Two Years After Lehman, Is the Financial System Safe -- or Just Safer?

Since Lehman Brothers went bankrupt in September 2008, financial regulators around the world have begun erecting a scaffolding of new rules and regulations designed to place limits on excessive risk-taking. The big question is: Are they enough to prevent another financial crisis from taking place?

The central plank of the new financial order in the U.S. is the Dodd-Frank financial overhaul bill signed into law by President Obama last July. The massive bill, spanning more than 2,000 pages, covers panoply of topics, from what constitutes a safe mortgage to the identification of large financial institutions as systemically important so that they can be taken over and dismantled in the event of another crisis.

The latest piece of the new regulatory framework emerged over the weekend of Sept. 11, when an international committee of central bankers meeting in Basel, Switzerland, approved new rules for bank capital requirements. Called Basel III, the rules aim to increase the amount of money banks have to set aside for an emergency from the present 2% of assets to around 7%, by 2019.

"Significantly Less Damaging"

Neither Dodd-Frank nor Basel III will come into effect immediately -- or possibly not even for years. In the case of Dodd-Frank, more than 60 regulations have to be written to describe exactly how the law will be implemented. Basel III must be approved by national governments around the world (and its major rules will be phased in over 10 years). Despite the momentum now built up for Basel III, its predecessor agreement, Basel II, was never approved by a rejectionist U.S. Congress.

"Nothing will keep us from having future financial crises, because we have systems that are run by humans," says Douglas Elliott, a former investment banker who is now a fellow at the Brookings Institution in Washington, D.C.

"What we can do is make them significantly less frequent and significantly less damaging," Elliott says. "Basel III will be a big help in that regard because one of the great things about capital is that it provides you with a general level of protection without having to guess in advance what the next problem is going to be."

While some critics have bemoaned the fact that the 7% capital requirement agreed was less than what the U.S. had wanted, Elliott pointed out that the regulators have also recalculated the risk weighting of assets, so the eventual cushion may end being 8% or 9%. "This is a big step forward," he says.

A Framework for Mitigating Damage

Delores Atallo-Hazelgreen, a leader in the governance, risk and regulatory financial services practice at New York-based consultancy Deloitte & Touche says one of Dodd-Frank's major achievements is that it wasn't written exclusively for banks. It also includes "nonbanks" among the institutions that are considered systemically important and thus within the Federal Reserve's regulatory reach.

After all, it was the collapse of an insurance company, AIG, that nearly brought down the financial system and had to be bailed out with the injection of $180 billion in taxpayer funds. AIG wasn't on the radar screens of financial regulators at the time of the collapse, so the new law seeks to bring companies like AIG under scrutiny.

"When you look at what the crisis was about, it was asset quality, it was about liquidity, it was about capital," Atallo-Hazelgreen says. "In Dodd-Frank, there's mindfulness about asset quality and specific oversight around capital cushions. Some good governance is also in the regulation. We're creating a framework where we're mitigating the things that got to us last time."

More Consumer Protections

Already Dodd-Frank has had an impact on Wall Street. Firms such as Goldman Sachs (GS) and Citigroup (C) have begun selling off their proprietary trading desks, where the firm bets its own money, something prohibited by Dodd-Frank's "Volcker Rule" (named after former Fed Chairman Paul Volcker, who was concerned about banks taking excessive risks). Morgan Stanley (MS) has also sold off its hedge fund.

Dodd-Frank also contains extensive protections for consumers on such things as mortgages and loans, thanks to a relatively independent Consumer Protection Board that will be housed within the Fed. There were reports Tuesday that Obama has chosen Elizabeth Warren, a Harvard law professor, to head the agency, despite opposition from Republicans in Congress who think she's too liberal.

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Atallo-Hazelgreen says another important part of Dodd-Frank is the requirement for "living wills," a document each institution will have to draw up to specify how it would unwind a failing part of its business or completely dissolve the firm. The idea is to have this done in an orderly manner, not the chaos the reigned when Lehman Brothers announced its bankruptcy filing on Sept. 14, 2008, leaving counterparties to transactions worldwide not knowing how much exposure they had to the firm.

A Step Backward?

Not everyone is totally sanguine about Dodd-Frank's ability to stave off the next crisis. Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University, says the bill has some major flaws.

For example, Hurley says, the Fed can no longer bail out an individual institution under the law but only can help a community of troubled banks at the same time.

"The Fed can't do a rifle shot," Hurley says "I think they removed the safety net. For two centuries, the essential function of a central bank has been to calm a panic. Now they can only calm a panic if it already has metastasized into more than one institution."

Asked if he felt that the body of new rules made the financial system safer than it was in 2008, Hurley replies: "No."