10 big changes since Lehman

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.

Lehman was the bank which, contrary to expectations, the authorities let fail - the exception that proved to rule. Pretty much every other bank survived only with the assistance of some form of state aid or bail out and a decade of quantitative easing and artificially low interest rates has followed.

If Lehman was “let go” to show that the taxpayer would not always ride to the rescue, those that made that decision also provided the central narrative for the crisis, the story that would provide the images, film scripts, plays and the morality tale on which we have had ten years to reflect.

Anniversaries of traumatic events and disasters are moments for remembrance and reflection – a short moment to recall what ten years of change have been designed to avoid and to reflect on whether enough has been done and on how close we might be to repeating the mistakes of the past.

In this and five more detailed articles we look to pay heed to the lesson of Lehman, remind ourselves why change is still being made are so important and take stock as to just how much progress has and has not been made.

More regulators

The financial crisis and the collapse of Lehman led to a wholesale re-examination of the structure of the financial system, its operation and regulation around the world. The broad consensus was that failures and complacencies in regulation and regulators had played a significant role.

HM Treasury concluded that the financial crisis revealed a number of serious deficiencies in the UK’s regulatory system. In particular, it suggested:

  • “the monolithic financial regulator, the Financial Services Authority, had too broad a remit and insufficient focus to identify and tackle issues early and it relied too heavily on a ‘tick box’ approach to regulation
  • the Bank of England did not have the tools or levers to fulfil its responsibility for ensuring financial stability
  • the Treasury had responsibility for maintaining the institutional framework but no clear responsibility for dealing with a crisis which put public funds at risk, and
  • no single institution had the responsibility or authority to monitor the system as a whole, to identify risks to financial stability and act decisively to tackle them.”

The then Coalition Government replaced the old Tripartite system with a new one based on the twin peaks theory - a reference to the separation of prudential and conduct regulation. The new system saw the FSA replaced by a new prudential regulator, the Prudential Regulation Authority (PRA) established as a subsidiary of the Bank of England and a new conduct-of-business regulator, the Financial Conduct Authority (FCA) to focus on ensuring confidence in wholesale and retail financial markets and delivering better levels of protection to consumers. A new Financial Policy Committee was established within the Bank of England tasked with “identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.”

The EU also overhauled its system in the wake of the crisis and, in the process, created the European Supervisory Authorities (ESAs) and the European Systemic Risk Board (ESRB). The ESRB oversees the financial system as a whole and coordinates EU policies for financial stability. Its stated objective is to prevent and mitigate systemic financial stability risk in the European Union in the light of macro-economic developments.

There are three ESAs - the European Securities and Markets Authority (ESMA) based in Paris, the European Banking Authority (EBA) currently based in London and the European Insurance and Occupational Pensions Authority (EIOPA) based in Frankfurt). These now supervise and provide regulatory guidance for individual sectors and institutions.

There has also been a concerted programme of regulatory reform by other governments and financial authorities around the world. Much of this programme has involved internationally coordinated work – for example, through negotiations in the Basel Committee on new capital requirements for banks, or the Financial Stability Board’s work on cross-border crisis management and recovery and resolution plans. These initiatives, and others, are covered in more detail below.

Cultural change

If the taxpayer is going to underwrite bank failure, the taxpayer is entitled to expect far higher standards from its bankers and it is entitled to expect that those that fail to meet the standards will be held to account. In 1929 rich bankers lost all their money and some took their own lives. In 2008 some rich bankers lost their jobs, some lost a lot of money but, by and large, the richest stayed rich. Very few were held to account. The perception was that while the massive profits to be earned had been privatised for the benefit of those in the financial sector when things went wrong, it turned out that failure and its consequences were still nationalised for us all to share.

A lack of individual accountability and poor culture were viewed as key drivers in the collapse of Lehman Brothers, the financial crisis and also the conduct scandals that followed such as LIBOR and FX. Measures have followed designed to help address those shortcomings; the Senior Managers and Certification Regime (SM&CR), whistleblowing regimes and a focus on culture. The aim is that individuals take responsibility and accept accountability and that firms and individuals are aware of the need to comply with the spirit as well as the letter of the rules.

