One Year Later: Fed, Treasury prevented catastrophe, but systemic risk remains

How would an optimist view the financial world, one year after the start of the global financial crisis? Well, to start with one would point to the everyday, hum-drum reality of commerce: day-to-day commercial transactions are taking place and business as we know it in the United States is still occurring.

That may not seem like a major achievement. But consider that about a year ago the global financial system came within hours of a complete meltdown -- a financial crash that certainly would have rivaled the Great Depression in economic, social, and political impact.
Lehman Brothers' collapse didn't just hurt firms that did business with the venerable investment bank. It was a calamity for the entire financial system, destroying banks' trust in each other around the world. The commercial paper market – short-term loans that many corporations use to fund daily operations, pay suppliers and meet payrolls – all but dried up. At the depth of the crisis, even industrial giant General Electric (GE), still bolstered by a "AAA" credit rating, was having trouble borrowing. Global commerce itself seemed imperiled.

Then the Federal Reserve and the Treasury stepped in. The Fed establishing a series of credit facilities to thaw the frozen credit markets. Meanwhile, the Treasury injected funds into, or offered guarantees for, Citigroup (C), Bank of America (BAC) Fannie Mae (FNM), Freddie Mac (FRE) and other pivotal financial institutions.

Taken together, these heroic measures resuscitated a global financial system on the brink and, at least for now, averted the a repeat of Lehman's collapse -- a turn of events that surely would have had truly devastating consequences for the world economy.

So when your neighbor asks you what good has come of the government's intervention, tell him that companies are paying workers, ATMs are still spitting out twenties, the stock market is open and banks are still making loans to creditworthy businesses and home buyers. In a nutshell, an optimist would argue that governments, here and around the world, played a central role in averting catastrophe.

Moral hazard remains

That's not to say the contagion that sickened the financial world last year has been completely cured. The financial industry's biggest players apparently haven't learned that it's unwise to play outside in the snow so soon after recovering from the flu. Given the size of the financial crisis, it's astonishing how little has changed on Wall Street.

Incredibly, taxpayers still seem likely to take the hit when banks lose money while shareholders reap the rewards when they profit. Without further reforms, if another big financial institution fails, will the federal government again have to spend public money to stabilize it or take it over?

What's more, very little has been done to reign in bank executives' pay. It's still possible to get rich by peddling toxic assets, after all. The European Union wants to place limits on executive compensation at banks, but there's little support for caps in United Kingdom and United States, so the measure is not likely to make a meaningful difference.

Lastly, there appears to be little change in Wall Street's culture of "IBG" -- as in, "I'll be gone" before the true costs of reckless decisions become clear. It's a mentality that puts quick gains ahead of practices that build shareholder value over the long term.

What could make the system safer? As a colleague, economist Peter Dawson has argued, two-tier banking -- federally insured deposits for typical, low-risk banks; no insurance for deposits (and no government bail-outs) at commercial banks that take high risks -- would be a step in the correct direction.

In summary, the optimist would say investors, and Americans in general, should be thankful that the Fed's and Treasury's actions have averted a global financial collapse. But even these optimists would recognize that very little has changed on Wall Street or in the financial system, and if the systemic risks are not addressed, they could lead to an even bigger financial crisis in the years ahead.

Financial Editor Joseph Lazzaro is writing a book on the U.S. presidency and the U.S. economy.
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