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Pot lashes out at kettle

2 September 2010

Under medieval insolvency laws, inquiries into bank failure could use torture and hostage taking to get answers. With the loss of traditional values, today’s investigators can only ask questions and seize documents.

Still, they do produce some startling revelations. Speaking to the US Financial Crisis Inquiry Commission yesterday, Dick Fuld, head of Lehman Brothers when it collapsed, said: “Deregulation of the financial industry and lack of government control helped us to make substantial profits in the years leading up to the crisis, so naturally we only have ourselves to blame for the mistakes and mismanagement that led to our bankruptcy”.

Ha ha, only kidding. In fact, he blamed poor decision-making by, wait for it: the Fed. Here’s what he actually said according to the New York Times: “Lehman was forced into bankruptcy not because it neglected to act responsibly or seek solutions to the crisis, but because of a decision, based on flawed information, not to provide Lehman with the support given to each of its competitors and other nonfinancial firms in the ensuing days”.

So, nothing to do with overleveraging, bad bets or Repo 105, an accounting trick that classifies a loan as a sale, thereby reducing Lehman’s liabilities by $50 bn (but only on the balance sheet).

Governments, as we all know, had to step in to clean up the mess, and not just in the US. From October 2008 to May 2010, more than 1400 bonds backed by government guarantees were issued by around 200 banks from 17 countries, for an amount equivalent to more than a trillion dollars.

Aviram Levy of the Banca d’Italia and Sebastian Schich of the OECD’s Financial Affairs Division look at the consequences in an article for the OECD Journal. They show that the guarantees have been effective in resuming overall long-term funding for banks and reducing their default risk, but at least two major issues now have to be addressed.

First, relatively weak banks with strong governments backing them (“sovereign guarantors”) have been able to borrow more cheaply than strong banks with weak sovereign guarantors.

Second, extending the scheme into 2010 allows non-viable banks to take advantage of the continued availability of guarantees and postpone addressing their own weaknesses or, even worse, adopt excessive risks in a “gamble-for-redemption”.

You can’t legislate against the toxic combination of ignorance and arrogance that brought the financial system crashing down. But governments and taxpayers shouldn’t be seen as blood donors permanently on call to stop banks dying from self-inflicted wounds.

Useful links

OECD work on financial markets

OECD Insights: From Crisis to Recovery

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