The cultural change agenda will take at least another ten years. It is to be hoped that its success or otherwise will only be truly tested once the Lehman veterans' generation has largely retired, though the chances are that such a test will come sooner than that. There are two distinct benefits of improved culture: the first is that the chances of bad, short term, profit focussed behaviours such as were seen in the US sub-prime mortgage market building the kind of problems for the financial system as a whole will be reduced, the second is that when problems arise, because confidence in behaviours and standards will be higher, “fear and contagion” will not be able to have anything like the same severity.

Both the SM&CR and whistleblowing regimes appear to have made significant steps in terms of addressing the question of who may be held to account: the SM&CR clarifies which senior managers are responsible for failings while whistleblowing is intended to defuse the concealment of failings. However, neither measure has moved the position forward significantly in terms of what behaviours trigger enforcement action: individuals and firms are still grappling with the nebulous concepts of “reasonableness”, “culture” and “tone from the top” when deciding how to act.

Whether the measures can overcome this uncertainty and prevent the next Lehman Brothers-like crisis will only become clearer when truly tested. Nevertheless, both measures are looking to achieve fundamental shifts in culture and behaviour intended to have an impact for years to come and to restore reputations in the sector.

Further discussion of this issue can be found in our dedicated article here.


The issues of remuneration and incentives are closely linked to culture and individual accountability, particularly in the minds of the public. The crisis, led directly to intense public scrutiny of executive remuneration and incentive arrangements, largely due to concerns that remuneration arrangements encouraged the excessive risk-taking which led to the crisis and that the previous culture rewarded failure. Since then, we have seen extensive reform and an increasing body of regulation, in the financial services sector, governing remuneration and incentives.

The UK regulatory authorities, the FSA and subsequently the FCA and PRA, responded to the banking crisis by implementing remuneration rules regarding the arrangements that firms can offer to their employees. The FSA published the original Remuneration Code on 01 January 2010, setting out the standards firms were required to meet when setting pay and bonuses. Since then, there have been ongoing changes at a domestic and European level, driven by European Directives including (among others) CRD III and IV and the Alternative Investment Fund Managers Directive (AIFMD). These developments have also led to differences across jurisdictions.

There are now no less than seven Remuneration Codes in the UK, tailored to different types of firm and which apply proportionality regimes, as well as supplemental UK and European guidance. The aim of the Codes in the UK is to ensure greater alignment between risk and individual reward, discourage excessive risk-taking and ensure that remuneration policies and practices are consistent with effective risk management.

There has been a significant impact on UK firms. The rules expect firms to identify those who are material risk takers and “code staff”, in relation to whom specific obligations under the remuneration codes apply. There are restrictions regarding bonuses, guarantees, termination payments, and in particular, the “bonus cap” requiring firms to set appropriate ratios between fixed and variable pay (usually up to one year’s pay without express shareholder approval). There are further requirements in relation to deferral, malus, and clawback - all PRA-authorised firms are required to make reasonable efforts to recover vested remuneration if there is reasonable evidence of misbehaviour, material error or a material failure of risk management.

With effect from January this year, MiFID II (a new EU Directive which replaced the original Markets in Financial Instruments Directive) introduced new remuneration rules applicable to investment firms. MIFID II imposes specific requirements including that firms must appoint management bodies to oversee remuneration policies, take steps to identify and prevent conflicts of interest arising from remuneration structures, and that variable remuneration must be paid by reference to a balanced scoreboard which includes quantitative and qualitive criteria.

The Financial Reporting Council set out its best practice recommendations for executive remuneration and incentives for listed companies in the UK Corporate Governance Code. There are now three versions of the Code: 2014, 2016 and the most recent being published in July 2018 (which will apply from January 2019). The Code makes numerous recommendations including that remuneration committees should determine an appropriate balance between fixed and performance-related remuneration, all bonus schemes should contain clawback provisions, and that long-term incentive schemes should be phased. Whilst the Code has quasi-voluntary status, companies are required to explain how they have applied it in their annual report.

