Looking back to the future

Regulators have shifted their oversight dramatically since the financial crisis 10 years ago, as Linkaters’ Jacques Schillaci discusses

Ten years have passed since the events of September 15 2008 which saw financial services firm Lehman Brothers collapse, arguably the most dramatic event in that year's global financial crisis. That a firm with over $600 billion in assets was allowed to fail ignited a debate that continues to this day.

IFLR's John Crabb speaks to New York-based Linklaters counsel Jacques Schillaci, who specialises in US bank regulation, about the collapse, the crisis and regulators' steps to prevent events of this scale from happening again.

If you look at the history of financial regulation in the US, the global financial crisis that surrounded Lehman's collapse is probably one of the two or three major events in the past 100 years in terms of precipitating change; the others being the Great Depression and the savings and loan (S&L) crisis. Arguably, the S&L crisis was less important because it involved smaller institutions and was more limited to the US, and while some reforms followed the S&L crisis, the scale of those reforms was relatively limited. The reforms following the financial crisis, however, are arguably second only to those that came after the Great Depression in terms of their scale and importance.

Regulators are at least thinking through what they would do if one of these big banks failed...That wasn’t really the case in 2007

The global financial crisis was an important lesson and a significant pivot point in the history of financial regulation. What has come out of it is a greater emphasis on a few key concepts, including the notion that regulators have to worry not only about individual institutions but also the financial system writ large. Regulators have placed a greater emphasis on how risks build up in the financial system and how regulators can head off those risks before they get out of hand.

It's not that regulators didn't look at systemic risk before the crisis, but the focus of a lot of the regulation in the US was on individual regulated institutions and the protection of their customers rather than how each institution might affect the broader system. While the concept of a too big to fail (TBTF) financial institution has only really entered the popular lexicon since the financial crisis, regulators had been wrestling with it for a while. That idea wasn't borne out of the financial crisis. For instance, the industry-led bailout of Long Term Capital Management was motivated in large part by the idea that its failure could bring down some of its counterparties as well.

Coming out of the crisis, there were a lot of new regulations that focus on the idea that if these TBTF institutions go down in an unplanned way like Lehman did, the knock-on effects to other market participants and the financial system can be really significant, and can destabilise a whole host of other market players. All of these financial institutions trade with each other, and those trades depend on the parties remaining solvent, so the failure of one can have a domino effect that takes down others.

Certainly, a lot of the rules that came out of the crisis have been very much targeted at limiting financial interconnectedness and the risk of the financial system while also making sure that TBTF financial institutions could be wound down in a somewhat orderly fashion. Regulators have been developing mechanisms like living will planning to make sure that large banks can be wound down in a planned out, organised way. They've also introduced requirements that are intended to mitigate the risks that a particular bank poses to another, such as the margining of derivative transactions.

There are, of course, pieces of the post-crisis regime that are arguably more difficult to square with these concepts, but broadly, mitigating this kind of risk to the financial system has animated the post-crisis regime.

From a regulatory perspective, I think that we are in a much better position today to handle a financial crisis than we were in 2007. There are tools in the regulators' tool belt now that just weren't there in 2007. Today, regulators are at least thinking through what they would do if one of these big banks failed, and they have developed regulations to help them prepare for that eventuality. That wasn't really the case in 2007.

While the regulators are in a better place now to detect the financial risks that led to the 2007/08 crisis, what if the problem is something different next time?

Another important point from a US perspective is that at the time of the financial crisis, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs were all investment banks. They didn't own commercial banks and so were not subject to the same kind of consolidated regulatory supervision that a bank like Bank of America was. The two investment banks that survived as standalone institutions, Morgan Stanley and Goldman Sachs, both became commercial bank holding companies and are now subject to that comprehensive regulation in the US. As a result, all of the largest US institutions are now subject to this more comprehensive, consolidated regulation.

This layer of oversight gives regulators a much better view of banks' assets and operations than they might otherwise have, which would be invaluable in heading off and/or dealing with a bank on the verge of collapse. Looking back at accounts of the crisis, it's pretty clear that lack of information about banks' problems and ambiguity about the extent of regulators' authority over individual institutions was a significant stumbling block. Hopefully, the more comprehensive oversight of the big banks will make these less of an issue. There is a much clearer early warning system in place now, and when you add in the Orderly Liquidation Authority (OLA), there is greater ability for the regulators to step in and take a failing bank apart in a way that doesn't interrupt the broader financial system or credit intermediation.

There are probably two big caveats to what I've said. The first is that we don't really know how a liquidation of a large bank under the OLA would work because, thankfully, we haven't had to do it yet. While I do think that the OLA puts regulators in a much better position to handle the insolvency of a TBTF bank, the effectiveness of the OLA depends a lot on who we've got in certain positions, who is running the Federal Reserve, who is running Treasury, and who is doing the actual work. Will they have the political will to pull the trigger and go into a TBTF bank and say, 'Look, you are in trouble and we are taking over because if you fall it is too big a price for the country?' I don't know the answer to that.

The other caveat is that whenever you are reacting to a crisis, and whenever there is a series of negative events, there is a tendency to adopt rules that would have addressed that specific crisis. Part of the consequence of reacting to something by preparing for it to happen again is that you are not necessarily preparing for something else bad. As such, the concern would be that while the regulators are in a better place now to detect the financial risks that led to the 2007-08 crisis, what if the problem is something different next time? What if there is some other sort of significant risk that builds up in the financial system that the regulators don't know to look for?

That said, there are people at the Federal Reserve and other government agencies who are looking at the economy and the financial system on a macroeconomic level. Arguably, it wasn't so much that regulators couldn't see the problem coming in 2007/08, but that they didn't act on it in time. There were warning signs at least as early as 2006 about the risks facing the financial system, and it may have been some degree of wishful thinking that led regulators to not act. To be fair, though, they didn't necessarily have the tools to counteract the problems that they saw in any event.

The message here is that the regulators certainly have better tools at their disposal now than they did in 2008. They probably have more readily available information regarding systemic risk that they didn't have in 2006/08, but whether or not that enables them to see something coming is another question. Overall my view is that we are in better shape now than we were, but I don't know anyone who would be brave enough to say that we definitely will be able to prevent or handle another financial crisis.