Part 1: Regulation pre- and post-Lehman’s collapse

Pre- collapse: lack of regulation

Prior to the collapse of Lehman the government failed to regulate several key areas of the financial system.  The government did not introduce measures that would have curbed risk taking, reined in the use of derivatives and increased disclosure within the system. These failures helped contribute to the collapse of Lehman and the wider financial crisis. As well as failing as chief regulator of Lehman the SEC (Securities and Exchange Commission) discovered that Lehman had excluded many important risk factors from their risk tests but failed to act (Valukas, 2010).Lehman was also allowed to operate repo 105 transactions without disclosing the true nature of the repos and was able to exceed many of its risk limits without disclosing this fact.

Why was pre-collapse regulation so weak?

(Google Images, 2013: Fat cat banker having his shoes polished by a member of the senate)

One view why regulation was so weak is regulatory capture. Regulatory capture can be defined as “The process by which regulatory agencies eventually come to be dominated by the very industries they were charged with regulating” (Investopedia, 2013)

One method of regulatory capture is lobbying which aims to influence decision makers. Wall Street spends an extortionate amount on lobbying government for example it is estimated that $3.28bn was spent lobbying in 2012 (Lobbying Database, 2012). Stigler (1971) found that regulated institutions frequently pressurised regulators to modify regulations. An example of regulatory capture occurred when politicians blocked attempts to reform the government sponsored enterprises such as Fannie Mae and Freddie Mac (Dowd, 2009) even though many admitted that the enterprises were major players in the financial crisis. In addition, financial institutions can exert pressure through political campaign contributions which also allows them to exert considerable influence.

So what could the government do?

Stricter governmental disclosure rules could have curbed excessive risk taking at Lehman. In addition, compensation packages in place in the financial sector have been accused of encouraging risk taking and short termism e.g. at Lehman compensation was often based solely on revenue (Valukas, 2010) . The government could introduce measures to regulate executive compensation, insisting it be based on a number of risk factors that are in line with the health of the financial system. Another piece of legislation could be introduced to regulate the creation and trading of complex financial instruments.

Bibliography

1.   Dowd, K (2009) ‘Moral Hazard and the Financial Crisis’, Cato Journal 29(1): 142-6
2.  Investopedia.com (2012) Regulatory Capture Definition | Investopedia. [online] Available at: http://www.investopedia.com/terms/r/regulatory-capture.asp#axzz2LeTwzYVa [Accessed: 23 Feb 2013] Opensecrets.org (2012) Lobbying Database | Open Secrets. [online] Available at: http://www.opensecrets.org/lobby/index.php [Accessed: 23 Feb 2013].
3. Stigler, G.J. 1971. "Theory of Economic Regulation." Bell Journal of Economics and Management Science 2 (Spring): 3-21
4. Valukas, A. (2010) LEHMAN BROTHERS HOLDINGS INC. CHAPTER 11 PROCEEDINGS EXAMINER REPORT. Jenner & Block, Volumes: 1-9.