“Too big to fail”

The financial crisis 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 so as to avoid financial instability and economic damage. It effectively enables an institution to hold the taxpayer to ransom. It represents an implicit public subsidy of private enterprise failure and it encourages complacency and 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 ten years since the financial crisis have witnessed an extraordinary regulatory effort to end TBTF led in large measure by the G20 and the Financial Stability Board which it established in 2009 as the successor to the Financial Stability Forum. The FSB itself has noted that despite much progress a substantial amount remains to be done to build effective cross border resolution regimes. It is therefore still too early to say whether the problems associated with it have been resolved.

Further discussion of these issues can be found in our dedicated article here.

Regulatory capital and capital adequacy

It was perhaps bad luck that the implementation of Basel II coincided very roughly with the start of the financial crisis in 2007 and, as might be expected, the financial crisis spurred the development of further amendments to the Basel capital standards. Basel II.5 was agreed in 2009 and the initial Basel III reforms followed soon after in 2010. The completion of Basel III took a little longer - the final set of amendments was only agreed in December last year.

One of the key changes introduced by Basel III was to improve the quality and quantity of capital. Although overall capital remained at 8% of risk-weighted assets, the Common Equity Tier 1 and the Tier 1 capital ratios were increased to 4.5% and 6% respectively and Tier 3 was abolished completely. Basel 3 also introduced a series of capital buffers, which are extra layers of capital above the minimum capital requirements. The capital conservation buffer has been set at 2.5% and the countercyclical capital buffer is designed to vary so that it reflects the credit cycle and the risks due to excess credit growth. In acknowledgment of the fact that the models used to risk weight assets may not always assess risk appropriately, Basel III also introduces a backstop measure called the leverage ratio, which is the ratio of Common Equity Tier 1 capital to (unweighted) on- and off-balance sheet exposures.

At the time it failed during the crisis, Northern Rock had one of the highest capital ratios in the UK, and this serves as a reminder that bank funding is just as important as capital. Basel III therefore introduced measures to ensure banks maintain sufficient liquidity. The Liquidity Coverage Ratio is designed to ensure that banks have sufficient short term funding and the Net Stable Funding Ratio is focussed on long term, stable funding.

Risk assessment and coverage have also been improved. The internal models approach to market risk in the trading book now includes a requirement to calculate stressed-value-at-risk as well as value-at-risk, and the capital treatment of securitisation positions in the trading book has been revised so it is more consistent with the banking book. Banks must now hold capital for credit valuation adjustment (CVA) risk and amendments to the capital requirements for positions in OTC derivatives work with reforms to clearing to incentivise central clearing. In parallel with these developments, credit rating agencies (which, according to some played a significant role in the crisis) are now subject to authorisation and regulation at an EU level, with a view to improving the quality of the credit ratings used as inputs into the standardised approaches to assessing credit risk in the banking book.

Basel III has been implemented in the EU by the CRD IV package of legislation (with some tweaks). Further amendments to CRD IV are currently progressing through the EU legislative process in the form of the CRD V/CRR II package, as are the Commission proposals to create a dedicated prudential regime for investment firms. The Commission is reportedly considering the December 2017 amendments to the Basel standards with a view to making further amendments (presumably CRD VI). Ten years after the financial crisis, the development of prudential regulation looks set to continue apace.


The collapse of Lehman tested to the limit the durability of the financial system in all major financial centres. In the UK, Lehman’s counterparties were unclear as to whether over 840,000 trades would go on to settle, while clients had more than $35bn in cash and assets tied up in the insolvent estate. The impacts on both market confidence and financial stability were severe.

