On September 15, 2008, the U.S. investment bank Lehman Brothers collapsed and sent a shock wave throughout the financial system. What followed was a global financial crisis and a worldwide recession. Since then, the fall of Lehman Brothers has become a symbol of all that is wrong with banking, with the financial system and--to some--with capitalism itself.
Two questions emerge from this: "How did it all happen?" and "What can we do about it?" Certainly these two questions are closely interlinked. We have to learn from the past in order to shape the future.
The roots of the financial crisis stretch back a long time, far beyond the day Lehman failed. And to some extent, the financial crisis had the same origins as many earlier crises: high credit growth, fueled by an environment of low interest rates.
There was, however, a specific element to this crisis: financial innovation. In the 1990s, new types of securitization were added to the toolbox of financial engineers. These made it possible to bundle together large portfolios of loans and to sell small tranches of them. In essence, securitization is an instrument to enable the efficient allocation of risks. However, there were two problems that turned this otherwise beneficial instrument into a "financial weapon of mass destruction": distorted incentives and a lack of transparency.
During the 2000s, many financial firms granted large amounts of loans, especially in the subprime segment of the mortgage market. However, they did not intend to hold these loans on their own books for long--the loans were only "warehoused." Instead, the firms securitized the loans and eventually sold them on to other investors.
This originate-to-distribute business model destroyed incentives for prudent behavior. The originators of the loan knew they would swiftly shift the risk further down the line, so why should they bother to take particular care in evaluating the creditworthiness of the borrower?
This induced a fall in lending standards and led to a flood of cheap mortgage loans to subprime borrowers. The associated risks were spread throughout the whole financial system. And due to a lack of transparency, no one really knew on whose balance sheets the risks eventually ended up.
Then in 2007, housing prices in the United States started to falter and U.S. subprime borrowers started to default on their loans.
Once that happened, a crucial asset in financial markets just vanished: trust. As no one knew the exact extent of banks'...