The extraordinarily comprehensive bankruptcy examiner’s report on Lehman Brothers is the gift that keeps on giving to financial reform advocates, above and beyond even the revelations that Lehman was cooking its books and no one noticed for years. According to Yves Smith at Naked Capitalism, the report is a damning portrait of how the patchwork regulatory oversight, much of which probably won’t get resolved by Sen. Chris Dodd’s (D-Conn.) Senate bill, contributed to the Lehman collapse.
1. The SEC had no actual authority to directly police Lehman because of Gramm?Leach?Bliley.
If that sounds crazy, it should. In fact, Gramm-Leach-Bliley created a situation in which no agency was explicitly given the power to regulate large investment bank holding companies, so no one did. The SEC had “voluntary” authority, which means it could suggest to Lehman that it ought to do things, but it had no authority to require Lehman to do anything or impose penalties.
2. The SEC’s only way into regulating Lehman was because a Lehman collapse might hurt SEC-regulated enterprises.
In fact, the only authority the SEC had over Lehman was to force it to remain a viable enterprise (something at which the SEC obviously failed) in order to keep SEC-regulated financial firms, like banks and broker-dealers. According to Smith:
While the SEC can supervise the holding company and unregulated entities, its scope of action is limited to preserving the health of regulated entities only.
That means that Lehman could only be indirectly regulated: It couldn’t cause harm to entities that the SEC could regulate — but how could the SEC determine if Lehman was in a position to harm other players in the financial system if the SEC couldn’t provide any direct oversight of Lehman, let alone enforce any actions it took?
3. The SEC weakened its requirements to get companies to submit to its voluntary authority.
Since the SEC had no direct authority, it had to induce investment banks like Lehman to cooperate with regulation and oversight — never an enviable or smart position for a regulatory agency to be in. The way that the SEC accomplished this in the case of Lehman was to lower its capital requirements — in effect, it allowed Lehman to bet more heavily on the market than other banks in order to be allowed a peek at the books. Smith says:
In keeping, to induce the US LIBHCs to participate in an toothless regulatory scheme, the SEC weakened net capital requirements, an action that many experts see as having played a direct role in the crisis (as it is allowed investment banks to attain higher levels of leverage).
So, what little direct authority the SEC might have had — over how much money Lehman had to have around in case the market went south — it conceded in order to look at Lehman’s books to try to indirectly regulate Lehman’s potential negative effects on the market.
4. Congress specifically prevented the SEC from providing further oversight.
As if the SEC’s hands weren’t tied enough when it came to overseeing and regulating investment banks like Lehman, Congress — during the tenure of Clinton SEC chair Arthur Levitt (1993-2001) — repeatedly scaled back the SEC’s enforcement ability through statutory actions and budget threats. According to Smith:
Congress has repeatedly limited SEC enforcement capabilities, starting with Arthur Levitt’s tenure as SEC chief. The SEC is the only major financial regulator which does not keep the fees it collects, but instead turns them over to the government and in turn gets an allowance, um, budget, that is considerably lower. But more important, when Levitt wanted to step up enforcement on the retail front (much less controversial and resource intensive than on the institutional investor side) he was not merely blocked by Congress, but actively threatened with budget cuts.
It appears that the financial sector’s lobby was nearly as influential then as it is now.
5. The Fed and the SEC failed to share information in their ongoing turf war.
One of the main criticisms of the current financial oversight system is that regulatory functions are split between too many agencies to be effective. In the case of Lehman’s collapse, both the Fed and the SEC were involved, but neither was talking to the other and, like a kid working between two fighting parents, Lehman made the most of that. Lehman required the cooperation of commercial banks to clear their transactions and stay in business but the commercial banks — more concerned than the government that Lehman would fail — required Lehman to put up more than the usual amount of collateral to continue doing business with them. In the mean time, the SEC was pressuring Lehman — though not requiring, because it had no statutory authority to do that — to keep more capital free to cover losses. So Lehman didn’t tell the SEC about the collateral requirements and left the money on its balance sheets; but it told the Fed, which didn’t know about the SEC’s liquidity demands. Smith says:
Oh, and by the way, the Fed was aware of at least some of these collateral tie-ups (p. 1514), yet didn’t inform the SEC even though the two bodies had a memorandum of understanding in place (the report makes clear both sides were not sharing all information with each other).
This exact problem is the one consolidating authority is expected to ameliorate, and the consolidation of authority is what financial services companies would like to stop.
Of course, it goes without saying that that the board of Lehman assumed that they, like other banks, would be deemed “too big to fail” and thus be bailed out — in other words, they acted with moral hazard, assuming that there was no real risk of failure because the government was so involved in the rescue process. Whoops.