Testifying before the House Financial Services Committee, Federal Reserve Bank (Fed) Chairman Ben Bernanke will outline two key financial regulatory reforms that arise from lessons learned during the failure of investment bank Lehman Bros. in September 2008. The fall of Lehman during a stressful time in financial markets and an already severe recession caused financial markets worldwide to seize up, thus creating a credit crisis.
Prior to Lehman’s collapse, the Fed had already begun monitoring the investment bank’s financial condition, even though the Fed had no direct regulatory authority over Lehman because it did not own a bank. Rather, Lehman was regulated by the Securities and Exchange Commission (SEC). In March 2008, the Fed oversaw the sale of failing investment bank Bear Stearns to JPMorgan Chase. Responding to the escalating pressures on primary dealers like Lehman, the Fed used its statutory emergency lending powers to establish the Primary Dealer Credit Facility and the Term Securities Lending Facility as sources of backstop liquidity for those firms. In its role as creditor, the Fed required all participants in these programs, including Lehman, to provide financial information about their companies on an ongoing basis. The Fed actually placed two employees on-site at Lehman, but their activities were limited to gathering financial information.
The Fed, with the SEC’s participation, developed and conducted several stress tests of the liquidity position of Lehman and the other major primary dealers during the spring and summer of 2008. The results of these stress tests were presented jointly by the Fed and the SEC to the managements of Lehman and the other firms. Lehman’s results showed significant deficiencies in available liquidity, which the management was strongly urged to correct. Those deficiencies were identified even without the Fed’s knowledge of how Lehman was using so-called “Repo 105″ transactions to manage its balance sheet.
Lehman’s attempts to raise additional capital fell short. During August and early September 2008, increasingly panicky conditions in markets put Lehman and other financial firms under severe pressure. In an attempt to devise a private-sector solution for Lehman’s plight, the Fed, the Treasury Department and SEC brought together leaders of the major financial firms in a series of meetings at the Federal Reserve Bank of New York during the weekend of Sept. 13-15, 2008. Despite the best efforts of all involved, a solution could not be crafted, nor could an acquisition by another company be arranged. With no other option available, Lehman declared bankruptcy.
At the time, no government agency had authority to provide capital or an unsecured guarantee, and thus no means of preventing Lehman’s failure existed. Moreover, it was unclear how the nearly one million derivatives transactions Lehman was a party to would be handled in bankruptcy court. This is what generally caused financial markets to cease operating.
Bernanke concludes in his prepared testimony: “The Lehman failure provides at least two important lessons. First, we must eliminate the gaps in our financial regulatory framework that allow large, complex, interconnected firms like Lehman to operate without robust consolidated supervision. In September 2008, no government agency had sufficient authority to compel Lehman to operate in a safe and sound manner and in a way that did not pose dangers to the broader financial system. Second, to avoid having to choose in the future between bailing out a failing, systemically critical firm or allowing its disorderly bankruptcy, we need a new resolution regime, analogous to that already established for failing banks. Such a regime would both protect our economy and improve market discipline by ensuring that the failing firm’s shareholders and creditors take losses and its management is replaced.”
Gregg D. Killoren
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