After the Fed bailed out Bear Stearns and arranged for its sale to JP Morgan, I blogged saying that the Fed hadn’t done the right thing, and was now creating a situation of moral hazard.
When Lehman was in trouble, I said that this was a good time for the Fed to make amends for not allowing Bear to fail. Reputed commentors such as Michael Lewis backed up my claims (sorry, i’m too lazy to find links). And the Fed seemed to take our suggestion. And Lehman was allowed to fail
Now, following Lehman’s collapse (and I’m not sure if there’s a causality here), the entire global financial system is in trouble. No one is lending to each other (remember that in my original post I had said that the point of removing the moral hazard is that no one will lend to bad banks. Based on that it’s like as if all banks are bad now). The remaining banks are going down one by one.
It seems like the Lehman collapse is just a small part of the larger picture, and if things continue to go bad the way they’ve been, it’s even likely that the impact of the Lehman collapse will not be major compared to the total size of the crisis.
So the real danger is that by the time the crisis is over and everyone has recovered (it’ll take a long time indeed for this to happen), people would’ve forgotten about Lehman. Forgotten that banks are not necessarily too big to fail (and given how bad things have got, the Fed cannot allow more banks to fail). Forgotten that no one will bail out the creditors if someone in the system tells jai. And people will go back to their old bad habits
Important question to ask here is the role of the Lehman collapse in the magnitude of the current crisis. There definitely has been some impact, but it would be interesting to see exactly how much. Would this collapse have been as bad had Bear been allowed to fail when it was about to fail? How much incremental damage was done to the system in the six months between the two major ibank failures?
In hindsight it seems like the Fed might have done better in letting Bear fail rather than letting Lehman fail; actually we aren’t even sure of this.
The question remains as to how discipline will be ensured in the system, without too many restrictions, once the system is back up on its feet (it’s going to take a long time, mind you). Maybe we will see smaller banks. Large networks of smaller banks, with none too big to fail. Yes, there will be continuous churn, wiht banks failing continuously and new banks coming up to replace them. Banks will be more ruthless in dealing with each other.
But how does one ensure that the system goes into this particular steady state, and not any other, once it’s back up?