Banking’s Lehman lesson is that change must be cultural

Investment bank for sale, no careful owners. John Stillwell/PA

This weekend will see the 5th anniversary of the collapse of Lehman Brothers, an event that tipped the world into economic crisis and shoved banking into the spotlight. The critical state of the world’s banks during the crisis has meant nearly everyone seems to have an opinion about how to fix these illusive institutions.

Among all the different opinions seems to be an agreement that banks need to be made safer. This means that they should not undertake risky activities as they had in the past, they should have a better understanding of the risks that they are running, and if they do indeed fail, they should be allowed to fail in a way which does not bring others down with them.

So five years on from the collapse of Lehman, it seems reasonable to ask, how are the banks doing on making themselves safer?

Many of the large UK banks have exited from some of the most risky activities. RBS, for instance, wound down or sold off much of its investment banking operations in 2010. This has meant what had previously been very profitable businesses have been closed or significantly scaled back. The decreased appetite for risk has seen most banks become less willing to lend to both individuals as well as small businesses.

In addition to taking fewer risks, banks have changed the way risk is placed in their business. Following the Vickers report, banks are planning to “ringfence” more investment banking activities so that they are separated from the retail banking. This measure is supposed to buffer individual savers from the activities of investment banks. However, it does not go as far as some had hoped in separating two types of very different activity.

Spotting the problems

The inherent risks carried by the banks was one major issue. But an equally large concern was that most banks did not adequately understand the risks they were carrying. This was because of both how complex their dealings had become and because the way that risks were calculated meant that events that had a small likelihood of happening, but would have major systemic consequences (so-called “black swans”), were not accounted for.

But perhaps the most important reason behind the poor understanding of risk in many firms is the fact that entrepreneurial risk taking was highly valued. Those staff tasked with assessing risk were seen as getting in the way of doing business, and their power suffered accordingly.

Following the collapse of Lehman, banks made massive investments in their capacity to understand the risks they are running. “Risk management” has grown from being a painful afterthought to an integral part of a bank’s operations, helped by new technology that tracks and assesses risk.

But there are a number of issues that are more difficult to fix. The real thorny problem is whether the technical expertise that the banks now possess is actually matched with a broader culture of safety and prudence.

Other industries which have sought to become dramatically safer have only done so through a widespread cultural shift. This means routines, procedures and mindsets all geared around reducing unacceptable risks. For instance, the oil and gas industry responded to the Piper Alpha disaster by addressing its gung ho approach to safety through a broader process of cultural change.

The clean-up job

Spotting risks is important, but having a plan of what to do when things go wrong is perhaps even more important. One of the stunning insights to come out of the collapse of Lehman is that senior figures did not expect failure and certainly did not know what to do when it happened. Letting Lehman go belly-up was supposed to reduce moral hazard by showing banks that they should be cautious because no-one was going to help them out if they ran unacceptable risks.

However, this decision ended up revealing another weakness: that a failure in one part of the system would quickly spread to other parts. To avoid these problems, nation states decided to step in to recapitalize the banks. This resulted in huge holes appearing in national finances and subsequent cuts to public spending. Citizen resentment naturally followed.

The lesson from these episodes appeared to be that letting banks fail is not an option, nor is bailing them out. This has left central bankers looking for solutions, from increasing the amount of capital that banks hold on their balance sheets to “bailing-in” failed banks, converting creditors into shareholders.

As the banks look back on the past five years, they can be assured that they have learned some tough lessons. They appear to recognise that they need to change their ways in order to win back public trust. And many of the large banks have made a start. They have appointed more risk averse leaders, they have invested heavily in risk management, and they strengthened their balance sheets.

But there is still plenty to do. Banks need to ensure they do indeed meaningfully separate retail and investment banking. And they need to build a culture that encourages financial safety rather than reckless speculation. This won’t be easy, but it is one risk is worth taking.