Learning from the Lehman crisis: Financial express September 12, 2014

September 15, 2008, has become as legendary as all other dates associated with catastrophesthis was the day when Lehman Brothers collapsed officially and become synonymous with everything that spells financial disaster. Lehman actually was the 'fall guy' as it came to epitomise everything that can go wrong in a capitalist world, which was personified by what the cinematic character Gordon Gekko said: "Greed, for the lack of a better word, is good." One may feel sorry for Lehman as the government and the Federal Reserve had helped bail out Bear Stearns before Lehman fell, and later AIG after Lehman collapsed. But a helping hand was not offered to Lehman. With the global financial order being restored after going through another upheaval of sovereign debt crisis in Europe, it is time to look back and reminisce over the last six years. The Federal Reserve has been drawing back on its quantitative easing programme and the indication is that, by 2015, the amount will be nil and that interest rates will be increased. It is more a sign of saying that the crisis is over and it is back to business. What have we learnt along the way? First, the crisis caught everyone off the guard and, therefore, the response was dissimilar. There was always the question of growing a moral hazard where, if the authorities bailed out one institution, others would also be tempted to go down under. Being the first of its kind, central banks were not quite sure of what they were doing. Even today there are no easy answers to whether distressed institutions should be bailed out or let to die, as the implications are severe for the system. Unlike a company where the shareholders are the losers, in case of banks, there is public money involved, which is often protected by the government. Second, as a corollary, the support provided to these institutions was not to prop up the company or the shareholders, but the financial system. Given that securitisation helped disperse risks, they had permeated a wide cross-section, and allowing these assets to fail would have sent the system crashing as various banks funded by deposits had exposures here. Therefore, even in future, one cannot allow such banks to fail. Third, the focus has shifted to more regulation and better supervision, and central banks across the world are more particular about their systems. Basel has moved to the third version and, after focusing a lot on capital in the second version, has now turned to liquidity as finally it is cash that matters in crunch time. Fourth, regulation has also pervaded the credit rating space, which till then had no oversight. There have been several changes in this area too, with new agencies such as ARC Ratings coming up as there has been a call for having more competition in this segment. To the credit of the Big Three CRAs, they have resurrected quite well after the double blow from the financial and sovereign debt crisis and today it is possible to say that they are better placed under the umbrella of supervision. Fifth, central banks started lowering interest rates to revive their economies under the stimulus programmes which combined higher fiscal imbalances. However, the impact was limited as banks were still not confident about dealing in the market. The crisis was about the loss of trust and credibility and this is why it has taken time to get up. A financial system in which players do not trust one another is bound to run into trouble as activity comes to an end since no one knows how good or bad the counter-party is. This means conventional tools do not work in exceptional circumstances. Sixth, following from the above, governments got their central banks to use desperate measures to revive their economies. Therefore, quantitative easing was necessary to restore liquidity into the system so that institutions could get cash from the Federal Reserve or the Bank of England or the ECB by either selling bonds or offering them as security depending on the comfort of the central bank. The theoretical issue raised was whether such surpluses would lead to inflation, a concern in the West. However, with low growth conditions, excess liquidity did not quite put pressure on prices. There were other problems, however. Seventh, with globalisation and the so-called bifurcation of the world economy, these funds have not been used within these geographies, and investors have had the tendency to borrow cheap from these central banks and invest in the emerging markets, thus fostering 'carry trade'. While this has spooked asset prices in the EMs, it has generated liquidity issues and called for monetary policy action in these countries as inflationary pressures have built up. Simultaneously, exchange rate adjustment has put pressure to correct the external balances as well as domestic liquidity. This has become an unintended consequence on both sidesfunds moving out of the developed countries and into emerging markets and creating policy problems therein. Eighth, with excess liquidity in the system, there is again a fear of the build-up of another asset bubble. Currently, it is hard to point towards any asset class that is under such a threat, but the fact that there is surplus cheap liquidity is a precondition for such a situation. Ninth, surplus liquidity and low interest rates have failed to bring about the desired level of change in the growth prospects of these economies. This is a conundrum which Keynes had spoken ofthe famous liquidity trap where even if you lower rates or increase liquidity, spending does not increase. The solution is to increase government spending, but with several constraints on this end, countries are not in a position to spend. The US also had a hard time to get through the Senate and faced the fiscal cliff and debt ceiling challenges. European countries cannot spend as it is a part of the deal to get finance from the ECB. Therefore, progress has been slow. Ten, notwithstanding all that has happened, economies still veer towards capitalism and the good part of the story is that countries have not quite turned protectionist or even leftist looking. This is important because capitalism is an evolutionary process which Schumpeter said involved creative destruction where one cannot move forward without letting the old order burn down. Only then do innovations come about. If CDO and CDS were the innovations of the pre-financial crises years, the QE model as a cure for stagnation is the highlight of the post-crises years.