The Lehman Brothers failure was a giant mess. It shook markets, caused panic, and helped to trigger the severe financial crisis that followed. It isn't hard to imagine why -- think of the financial market as a human being and their kidneys as Lehman. Just like the human body, the financial market is interconnected, so when one of its vital organs fail -- a big bank -- the entire system can collapse. But what if last summer's financial regulation bill had been in place? Would the failure of Lehman been easier for the market to handle?

A new analysis (.pdf) released this week by the Federal Deposit Insurance Corporation examines this question. It asserts that a few mechanisms in the regulation bill would have made the situation much less painful and less costly. In particular, it imagines how its expanded powers under the newly established non-bank liquidation authority would have helped.

The paper provides some detail on how the situation would have been different, but it can be summed up pretty easily: the FDIC would have forced Lehman to find an acquirer sooner, and a bid would have been accepted. The way the FDIC claims it would have accomplished this feat has to do with four central factors.


The first key is the FDIC's new power to wind down an institution when regulators ask it to do so. In 2008, it could not have told Lehman that it intended to wind it down once reports surfaced that the firm was experiencing serious problems. Today, Lehman's liquidation could be ordered.

This would have made a big difference. Back in 2008, Lehman's management first insisted that the firm was fine and would survive. Once the firm's problems became undeniable, management asserted certain that it would be acquired. Once management realized a deal couldn't get done to its liking, it sought government assistance for a deal, like we saw with Bear Stearns. When the government balked, it was forced to declare bankruptcy.

In the future, the FDIC would inform a financial institution much earlier on that it intends to wind the firm down. Once management and the board of directors got this news, they would take acquisition offers far more seriously, because shareholders would be better off if the firm was acquired than if it got wound down by the government. In the latter situation, management would be removed and shareholders wiped out. 


But couldn't a firm simply wait until the government is forced to bail it out? According to the financial regulation bill, it could not. The legislation forbids the government from rescuing firms in the future, like it did in 2008. If big institutions believe this threat is real, then they must take the FDIC's authority seriously and accept a reasonable offer for acquisition.


Another luxury that the FDIC lacked in 2008 was access. Its new resolution authority allows the regulator significant access to systemically relevant firms. If their stability becomes questionable, then the FDIC has the ability to analyze its financial statements and determine if resolution is the right course of action. It can also provide better access and information to potential acquirers, something that some firms considering acquiring Lehman complained about.


Finally, the bill requires that all systemically vital firms create living wills. These will act as failure plans, so that the FDIC can be ready to push whatever buttons it must to ensure that the financial markets are impacted as minimally as possible by a firm's resolution. Obviously, it's impossible to avoid all disruption, but it is possible to do a better job of winding down a firm swiftly and cleanly through better planning.

The FDIC argues that its resolution authority could have drastically reduced the costs of Lehman's failure. When the firm declared bankruptcy much of the firm's debt or other obligations were sold at deep discounts as the market panicked. FDIC liquidation has long avoided this problem in the case of bank failures and would now provide the financial market the same benefit when a large institution collapses.

While the FDIC's paper is helpful in understanding how Lehman's failure might have been easier through its resolution authority, it fails to answer the tougher question: how would its liquidation authority have functioned when Goldman, Bank of America, and Citi also appeared to be on the verge of collapse? It's easy to wind down one firm in a vacuum, but when several of the industry's behemoths appear to be collapsing under market panic, you can't wind them all down simultaneously. How can regulators calm markets in that situation without a bailout?

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