Run, banks, run

Fannie Mae may have been too big to fail 8212; but Fannie Mae, by definition, could not fail. The whole point of the US government-backed home loan provider was that the government guaranteed it wouldn8217;t. Which is why its shareholders felt justified in expanding further and further, and racking up risk that they knew the government would take off their hands if things went south.

Lehman Brothers and Merrill Lynch were not too big to fail. Storied investment banks they may have been, with fingers in dozens of pies, yet the fallout of their collapse will almost certainly be limited 8212; first, because in a major change, the Fed has finally admitted that investment banks are subject to some of the same risks as commercial banks, and thus have access to the Fed8217;s emergency funds; and second, because we8217;ve known Lehman would fall for six months. If you still lost money unexpectedly, fire your wealth manager.

American International Group might just be too big to fail, we are now being told. Certainly, if the system can deal with the crisis within AIG 8212; and it should 8212; it can survive anything. For AIG is not a Lehman, a risk-prone investment bank; it is a giant insurer. So large, so credible is it that it is one of the four financial firms in the Dow Jones industrial index. Yet it now needs 75 billion to get out of trouble. As an insurer, it doesn8217;t have access to the Fed8217;s emergency funds; plus, if it collapses it destabilises all those who relied on AIG to hedge them against the risk of other people collapsing; thus it takes more of smaller players down with it. And also the larger players of Manchester United, whom they sponsor. Really, given the fact that Northern Rock, which collapsed last year, backed Newcastle United, the Premier League is clearly the kiss of death. Anil Ambani, currently eyeing Everton, is either a very brave man, or not at all superstitious.

The truth is that contagion has never really spread through a financial system because of the collapse of one institution. A systemic crisis is not because one institution makes mistakes 8212; systemic crises are, well, systemic. In any case, even poorly-designed or -grown systems are partly self-correcting, as we can see from the fact that everyone has been preparing for Lehman8217;s fall for months.

Some corrections are made to such systems before the crisis. Some must be made after. Now that the business model of the four great pillars of Wall Street 8212; Lehman, Merrill, Goldman Sachs and Morgan Stanley 8212; is under attack, it is entirely possible that the pressures of the market will force even the two remaining 8220;independent broker dealers8221; to alter their operations. For one thing, Fed funding means regulation, which alters their profit margins. For another, nobody really trusts securitisation that much any more. They8217;ll be under pressure to sell themselves, and that pressure might be to stave off a cascade of defaults in which institutions fall like dominoes.

What else will change? Well, we now know the problems with 8220;maturity mismatches8221; 8212; when a firm borrows money in the short term but invests it in the long term. If something happens to the money market, the firm struggles to call in its longer-term investments. Commercial banks have some insulation against this; they have a stable buffer of government-insured deposits. Investment banks don8217;t, unless they8217;re part of a larger group, like Citi.

For another, something was wrong with incentives. The firms that went down were the right ones, with overdriven leaders 8212; Lehman8217;s head, the absurdly-named Dick Fuld, was the sort of buccaneer of whom friends on Wall Street would tell whispered stories. Last year, as the mortgage-backed securities market collapsed, he pushed Lehman into actually doubling their exposure to it. On a giant poster of his lantern-jawed head outside their HQ in Times Square, an angry someone has scrawled, 8220;I hope his villa8217;s safe.8221; People are realising, including presidential candidates, that this might be a small problem; though the sight of

McCain lecturing CEOs on incentives and golden handshakes while standing next to Carly please-take-21-million-to-go-away Fiorina is not particularly awe-inspiring. It hasn8217;t escaped notice that hedge funds and private equity, the bad boys of corporate governance, aren8217;t the problem. Their leaders have better-aligned incentives, perhaps.

Finally, everyone must recognise that credit rating agencies actually have a job consisting of more than saying 8220;if rich people are willing to buy this piece of paper, it must be rated AAA8221;. At least they haven8217;t hesitated in further downgrading AIG8217;s debt, regardless of the risks. Contagion is not about interconnection, or indebtedness. It is about correlations. If everyone is doing the same thing say, leveraging illiquid assets that8217;s real risk. Even if everyone is buying something stupid, it8217;s still something stupid 8212; and ratings agencies are supposed to tell us that, not point out something we all know: that people are buying it. Banks are bureaucracies like any other; an individual banker will think something8217;s okay if it8217;s been done before.

What lessons here for India? Well, the first is that, sure, capital control proponents can be happy that institutional investors losing money with Lehman aren8217;t taking a lot of the money away from us. But our markets are growing: we will have to start worrying about contagion here soon enough. When that day comes, what8217;s partly insulating us now may mean that our system doesn8217;t have the adaptability that others do. The second? Think hard about regulation. It isn8217;t the under-regulated that may fail 8212; perhaps it8217;s the incentives that need to be looked at. The third 8212; we have the chance to build an open, transparent, comprehensible financial system from scratch. Let8217;s not lose it.

mihir.sharmaexpressindia.com