Lehman Brothers - Is a Better Risk Management the Key to Prevent Such Another Failure?

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Table of Contents

Executive Summary        

1. Background        

2. Development of the Problems        

3. The Culprits of the Failure        

4. Failure of Controls        

5. Prevention Approaches        

Conclusion        

Bibliography        

Executive Summary

The failure of Lehman Brothers is an important point of modern economic history, as it is seen as the starting point of the financial crisis of 2008.  In a matter of just eight months a successful and respected financial institution filed for bankruptcy creating a ripple effect across the banking industry worldwide.

 In this paper the genesis of the risks of Lehman Brothers are examined and it is found that the risks were well within the limits of executives and management of Lehman Brother to prevent or at least limit the consequences of the complete failure. It was possible to survive despite suffering a serious damages if Lehman Brothers did not blindly believed that their all of their actions will be met by success – a classic example of gamblers fallacy and a critical point of risk management.

The business model Lehman was following was nothing uncommon in the banking sector. A large number investment banks have followed some variation of a high‐risk, high‐leverage model based on the assumption of counterparties to sustain. ). But the assets were mainly long‐term, while the liabilities were largely short‐term, resulting in a classic case of asset liability mismatch. Lehman funded itself through the short‐term repurchase agreement (repo) markets and therefore had to keep borrowing large sums of money in those markets on a daily basis to be able to operate. A critical point in that systems was the confidence of counterparties; the moment such repo counterparties will lose confidence in Lehman and decline its daily funding, Lehman will be unable to fund itself and/or continue operation.

Lehman ultimately failed because it was unable to retain the confidence of its lenders and counterparties. A series of business decisions of Lehman had led to heavy concentrations of illiquid assets with deteriorating values including residential and commercial real estate.

Even though the majority of decisions of Lehman Brothers were basically not unordinary and at least partly comprehensive, there was a big failure in terms of relating the decisions to its risk taking capacity. It is also proven that Lehman Brothers did not follow proper valuation procedures and that some valuations were unreasonable for the purpose of solvency analysis (Bruemmer & Sandler, 2008). In addition the way Lehman Brothers used REPO 105 can be defined as fraudulent, it focused on form over substance. The purpose of the repurchase agreements was to temporarily remove securities inventory from Lehman’s balance sheet and resulting create a materially misleading picture of its financial condition. Additionally to its material omissions, Lehman also misrepresented in its financial statements that it treated all repo transactions as financing transactions for financial reporting purpose in its financial statements. All these control failures led to the collapse of Lehman Brothers.

But all in all proper articulation and observance of risk management controls from internal and external parties could have prevented the collapse of Lehman Brothers. The most critical role in prevention and limited consequences of company failure is an adequate, reliable, complete risk management through out the entire company. Such an implemented risk management could have prevented or at least limited the damage of the Lehman collapse.

1. Background

Lehman Brothers Holdings Inc. was a global financial services firm a company with a 158-year history, including 14 years as an NYSE-listed giant. It was the fourth-largest investment bank in the US, doing business in investment banking, equity and fixed-income sales and trading (especially U.S. Treasury securities), research, investment management, private equity, and private banking. Lehman once employed 28,000 people across the world, including 5,000 in London. But within just 8 month Lehman Brothers collapsed and declared bankruptcy on September 15, 2008. Lehman Brothers bankruptcy is seen as a critical event in the Global Financial Crisis, exposing serious fault- lines in the structure of global financial markets and leading to widespread economic disruption worldwide.