A number of central counterparties (CCPs) and market participants reportedly started developing solutions to enable trades to continue to settle after the failure of a clearing member, but this was put on a legislative footing in 2012 by the European Market Infrastructure Regulation (EMIR). EMIR requires CCPs to be authorised (if based in the EU) or recognised (if based outside the EU). As a minimum, CCPs and clearing members are required to offer clients the choice between omnibus accounts and individually segregated accounts. The difference is that omnibus accounts hold positions and margin relating to a group of clients (which are therefore commingled) whereas individually segregated accounts hold positions and margin relating to just a single client. Since a clearing member acting on a principal-to-principal basis will receive margin from its clients on a gross basis but can (if it wants) post margin to the CCP on a net basis, an omnibus account operating on a net basis will be cheaper for a clearing member to operate but will offer clients less protection. EMIR requires CCPs and clearing members to disclose publicly the levels of protection and the costs associated with different types of account.

A CCP must have default rules which enable it to transfer client positions and margin from a defaulting clearing member to another clearing member. This is intended to avoid the problem which arose on the failure of Lehman for the 840,000 outstanding trades.

The hope in the future is that a CCP could, so far as practically possible, transfer outstanding trades with a defaulting clearing member to other, financially viable, clearing members and thereby insulate the markets from the default. Implementing these reforms in the UK required quite intricate amendments to Part 7 of the Companies Act 1989 and the Financial Markets and Insolvency (Settlement Finality) Regulations 1999.

When coupled with reforms made by EMIR to require certain classes of OTC derivatives to be cleared, the systemic impact of a failure of a large investment firm is now reduced. The downside, however, is that the systemic impact of a CCP failure is increased, and this has been the subject of a separate set of reforms.


Although not triggered directly by Lehman’s collapse, the increased regulatory scrutiny it heralded arguably brought other conduct-related issues to light, including the rigging of benchmarks. Since the collapse there have been significant changes to the regulation of indices and benchmarks in the UK and Europe more widely. These changes followed in the wake of concerns about the integrity and accuracy of the benchmarks used by the financial markets and, in particular, the manipulation of interest rate benchmarks such as the London Interbank Offered Rate (LIBOR). These concerns led to regulators investigating, from 2009 onwards, the manipulation of LIBOR and other benchmarks.

The UK’s response to these concerns was to the launch the ‘Wheatley Review’ , out of which, following one of the report’s key recommendations, came the first wave of benchmark related regulation in the UK. Specifically, Wheatley recommended a comprehensive reform of LIBOR under which there should be a statutory regulation of, administration of, and submission to, LIBOR. In 2012, following the Wheatley Review, the UK government used the Financial Services Act 2012 to create a new regime for the regulation of benchmark-related activities, among other significant regulatory changes. So, on 02 April 2013, the UK saw the introduction of new regulated activities relating to certain specified benchmarks. The list of specified benchmarks was later expanded upon to include a total list of eight specified benchmarks, which included LIBOR and Sterling Overnight Index Average (SONIA), amongst others.

The next, significant change, came in the form of the EU Benchmarks Regulation (the “BMR”) , which, with some exceptions, has applied since 01 January 2018. At a European level, the BMR seeks to address the concerns about the integrity and accuracy of benchmarks by way of broad application to market participants in respect of either the provision, contribution of input data, or use of, benchmarks. Whilst the BMR, as a regulation, has direct effect in the UK, The Financial Services and Markets Act 2000 (Benchmarks) Regulations (SI 2018/135) (the “UK Benchmark Regulations”) give effect to the BMR by making the activity of administering a benchmark a regulated activity and designating the FCA for the purposes of the BMR. For the time being, until the end of the BMR’s transitional period on 01 May 2020, the UK Benchmark Regulations provide for a dual regulatory regime. From 01 May 2020, the new specified activity of administering a benchmark will then become the sole regulated activity in relation to benchmarks.

The protection of consumers

The financial crisis which followed the Lehman collapse triggered a tsunami of litigation brought by consumers against financial institutions and, unsurprisingly, led regulators to impose a raft of changes aimed at better protecting consumers.

