What have we learned from the bank crash?

Enough to avoid another one, you’d have thought. But there has been too little reform and banks are still too complex and interconnected, say Yalman Onaran, Michael J Moore and Max Abelson

Five years ago when Lehman Brothers collapsed into a maelstrom of debt and financial destruction, the world changed forever. Or did it? Amid hours of television and acres of newsprint devoted to the inauspicious anniversary of the banking crisis’s defining moment, there really remains only one question: have we changed enough to stop it happening again?

To put it another way, has Washington created a safe banking system, forcing Wall Street to take fewer risks, or have the bankers won again, lobbying the politicians to retain the status quo?

Unfortunately for taxpayers, the answer is: mainly the latter.

While the amount of capital held by the six largest US lenders as a buffer to protect against losses has almost doubled since 2008, many politicians, and some Wall Street veterans, say that’s not enough. They see a system still too leveraged, complicated and interconnected to withstand a panic, and regulators ill equipped to head one off – the same conditions that led to the last crisis.

“We’re safer, but we’re not safe enough,’’ said Stefan Walter, who led global efforts to revise capital rules as general secretary of the Basel Committee on Banking Supervision. The capital cushions may have got bigger, but so have the surviving banks as they merged and took over the weaklings. Combined assets of the six biggest Wall Streeters have increased 28 per cent since 2007, making it harder to let them fail.

Although nobody has gone to jail, we all know the villains of the financial crisis story: banks selling subprime mortgages, government-supported agencies backing the loans, Wall Street packaging them for investors, ratings firms giving seals of approval, regulators offering little objection, politicians encouraging it all to happen and, of course, homeowners taking on too much debt.

But, systemically, three fundamental flaws stand out. Regulators stripped of power allowed banks to embrace too much risk and load up on toxic debt with short-term funds. Insufficient capital left them little margin for error when those assets plunged in value.

A system too large, opaque and interconnected meant they couldn’t fail without catastrophic consequences for the economy.

Regulators have since pushed banks to cut the amount of borrowed funds they use, what’s known as leverage. They have been ordered to hold more easy-to-sell assets and rely less on overnight loans. The 2010 Dodd-Frank Act established a protocol that would, in theory, enable authorities to seize even the largest lenders and dismantle them without bringing down the entire system.

But the largest banks remain Byzantine, with hundreds of subsidiaries around the world, which could thwart efforts to unwind them. Six US regulators with overlapping authority often clash and are besieged by an army of highly paid lobbyists.

Leverage is still too high, some regulators and economists say. Derivatives mask who is holding the underlying risks being taken.

“The basic model hasn’t changed much, and it’s still fragile,’’ said Anil Kashyap, an economics professor at the University of Chicago Booth School of Business. “The banks need much more capital and liquidity. They’re still way short of being safe.’’

One reason is the intensity of Wall Street’s pushback against reforms. As an example: bank executives, lobbyists and lawyers logged more than 700 meetings with regulators on just one section of Dodd-Frank: the one that seeks to curb banks’ proprietary trading (“gambling” on the markets with their own funds).

An October 2011 proposal for implementing the rule, named after former Fed chairman Paul Volcker, generated more than 18,000 letters.

Regulators still haven’t finished the Volcker rule and the current proposal has so many exemptions that even Mr Volcker himself says he isn’t sure it will do what he wanted. Only 40 per cent of the nearly 400 legislative requirements needed to instal the Dodd-Frank act have been completed.

“At a point where politically you would think that the big banks are at their weakest, still they have had an enormous amount of influence,’’ says David Skeel, a University of Pennsylvania law professor.

That’s not to say nothing has improved. For all their groaning, banks have taken steps to improve their defences. Take Morgan Stanley, whose assets at the end of 2007 were 38 times its equity. It sold a stake to a Japanese bank, raised $6.9bn (£4.4bn) in 2009 and curtailed dividends and share buybacks. Leverage fell to 14 times equity.

But it still has the highest leverage of any of its peers under a proposed Fed rule that would require banks to have at least $5 of equity for every $100 of assets. The firm now has $4.20, according to that measure.

It has also increased its derivatives holdings in the past four years. The notional value of those deals, most of which aren’t recorded on its balance sheet because they’re netted out under accounting rules, surged 20 per cent to $46.9trillion as of the end of March.

