Keeping Interest Rates Low is a Fitting Way to Acknowledge the Anniversary of Lehman’s Collapse

von Nicole Raz / 19.09.2015

It is fitting that the anniversary of the Lehman Brothers collapse and the Federal Reserve decision to not raise interest rates would be just days apart. Federal Reserve Chair Janet Yellen announced Thursday interest rates will be left unchanged. American Economics Reporter Nicole Raz investigates for NZZ.at how low rates, and other policies implemented since 2008, have worked against broad banking reforms.

Seven years later, the world is still feeling the effects of the Lehman Brothers collapse in softened economic prosperity, ongoing yet-to-be-implemented reforms proposals, and an ongoing Federal Funds rate of nearly zero percent.

While Federal Reserve policies have helped to bolster the financial system, they have also improved banks’ lending capacity, which may not have been for the best.

“The policies that have been adopted to provide an artificial cushion and stimulation to the financial system and capital markets, means that we have had excess corporate debt issued, which could prove dangerous when rates rise due to increased defaults,” said Nomi Prins via e-mail, who is a senior fellow at the non-partisan public policy institute Demos.

Though financial markets are by no means currently in crisis mode, it is only a matter of time before the next storm hits—and the world will have few new tools to tackle it.

The Sweet & Sour Aftert of the 2008 Meltdown

Although low interest rates have helped to facilitate business spending on capital goods and promote household spending, they’ve also come with some powerful negative consequences. They are not only are serving as an incentive for bond holders to turn to riskier assets like the stock market to get higher risk premiums—which may have created a bubble, but low rates have also served as an incentive for companies to buy back their own stock to enhance their earnings.

According to a 2012 Federal Reserve Bank of St. Louis report, the most recent report available, 62 percent of gains in the economic recovery was due to increased stock market wealth. Since 2012, though, the US economy has also gotten a boost from consumer spending (largely stemming from falling gasoline prices), as well as improvements in the labor market.

“We are no longer viewing investing as a value proposition, but [instead] using the crutch of artificial liquidity and cheap money to boost markets and related earnings rather than on-the-ground economic stability,” Prins said.

Small Steps Forward … Or Maybe Just In Place

In addition to quantitative easing to contain the recession, the US also implemented a law in 2010 aimed at preventing the excessive risk-taking that lead to the financial crisis, called the Dodd-Frank Wall Street Reform and Consumer Protection Act. The law is also supposed to avoid a taxpayer-funded bailout in the event of another crisis.

“This was real, structural change, and it’s working,” US Sen. Elizabeth Warren said at an event in July. “Mortgages have gotten clearer and easier to read, and the [Consumer Financial Protection Bureau] agency is fighting back against the big banks that have cheated consumers.”

Since 2010, the CFPB has returned $10.8 billion to consumers who were harmed by illegal practices in the financial services sector.

“Some of its rules have forced banks to pare back some of their trading operations, for their own accounts,” Nomi told NZZ.at. “But, because of a plethora of loopholes in the Act, plus much language still up for lobbying debate, general ‘market making’ trading is still allowed; and it was market-making-type trading at the crux of the crisis.”

Banks can still create complex securities and go onto trade and sell them globally, while having the benefit of deposits’ money in the same institutions.

From Bad to Worse?

Other financial reforms set up around the world, including the Vickers Commission and the Third Basel Accord, have also not had their intended impact.

The Vickers Commission set out to keep the British economy safe from another financial failure through a series of recommended changes in banking—including separating retail banking operations from trading and investment banking activities, knowing as ring-fencing.

Boston University Economist Larry Kotlikoff f opines that the Vickers Commission and Basel III have instead “made a bad situation worse.”

“Basel III has been adopted to ostensibly require big banks to hold more in reserves against risky securities,” Prins said. “US banks, for instance, have basically refused to adopt Basel III rules for mortgage related complex securities—precisely though at the crux of the Lehman collapse and financial crisis.”

Kotlikoff and Tavakoli agree that there are two root causes of the collapse of the global financial system that have yet to be addressed: Opacity and leverage.

As Sen. Warren said, “Markets work only if people can see and understand the products that they are buying, only if people can reasonably compare one product to another, only if people can’t get fooled into taking on far more risk than they realize.”

