Ben S Bernanke: Lessons from the failure of Lehman Brothers
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 20 April 2010.
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Chairman Frank, Ranking Member Bachus, and other members of the Committee, I appreciate
the opportunity to testify about the failure of Lehman Brothers and the lessons of that failure. In
these opening remarks I will address several key issues relating to that episode.
The Federal Reserve was not Lehman's supervisor. Lehman was exempt from supervision
by the Federal Reserve because the company did not own a commercial bank and because
it was allowed by federal law to own a federally insured savings association without
becoming subject to Federal Reserve supervision. The core subsidiaries of Lehman were
securities broker-dealers under the supervisory jurisdiction of the Securities and Exchange
Commission (SEC), which also supervised the Lehman parent company under the SEC's
Consolidated Supervised Entity (CSE) program. Importantly, the CSE program was
voluntary, established by the SEC in agreement with the supervised firms, without the
benefits of statutory authorization.
Although the Federal Reserve had no supervisory responsibilities or authorities with respect
to Lehman, it began monitoring the financial condition of Lehman and the other primary
dealers during the period of financial stress that led to the sale of Bear Stearns to JPMorgan
Chase.1 In March 2008, responding to the escalating pressures on primary dealers, the
Federal Reserve used its statutory emergency lending powers to establish the Primary
Dealer Credit Facility and the Term Securities Lending Facility as sources of backstop
liquidity for those firms. To monitor the ability of borrowing firms to repay, the Federal
Reserve, in its role as creditor, required all participants in these programs, including Lehman,
to provide financial information about their companies on an ongoing basis. Two Federal
Reserve employees were placed onsite at Lehman to monitor the firm's liquidity position and
its financial condition generally. Beyond gathering information, however, these employees
had no authority to regulate Lehman's disclosures, capital, risk management, or other
business activities.
During this period, Federal Reserve employees were in regular contact with their
counterparts at the SEC, and in July 2008, then-Chairman Cox and I negotiated an
agreement that formalized procedures for information-sharing between our two agencies.
Cooperation between the Federal Reserve and the SEC was generally quite good, especially
considering the stress and turmoil of the period. In particular, the Federal Reserve, with the
SEC's participation, developed and conducted several stress tests of the liquidity position of
Lehman and the other major primary dealers during the spring and summer of 2008. The
results of these stress tests were presented jointly by the Federal Reserve and the SEC to
the managements of Lehman and the other firms. Lehman's results showed significant
deficiencies in available liquidity, which the management was strongly urged to correct.
The Federal Reserve was not aware that Lehman was using so-called Repo
105 transactions to manage its balance sheet. Indeed, according to the bankruptcy
examiner, Lehman staff did not report these transactions even to the company's board.
However, knowledge of Lehman's accounting for these transactions would not have
materially altered the Federal Reserve's view of the condition of the firm; the information we
obtained suggested that the capital and liquidity of the firm were seriously deficient, a view
that we conveyed to the company and that I believe was shared by the SEC and the
Treasury Department.
Lehman did succeed at raising about $6 billion in capital in June 2008, took steps to improve
its liquidity position in July, and was attempting to raise additional capital in the weeks
leading up to its failure. However, its efforts proved inadequate. During August and early
September 2008, increasingly panicky conditions in markets put Lehman and other financial
firms under severe pressure. In an attempt to devise a private-sector solution for Lehman's
plight, the Federal Reserve, Treasury, and SEC brought together leaders of the major
financial firms in a series of meetings at the Federal Reserve Bank of New York during the
weekend of September 13-15. Despite the best efforts of all involved, a solution could not be
crafted, nor could an acquisition by another company be arranged. With no other option
available, Lehman declared bankruptcy.
The Federal Reserve fully understood that the failure of Lehman would shake the financial
system and the economy. However, the only tool available to the Federal Reserve to address
the situation was its ability to provide short-term liquidity against adequate collateral; and, as
I noted, Lehman already had access to our emergency credit facilities. It was clear, though,
that Lehman needed both substantial capital and an open-ended guarantee of its obligations
to open for business on Monday, September 15. At that time, neither the Federal Reserve
nor any other agency had the authority to provide capital or an unsecured guarantee, and
thus no means of preventing Lehman's failure existed.
The Lehman failure provides at least two important lessons. First, we must eliminate the
gaps in our financial regulatory framework that allow large, complex, interconnected firms like
Lehman to operate without robust consolidated supervision. In September 2008, no
government agency had sufficient authority to compel Lehman to operate in a safe and
sound manner and in a way that did not pose dangers to the broader financial system.
Second, to avoid having to choose in the future between bailing out a failing, systemically
critical firm or allowing its disorderly bankruptcy, we need a new resolution regime,
analogous to that already established for failing banks. Such a regime would both protect our
economy and improve market discipline by ensuring that the failing firm's shareholders and
creditors take losses and its management is replaced.
Thank you. I would be glad to respond to your questions.