A decade after the ‘Lehman shock’

Ten years ago this week, on Sept. 15, 2008, Lehman Brothers, the fourth-largest U.S. investment bank and with a history that extended over 150 years, collapsed, setting off the worst global financial crisis in over half a century. That cataclysm, sometimes called the Global Financial Crisis or the Great Recession, has receded in memory, but its impact lingers. Changes have been made to protect against another “Lehman shock,” but markets again show signs of asset bubbles and questions are being asked with increasing urgency about the resilience of financial markets and whether the global financial system could absorb another shock.

Hundreds, if not thousands, of books have been written on the causes and consequences of the financial crisis, yet debate continues. It is generally accepted that the crisis had two principle causes: an overheated housing market in the United States, in which too many loans were made without regard for their ability to be repaid, and an under-regulated financial system that allowed banks to make loans without sufficient reserves and permitted them to hide their links so that vulnerabilities would quickly cascade throughout the world.

In short, a U.S. housing bubble popped and banks that had extended loans could not cover their losses. Those losses dragged down other financial institutions that were owed money by the failing banks. The result was a loss of more than $2 trillion in global economic growth, a drop of nearly 4 percent.

Japan weathered the initial shock as housing markets imploded because bankers here had not purchased the arcane and complex financial instruments that were based on those housing loans. Yet, as the global financial system imploded and economic activity halted, Japan was badly hurt as capital dried up, foreign funds were withdrawn to cover rising liabilities in other countries and export markets evaporated. As a result, Japan’s economic growth dipped into negative territory in 2008 and it endured the deepest and longest-lasting cuts in growth among major economies.

Numerous measures have been put in place to prevent another crisis. Banks have been forced to increase reserve requirements to prevent them from being crushed by unexpected losses. They have simplified organizational structures so that links between main banks and related institutions are clear and responsibilities — and potential liabilities — visible. In the U.S., banks must separate their own trading from that of customers so that bank losses will not impact depositors. Worldwide, banks are smaller and those large enough to be deemed “systemic risks” are regularly tested to ensure that they can survive a crisis. Finally, the U.S. and the European Union have created mechanisms to deal with crises and wind down stricken banks if they are threatened with collapse.

Unfortunately, these steps are unlikely to prevent another crisis. First, in the U.S. at least, time has proven a convenient balm and some of the most stringent prophylactic measures imposed in the wake of the crash have been repealed. Once again, deregulation is in vogue and memories are short. It should be alarming that the amount of U.S. leveraged loans and junk bonds has more than doubled in the past 10 years. This has been facilitated by an environment of low interest rates that has persisted for over a decade as investors seek higher returns — a search for profits that animated the original crisis.

Second, new risks have emerged and are marked by the same opacity that proved so dangerous a decade ago. China’s dynamic economy has a shadow banking sector that alarms economists. Total bank lending is estimated to be 143.7 trillion yuan (¥2.363 quadrillion); the inclusion of shadow bank lending could push the total to ¥2.9 quadrillion to ¥3 quadrillion. According to official Chinese figures, bad loans range from 1 to 2 percent of the total, but Japan’s experience suggests the number could — and likely is — at least 10 times higher, or more than ¥350 trillion, which exceeds a quarter of China’s GDP. There is a worrisome amount of bad government debt in China too, which magnifies the potential for an economic crisis.

Equally troubling is the rise of cryptocurrencies. These instruments are very volatile and regulation is in its infancy. It’s not clear how vulnerable the global financial system is to such a contagion, but study is needed. Finally, there is the low interest rate environment, a natural response to the crisis but a situation that has persisted and which limits the tools that policymakers have in the event of a shock. Central banks must be able to lower rates to spur growth if there’s a crisis: That’s impossible when interest rates are already at or near zero.

That absence of room for maneuver assumes additional significance when economic historians note that crises tend to occur on a cyclical basis every 10 years. World debt has expanded from $142 billion to almost $250 billion, or 76 percent, since 2007, well outpacing global GDP growth. We may soon discover how well we learned the lessons of the Lehman shock.