A cold wind blew through the offices of the world's investment banks five years ago this weekend, writes Clancy Yeates.
It was the corporate collapse that shook global finance to its core. Former US Federal Reserve chairman Alan Greenspan dubbed the bankruptcy of Lehman Brothers and its fallout a "once-in-a-half-century, probably once-in-a-century type of event".
A top Australian banker describes the investment bank's demise as the moment when credit markets realised "banks can go broke". "In the past as a bank you could basically borrow as though there was no risk," the banker says.
When the once-venerable US bank filed for bankruptcy five years ago this weekend, it triggered a wave of panic and an unprecedented freezing up in the world financial system. Its legacy still lingers around the world today, including in Australia.
Australia's S&P/ASX 200 Index fell by a third of its value between September and November 2008, destroying hundreds of billions of dollars in retirement savings.
Even though the market is now back to levels from before the Lehman collapse, BT Financial chief economist Chris Caton says the crash fundamentally changed the way many Australians see the sharemarket.
"They thought the sharemarket was a 'get rich quick' machine, but they've also discovered it can be a 'get poor' machine," he says.
"Investors are still very gun-shy even five years later, because they feel they've taken a real hit."
But the bruising of investor sentiment is just one of many impacts still working their way through the financial system.
Australia's big four banks - behemoths that hold $1.5 trillion in loans - have been forced to make sweeping changes to their business models. Profits are still growing strongly, but the sector faces a future where credit will not expand nearly as quickly as it did in the past.
Credit markets have also changed fundamentally. While confidence is recovering, investors are deeply dependent on support from central banks - support that must eventually be withdrawn.
This patchy recovery since the Lehman collapse has left global authorities in the middle of a delicate balancing act, with a financial system that is safer and more stable, but also less competitive and dynamic, and potentially a drag on future growth.
While Australia dodged the worst of the 2008-09 global recession, Lehman's collapse and its aftermath continue to have far-reaching consequences for the country's financial system. And there are no bigger players in this system than the major banks: Commonwealth, Westpac, ANZ and NAB.
As industry insiders see it, two monumental changes stand out: One is how the banking system funds itself; the other concerns global regulation.
Over the 1990s and early 2000s, the business model that was driving more and more of the banks' growth was to borrow from large investors, rather than depositors, and then lend out the money.
When markets stopped trusting the banks after Lehman's collapse, this supply of wholesale money threatened to dry up. Banks have since been forced back towards the traditional model of raising money from depositors.
Ian Harper, a panel member of the Wallis review of the financial system in 1997, says this change has been one of the most critical shifts of the past five years.
"Prior to Lehman Brothers, you would have expected that capital markets would continue to grow and that balance sheet borrowing and lending - that is to say, taking deposits and making loans - would shrink," he says.
"Lehman Brothers turned that on its head. Now five years later balance sheet banking, good old traditional taking deposits and making loans, is more important than it's ever been," says Harper, a partner at Deloitte Access Economics.
Prime minister Kevin Rudd's immediate response was to guarantee banks' wholesale liabilities with the government's AAA credit rating, but the longer-term response of banks has been to scramble to get their hands on more deposits.
Since mid-2008, consumers have ploughed $239 billion into bank deposit accounts, boosting the value of total household bank deposits by 55 per cent.
The share of bank funding that comes from deposits has surged from about 40 per cent in 2008 to almost 60 per cent today, a shift bankers say should not be underestimated.
So far, this trend has gained publicity because banks have blamed it for not passing on interest rate cuts to borrowers in full. But bankers predict it will have much wider consequences for the economy in the long term. Most new loans must now be funded by deposits, which could put a brake on growth when credit demand picks up.
The other critical change in the financial landscape is tougher regulation.
Under rules set by banking regulators, lenders around the world are being forced to hold much higher amounts of capital, or shareholder equity, to absorb losses.
