Lehman: too big to fail, too small to succeed?

This article is part of our series marking the 10 year anniversary of the collapse of Lehman examining today's issues from the perspective of Lehman and Lehman's legacy.

The financial crisis of 2008-2009 produced a range of initiatives from policymakers around the world determined to ensure that such a crisis could not happen again. A number of these were grouped under the phrase “too big to fail” and the initials TBTF would become one more acronym in the lexicon of lessons learned.

TBTF refers to the systemic risk posed by the threatened failure of a systemically important financial institution. The risk of an institution’s imminent failure leaves public authorities with no option but to bail it out using public funds to avoid financial instability and economic damage.

TBTF effectively enables an institution to hold the taxpayer to ransom. It represents an implicit public subsidy of private enterprise failure. It encourages complacency and it creates an uneven playing field, skewing the allocation of resources from the public purse to the detriment of all but the institutions concerned.

Before the financial crisis, policymakers relied on the concept of constructive ambiguity. The concept was based on the premise that a government should not give any categoric assurance that it would bail out a failing institution. It was believed that the absence of a clear assurance would reduce the moral hazard created by the certainty that a central bank would act as the lender of last resort.

The financial crisis established the limitations of constructive ambiguity. After it, policymakers concluded that certainty was preferable. The measures to be taken to create a regulatory landscape in which a systemically important financial institution would, and could, be allowed to fail without producing systemic disruption or collapse would be a manifestation of their sincerity.

The first tentative steps to address TBTF were taken while the financial crisis raged. The leaders of the G-20 countries met in Washington DC on 14 and 15 November 2008. Only days before the summit, the US Secretary of the Treasury, Hank Paulson, had announced that funds from the Troubled Asset Relief Program would be used to subscribe for equity in several US banks.

The Washington summit was the first occasion on which the leaders of the G-20 had met in person as a group, rather than through their finance ministers. The fact that they did so was due in large part to the efforts of the French President Nicolas Sarkozy and the UK Prime Minister Gordon Brown.

In a press conference at the summit, Gordon Brown (no longer talking about having broken the cycle of boom and bust in the UK) observed that these were extraordinary times and required extraordinary measures. The problems were global and required a global solution. World governments could, and should, provide a lead.

In the declaration issued at the Washington summit, the leaders of the G-20 agreed on the need to stimulate economic growth, reform financial markets, reform the World Bank and the International Monetary Fund (IMF) and reject protectionism.

The political consensus reached in Washington was built on at the London summit in April 2009 and at the Pittsburgh summit which followed it in September of that year.

The leaders’ statement at the Pittsburgh summit expressed an aspirational desire for “growth without cycles of boom and bust and markets that foster responsibility not recklessness.” The leaders made a commitment “to create more powerful tools to hold large global firms to account for the risks they take” and agreed that standards for those firms “should be commensurate with the cost of their failure.”

The design of such tools was entrusted to the Financial Stability Board (FSB), established by the G-20 in April 2009 as the successor to the Financial Stability Forum. The FSB has since taken a leading role in promoting debate and recommending and monitoring the use of the tools.

The tools to tackle TBTF are many and varied. They can, for example, require an institution to hold more capital. They can make it easier for an institution to be resolved in an orderly manner. They can prohibit an institution from conducting certain activities or require them to be conducted from within a ring-fenced group within the larger institution. They can require counterparties to have unique identifiers to enable the more accurate assessment of their liabilities.

The FSB released the Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution in November 2015. The paper was designed to ensure that if a global systemically important bank failed, it had sufficient loss-absorbing and recapitalisation capacity available to implement an orderly resolution that minimised impacts on financial stability, ensured the continuity of critical functions and avoided exposing public funds to loss.

The FSB issued the Key Attributes of Effective Resolution Regimes for Financial Institutions in October 2011. Its aim was to make it possible to resolve a financial institution without severe systemic disruption or exposing taxpayers to the risk of loss, while protecting the firm’s functions that are critical to the financial market or the real economy and ensuring that losses are borne by shareholders and creditors of the failing firm, as they would be in insolvency.

The FSB facilitated a discussion on the desirability of implementing structural reforms based on either the outright prohibition of certain combinations of financial activity (such as the Volcker Rule) or the requirement that certain types of financial activity should be conducted by separately capitalised subsidiaries within larger groups. The policy option was considered in the UK by the Independent Commission on Banking (and subsequently enshrined in the ring-fencing requirements of the Banking Act 2009) and in the EU by the High-level Expert Group on Reforming the Structure of the EU Banking Sector.

The FSB recommended the introduction of a system of global legal entity identifiers to create a common, accurate and comprehensive system for the identification of parties to financial transactions and so improve the quality of financial data, the assessment of micro- and macro-prudential risk and the facilitation of orderly resolution. The FSB took a leading role in advocating such a system before the LEI Regulatory Oversight Committee was established in January 2013.

Much has been done by the FSB, and other policymakers, since the financial crisis but TBTF remains work in progress.

In a statement made in October 2013, Mark Carney (speaking as chairman of the FSB) said that firms and markets were beginning to adjust to authorities’ determination to end TBTF, however, the problem had not yet been solved. In the Global Financial Stability Report of April 2014, the IMF considered the related concept of “too-important-to-fail” and noted that there was still scope for further strengthening of reforms.

The point has been repeated more recently. In July 2017, Mark Carney wrote to the G-20 leaders shortly before the Hamburg summit. He advised that, a decade ago, “many large banks were woefully undercapitalised, with complex business models that relied on the goodwill of the markets and, ultimately, the taxpayers.” He noted that:

“To bring back the discipline of the market and to end the reliance on public funds, the FSB has led work to end too-big-to-fail.”

He referred to the progress made in implementing key standards and guidance but then noted that:

“Despite this progress, there is no room for complacency as substantial work remains to build effective cross-border resolution regimes and to operationalise resolution plans for cross-border firms.”

The ten years since the financial crisis have witnessed an extraordinary regulatory effort to end TBTF but is still too early to say whether the problems associated with it have been resolved.

Progress can be seen very clearly in terms of the loss-absorbing capital that systemically important financial institutions are required to hold; the regimes to facilitate their resolution; the structural reforms that have been made and the steps taken to enable the more accurate assessment of liabilities across complex groups.

The regulatory requirements make systemically important financial institutions less likely to fail and may allow a part to fail without destroying the whole. But, at the same time, many of the banks are bigger than ever, in part due to the consolidation prompted by the financial crisis itself and in part due to the economies of scale required for a globally competitive institution.

Lehman was the exception in the last financial crisis. It was allowed to fail to destroy the complacency that the taxpayer would always come to the rescue. Subsequently, of course, all other banks were rescued. If the same were to happen again, some institutions might still satisfy the TBTF threshold of 2008.

The likelihood is, however, that a decade later, with a series of scandals to look back on, a rise in populism and continued public and political anger, the result may simply be a higher threshold.

For more information on issues raised here, please see our articles on Bank Crisis Management and ResolutionBank Structural Reform and The Global LEI System.  Please note that you will need to be registered with elexica and logged in to view these articles.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.