The most taxing problem of our time

On the one year anniversary of the Lehman Brothers collapse, we put together a series of articles to mark the event and assess what problems still remained. The issue of banks that are 'too big to fail' but 'too big to save' remained unsolved.

This is our piece.

One year later we still don’t know if the regulators choice to sacrifice Lehman Brothers was the right one. But we do know they will do whatever they can to not have to make that choice again. Reports Jonathan Shapiro and Jane Lee.

In the final hours of the 158 year existence of Lehman Brothers, the ex-Treasury secretary and former rival banker Hank Paulson, Fed Chair Ben Bernanke, and NY Fed president Tim Geithner faced the toughest call of their lives.

Should they intervene and save the firm? And if they let it fail would the already brittle confidence of the financial markets withstand its collapse?’

While opinions are divided, the current version of history reads that the decision to let it fall was a catastrophic misjudgment. It’s a choice that the world wants to make sure never has to be made again.

The RBA governor Glenn Stevens concedes that managing the systemic risks posed by large bank failures is one of the defining challenges that regulators of his generation will face.

‘The most taxing problem of our time’

“The global policymaking community will have to grapple more effectively with the problem of entities that are ‘too big to fail’, but potentially ‘too big to save’, especially where their activities cross national borders. This is probably the most taxing financial regulatory problem of our time," he said recently.

Some believe that the problem of banks that are too big to fail will never go away.

"There will always be too-big-to-fail banks, no matter where the current debate leads us. When I say that banks’ balance sheets should be capped at $300 billion, I’m not for a minute saying that $300 billion is small enough to fail; I’m just saying that such banks are small enough to rescue,” says financial markets commentator Felix Salmon.

“Too big to fail we can cope with, by rescuing banks rather than letting them fail. Too big to rescue we can’t cope with. And right now, the big four banks in the US are too big to rescue. Which is scary," he said.

Stuff them with capital

One approach is to ensure big banks are more than adequately capitalised.

“If we cannot split banks up and cap the size then as a minimum we have to stuff them full of capital,” says Gary Jenkins, head of fixed income research at Evolution Securities in London.

"They just have to have lots of capital and we have to have much lower risk products being done by the banks and much less risk being taken so that they are much safer entities. And the only way you’ll do that is with regulation."

Others feel that being equiped to manage the failures, rather than preventing them is a more pragmatic approach.

"You’re not going to stop these things from failing, the best you can do is improve your ability to mop up afterwards. One of the big problems – and AIG illustrates it very clearly – is we’re still trying to regulate a global financial system with local rules. AIG was a classic example because as an insurance company it does not fall within central bank regulations. It does not fall under the transparency requirements of the central bank. And that was true of the investment banks too," said David Weiss, S&P's global chief economist.

Servant not master

Another way to manage the ‘too big to fail problem’ is reducing the importance of banks. Measures such as increasing the size and accessibility of capital markets so that businesses can lend directly from institutions is one such measure.

“In the same way that big companies can access funding directly from capital markets, by issuing bonds or commercial paper, I want to start creating a different financial model in the future, in which small companies get funding from sources other than banks,” said Chancellor Alastair Darling of the UK Treasury in a recent article.

“Our goal is to make finance the servant, not the master, of the real economy,” he says.

Jenkins shares a similar view on the role of the banking system.

“When you actually think about it what is a bank? What is it there to do? To oil the wheels of commerce. It being commerce itself is actually in some ways wrong,” he says.

He feels that the banking system should be a commodity or utility-like product, especially since it has become evident that the taxpayer has to stand behind it.

“That’s what it should be and that’s what regulators should want because if, at the end of the day, you have to bail it out - why on earth do you want it to be the main kind of money making machine in your economy? It doesn’t make any sense. They need to have a complete re-think about how the financial system should work. But I don’t think it will happen.”