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Can a Lehmans happen again?

Could a large, systemically important bank fail in the current environment? To answer we need look at how the world has changed since September 2008.

Concerns about the European debt crisis continued to panic investors despite a G-20 communiqué announcement which promised significant action to help resolve the sovereign debt problems.  The G-20 vowed to "take all necessary actions to preserve the stability of banking systems and financial markets" whilst committing to an action plan of short-term and medium-term policies. Elsewhere, there were rumours the European Central may be cutting rates by 50 basis points.

Investors anxiety was somewhat alleviated after global officials pledged to maintain financial stability, however, worries over a global economic slowdown and the markets strong downside momentum are still major issues plaguing investors. In Europe, the FTSE 100 rose 0.5% and DAX climbed 0.6% as investors were helped by hopes of further measures from the European Central Bank to ease the region's debt crisis.  A pledge by the Group of 20 major economies to work over the next few weeks to approve a plan to increase the flexibility of the EUR440 billion Financial Stability Facility bailout fund to aid the troubled European banks also helped relieve investors' concerns.  And while Greece could get the next instalment of its bailout package (EUR8bn), conditions attached to it could be changed and a default is not being ruled out by either the markets or senior European political figures.

Against this backdrop it is worth asking the question whether a large systemically important bank could again fail in this environment.  To answer this question it is crucial to understand how the world has changed since that fateful day in September 2008.  The years leading up to the global financial crisis had produced several systemic failures from the stock market crash in October 1987 to the bursting of the dotcom bubble in 2001.  These events were quickly resolved through the institutional framework in place when they occurred:  generally comprising monetary policy action by central banks in the developed world and supra national lending institutions in the developed world.  These lessons taught the policymakers that volatility was only temporary and easily solved.

When US structured finance markets began to crumble in 2007-08 the initial response was to use the tried and trusted tools of accommodative monetary policy to try and ease financial market pressures but these moves failed to provide the desired results.  As asset values continued to decline the solvency of large banks was increasingly called into question and short term credit markets, which they rely on for survival, began to freeze in what became a classic system-wide bank run.  The institutions that existed at that time did not give policymakers the tools needed to save the system and the rules needed to be created on the run with little historical precedent for the consequences of their actions.

US Treasury Secretary Hank Paulson was ultimately left with the moral dilemma of whether to bail out all banks and formalise the 'too big to fail' concept in the US or allow selected banks to fail and show markets that imprudently run organisations would not be given blank cheques from the taxpayer.  He chose the latter, without precedent as a guide to what the consequences would be. The resulting chaos proved just how large a policy error this was and governments and central banks around the world came to realise that such a systemically important organisation could never be allowed to fail again.

Now that the economic tide has gone out we are left with a developed world and European Union in particular with a debt burden which is simply too large to be repaid.  A large proportion of this debt is owed to European banks, banks which are systemically as important as Lehman Brothers. The threat to the solvency of these banks is very real. Ultimately the only endgame to this situation is a socialisation of this debt burden with losses ultimately accruing to taxpayers.

The institutional framework in place today is much better prepared to deal with this eventuality than it was in 2008 and market participant's perception of bank bailouts has changed dramatically. What used to cause shockwaves is now part and parcel of the new world order. Global central banks now stand ready to provide what seems like unlimited liquidity to banks, offering special lending programs where exotic bank assets such as asset-backed securities and junk-rated government debt can be pledged as collateral against short term borrowing, dramatically reducing the likelihood of another run on the banking system.  These programs have been supplemented with direct asset purchasing programs by various central banks.  For example, the QE1 program in the US purchased illiquid mortgage-backed securities directly from banks at above market price and similarly the European Central Bank has purchased the bonds of troubled Euro nations who are unable to sell these in the open market.

Turning to Europe in particular, actions by policymakers have succeeded in dramatically changing who is owed money by countries on the European periphery.  Although several systemically important banks, particularly in France, continue to hold dangerous levels of this type of debt the largest holder is now the ECB.  Similarly, the proportional share of debt held by the IMF and local European central banks has risen sharply in contrast to the declining share of commercial banks. This gradual socialisation will eventually reach a tipping point where the entire European system will be threatened by peripheral default and a Europe-wide bailout program will need to be put in place.

So in answer to the original question of whether another systemically important global bank could fail, it seems unlikely.  Bank liquidity is well supported by global central banks that now have an enhanced framework to deal with these issues. European banks remain amongst the most leveraged in the world but the stakes for the European Union and its institutions are too high to allow for a disorderly default and banking system insolvency.  Eventually they will have to provide a union-wide solution for the socialisation of excessive debt.

I would like to end by apologising for the complexity of this week's reflections however the explanation is guided by the subject matter. It is the short-term uniformed/panicked selling by many investors that has contributed to much of the unnecessary volatility in the market.

"Battles are won by slaughter and manoeuvre. The greater the general, the more he contributes in manoeuvre, the less he demands in slaughter."
Winston Churchill (1874 - 1965); British politician and statesman