Tens of thousands of retail investors globally held over £1bn of investments in products issued by Lehman Brothers on 15 September 2008. When Lehman filed for bankruptcy, those products ceased providing an income stream and seemed likely to be worthless. Ten years on, the question we are asking ourselves is have all the changes intended to better protect consumers worked?

We will only really know the answer to that when the next seismic market event hits us. However, to borrow from the thematic findings in the FICC Markets Standards Board paper on “Misconduct patterns in financial markets” (published in July 2018) there are a limited number of repeat behavioural patterns, they are jurisdictionally and geographically neutral, they occur across asset classes and they adapt to new technology and market structures. So perhaps we should not be too optimistic.

The Lehman legacy from a consumer protection stand point could perhaps be described as leaving behind a regulator which is seeking to intervene more often, in more ways and earlier in the process, which must be a good thing. However, what may be the real hero of the hour is the FCA’s cultural revolution and its focus, as Andrew Bailey (FCA CEO) stated earlier this year, on the “simple concept” of “individual responsibility and accountability”. Of all of the post-Lehman changes this is the one which goes to the heart of what financial service firms are and stand for, and should ensure that the majority of consumers in the future will have a much more positive experience of the financial services industry.

Further discussion of these issue can be found in our dedicated article here.

Crime and punishment

In the wake of the crisis there was a widespread (and largely unsatisfied) public demand for scalps – the criminal prosecution of those considered responsible. Since then there has been a proliferation of instruments available to prosecutors dealing with economic crime including significant changes to the market abuse and money laundering regimes and the introduction of failure to prevent offences. Financial institutions’ exposure to criminal liability has increased commensurately.

However, it is still not clear that the criminal law has expanded sufficiently in order to capture some of the conduct of financial markets participants subsequently regarded by many as criminal. Despite the public outcry, there have been very few successful prosecutions in the financial services industry in the decade since Lehman fell. It is not altogether clear that the laws introduced to date would have markedly changed that reality. Even though compliance burdens have increased, hopefully making the system safer in the process, it remains very difficult to prosecute large, complex companies of any kind or their senior employees for economic crimes of the type revealed by the financial crisis which are carried out in the course of their business.

For that reason there remains considerable impetus behind further reform - perhaps the introduction of a general “failure to prevent economic crime” offence, though that proposition has a number of disadvantageous elements. There is a perception amongst many that, in the absence of such sweeping provisions, it will remain very difficult to prosecute a company on the basis of supposed criminal wrongdoing of the sort revealed by the crisis.

Moreover, there is a significant risk that the spotlight placed on financial services in the last decade has dimmed the focus placed on other, growing areas of criminal conduct that are not so well accounted for. Most significant of all may be the increasing importance, and vulnerability, of data in the modern economy where cybercrime has become the most prevalent and damaging type of fraud in the UK.

Further discussion of these issues can be found in our dedicated article here.

Not quite so bust after all

If you could step Alice in Wonderland - like through a mirror from September 2008 to September 2018 an awful lot might feel back-to-front. Lehman had been too bust to save and Lehman debt in the UK was trading at cents in the dollar, a shortfall to unsecured creditors in the administration of Lehman Brothers Europe International (“LBIE”) was generally considered inevitable.

Ten years later on, LBIE has repaid all its creditors 100% and the debate has been as to the entitlements to the $7 to $8bn surplus. LBIE debt turns out to have been one of the best performing assets of the last decade and the rewards for those that identified the opportunity early and bought LBIE debt in the secondary market before the scale of creditor recoveries became clear must have had their wildest expectations exceeded. Of course, had the FSA, the Bank of England and PWC known in September 2008 about LBIE and its assets and liabilities what we now know, then the story would have unfolded very differently, much less dramatically and far quicker. If the reforms of the last ten years achieve only one thing: reducing the fear that prompted contagion, that could make all the difference.

Further discussion of these issues can be found in our dedicated article here.

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.