Banks are still not required to reform their disclosure activities. As a result, reported losses, or suspicions of losses determine investor activity—and investor panic.

Leverage, or the ratio of debt or assets to equity, was also a problem leading up to the financial crisis. Leverage went from about 12-to-1 in 2004 to 33-to-1 in 2008.

“Although the [Vickers] Commission asserts that Basel III’s proposed 33 times leverage is too high, it recommends sticking with that limit except for large ring fenced retail banks for which it recommends up to a 25 times maximum leverage ratio depending on their size. The Commission places no additional restrictions on the leverage of wholesale investment banking groups,” Kotlikoff wrote in 2012.

Regulated Chaos

Seven years after the collapse, US and European banking regulatory systems are still working to implement changes.

In addition to the consumer protection aspects of Dodd-Frank, the act has also given the Federal Deposit Insurance Corporation tools to shut banks down more quickly. Bill Murden, with the FDIC’s International Planning & Outreach Branch, said Tuesday at a bank supervisory conference in Vienna that the FDIC can now intervene in investment banking operations, as opposed to just being able to intervene in commercial banking operations.

“It gives us new tools similar to what we already have for regular banks: Additional liquidity—we have bridge bank tools, and the ability to convert debt to equity,” Murden said.

The FDIC is working with large, complex international banks to develop living wills, or instructions for how to shut the bank down, if necessary.

“It’s taken five years to get here,” Murden said, adding that there is still work to be done.

Meanwhile, European regulators—which have the added complexity of communicating effectively across borders and governing systems—are looking to the US as an example. Only now are major European banking regulators, such as the Austrian Financial Market Authority, beginning to talk to banks about working together to implement reforms.

Lessons Learned—But Go Ignored

While the US has the benefit of a central banking system to help recapitalize its banks, the financial service sector is still engaging in what Tavakoli terms “garbage finance:” Leveraged buyouts, and in some cases issuing debt to pay dividends and buy back stock.

There are ways to have clean finance, and solutions are out there. One of which is Kotlikoff’s “Purple Financial Plan,” or a proposal for Limited Purpose Banking.

“We do have an answer, its about the length of a postcard, and its been endorsed by top economists from around the world, former treasury secretaries, former heads of OMB [US Office of Management and Budget], former policy makers,” he said.

Under Limited Purpose Banking, all financial companies protected by limited liability would only be allowed to operate as mutual fund companies that market mutual funds.

“Mutual funds are not allowed to borrow and, thus, never fail,” the Purple Plan reads.

Just as the Congressional testimony of experts who warned of the dangers in financial markets leading up to the collapse went ignored, so too is the Purple Plan.

“It’s gotten no attention whatsoever in Washington.”

Kotlikoff first proposed the Purple Financial Plan in 2009. Six years later, he is still trying to get politicians to take note.

Others,suggest resurrecting the Glass-Steagall Act, which separated investment and commercial banking activities.

“The mix of over-leverage/derivative-wrapped securities on investment bank balance sheets like Lehman Brothers, predicated on overzealous financing by commercial-investment banks like JPM Chase that were enabled and fortified through the repeal of the Glass-Steagall Act in 1999,” Prins said.

However, the argument that banks need to diversity in order to provide a safe marketplace ultimately killed the Act and conceived the the Gramm-Leach-Bliley Act in its place, which expanded the financial services sector to what it is today.

Additionally, Stanford Business School Professor Anat Admati and Marin Hellwig, director of the Max Planck Institute for Research on Collective Good pose another solution: A mandate that banks hold more 20 to 30 percent equity capital and, correspondingly, far less debt.

if a bank’s equity is 20 percent of its assets it can absorb losses of 20 percent of those assets before it becomes insolvent, that is before its liabilities exceed its assets.

“The presence of debt makes risk more palatable to a borrower because he benefits from the upside but shares the downside with his creditors, and possibly with others that provide insurance for creditors. This is a fundamental conflict of interest that is due to borrowing and is particularly strong when borrowing is heavy,” Admati and Hellwig write in The Bankers’ New Clothes.

There were many lessons that came out of the financial crisis, and many factors to blame for its creation—but if any broad, visible changes are to come out of the Lehman Brothers collapse, it will be a decade later.