The transactions are supposed to be offset, or hedged, with other agreements but it is impossible to tell exactly how well they really cancel each other out. Or what happens when a counterparty on a trade goes bust.

Derivatives have created a shadow-banking system that has more than doubled since 2002. While notional values exaggerate the extent of the risk, netting underestimates it and provides hidden leverage to banks, says Gary Gorton, a finance professor at Yale University.

“You can’t really see how big the banks are or what risks they’re taking by looking at their balance sheets,’’ Mr Gorton says. “We don’t really know where the risk is.’’

The ability of banks to hide risk, years after Lehman’s fall, was demonstrated by JPMorgan’s $6.2bn loss in 2012 derivatives bets by a trader known as the London Whale.

The trades, which had a notional value of about $150bn, appeared much smaller on the balance sheet of the largest US bank.

JPMorgan survived the Whale. But what if a big bank’s trading mess-ups prove fatal, like Lehman Brothers’ did? Dodd-Frank rules require the largest firms to submit guides for how they could wind themselves down in an orderly manner should the worst happen. The Federal Deposit Insurance Corporation, which has taken over and liquidated hundreds of small banks, was given the job of coming up with a strategy for the biggest.

That’s a difficult task when an institution as vast as JPMorgan has 3,391 legal entities in more than 100 countries. The FDIC’s plan involves seizing a bank’s umbrella holding company, converting its debt to equity and providing bridge loans to ensure operating companies can continue functioning. Sounds good in principle, but the strategy could fail if some of the world’s largest banks implode simultaneously.

For John Reed, a former Citigroup co-CEO, Wall Street hasn’t changed as dramatically as it should have. He said he worries that a recovering economy, record share prices and hefty bank profits might lull people into complacency.

“There are some banks that would believe the longer the delay the better,’’ Mr Reed says. “The world looks pretty benign right now. But it always does until it isn’t.’’

©Washington Post/Bloomberg

On the brink: The week that shook the markets

Monday 15

In the small hours of 15 September 2008, Lehman Brothers filed for bankruptcy. A frenzied weekend of talks at the offices of New York Federal Reserve had failed to find a buyer and the US Treasury, led by Wall Street veteran Hank Paulson along with the Fed chairman Ben Bernanke decided not to use public money again to bail out a financial institution. The 164-year-old banking giant was not, they ruled, too big to fail.

The fallout was immediate and unexpected. Liquidity, the lifeblood of the financial world, evaporated as market players questioned how secure the counterparties they were dealing with were. Within 24 hours Merrill Lynch, another US investment banking giant, had sold itself to Bank of America and across the Atlantic Lloyds TSB was in talks about rescuing HBOS.

The Dow recorded its sharpest fall since the September 11 terrorist attacks as hedge funds found their cash tied up in Lehman subsidies and became forced sellers of other assets. As chaos spread in the credit markets, where Lehman had been a pivotal player, attention turned to the insurance giant AIG, which had written guarantees on $440bn of mortgage derivatives.

Tuesday 16

On Monday night AIG was asking for a $40bn bridging loan. By Tuesday morning, it needed $70bn. At 8pm the United States government provided $85bn, in exchange for 80 per cent of the insurer in an effective nationalisation. By then Barclays’ then investment banking boss Bob Diamond had also agreed to buy Lehman’s North American broking business for $1.75bn, having been blocked from striking a deal over the weekend by the Chancellor, Alistair Darling .

Wednesday 17

The BBC revealed Lloyds TSB would buy HBOS in a government-sponsored deal on Wednesday morning – the official announcement came at 7am on Thursday. Back on Wall Street, Goldman Sachs and JPMorgan turned to US regulators demanding something be done about the speculators driving their shares lower.

Thursday 18

Amid fears that cash machines could actually run out of money as the liquidity crisis continued, the world’s top central banks clubbed together with a multi-billion dollar lifeline to free up frozen lending between banks. The US Fed made $180bn available to other banks to restart the short-term money markets.

Friday 19 and Saturday 20

The prospect of billions of bailout cash relaxed the markets, with the FTSE 100 jumping 9 per cent and the Dow Jones up 400 points. On Saturday, nearly a week after it refused to support Lehmans, the US unveiled a $700bn package to bail out firms with bad mortgage debt. The following Monday, the Japanese banking giant Nomura bought Lehman’s business in Europe and Asia-Pacific.