The Australian Prudential Regulation Authority, which prides itself on being conservative, is implementing these rules ahead of some other countries, sparking complaints within the banking industry.
An associate professor of finance at the University of Technology, Sydney, Harry Scheule, describes the new rules, known as the Basel III regime, as the most important changes to the financial system since Lehman's collapse. "It will most likely bring down return on equity for banks. It will make banking less profitable but much safer because it means that banks have to cover future losses," he says.
So far, the big banks' profits have not been meaningfully squeezed by the changes - return on equity in the sector is still a healthy 15 per cent and big bank profits are on track to exceed $26 billion this year.
But the Reserve Bank has repeatedly told banks they can no longer expect to rely on rapid growth in their balance sheets to expand profits.
The RBA's assistant governor responsible for the financial system, Malcolm Edey, stressed this point in a speech in March. "On any reading, it seems clear that this will be an environment where it is harder in general for banks and for the system as a whole to grow," he said.
Bankers also say the tougher regulations are likely to be a constraint on future growth in credit - and hence the economy.
"For every dollar of capital, we will be able to extend less credit next time than we were able to last time," one says.
And the managing director of Triple T Consulting, Sean Keane, points out that the global regulatory push has encouraged residential lending rather than business lending because home loans receive more lenient capital treatment. "There's much more caution among the commercial banks in Australia about lending for non-residential mortgage purposes," Keane says.
For all the tougher regulation, however, a key effect of the changes has been to concentrate power among the big banks.
After swallowing rivals such as St George, Bankwest, Wizard and Aussie Home Loans, the big four enjoy about 80 per cent of the market in deposits and loans.
Harper says the big four are now more powerful than they've been for decades, a theme that is likely to feature in the Coalition's planned financial system inquiry.
Against this, the system is also more stable than it was before Lehman imploded. Banks have more capacity to absorb losses, more stable funding sources, and they have so far been more cautious in their lending.
It is often said that regulators must trade off competition and stability when setting the rules for a financial system. After the shock of Lehman, they have opted for stability.
Changes in Australia are only part of the story, however.
As an importer of capital, the country is strongly affected by global credit markets. These virtually froze when Lehman collapsed. Conditions in these markets have improved dramatically from the lows of the global financial crisis.
A gauge of the global risk of lending to 25 of Australia's biggest companies, the iTraxx index, now trades just 110 basis points above the benchmark, compared with the spread above 400 at the worst of the GFC.
Bullish investors this week also pushed the S&P/ASX 200 Index to fresh five-year highs.
"It's not back to where it was, but it's a whole lot better than it was and it's out of the danger zone," says Nomura interest rate strategist Martin Whetton.
"Five years ago if you were a bank you could not borrow on the capital markets, you had to use the government guarantee. You don't need the sovereign balance sheet any more to raise money," he says.
"The 30,000-foot view is that we had those problems but they've largely been patched over by the amount of liquidity that's been injected into the system."
He points out that the yield on 10-year bonds issued by the Irish government - Ireland's was one of the economies worst hit by the GFC - is almost level with Australian government paper, which reflects this improvement.
"It's not just about safe havens any more, it's about yield. It shows that the risk in the 'bad' parts of the world, like Europe, has abated substantially," Whetton says.
But while confidence has risen, markets are far from standing on their own feet. Investors are being supported by central banks pumping billions of dollars worth of cheap credit into the market every day.
Keane says the improvement must be seen against "ongoing massive central bank support".
"The degree to which markets have wobbled in the last couple of months at the mere mention of tapering by the Federal Reserve gives you a real sense of the degree of reliance markets continue to have on the central banks," he says.
In the past six years, central-bank balance sheets globally have swelled from $US10.4 trillion to $US20.5 trillion as money printing was unleashed in full force.
The Bank for International Settlements warned in June that investors had become "overdependent" on this type of stimulus, and it was time for banks to wind the measures back.
But the very threat of withdrawal has created its own set of headaches.
The first mention of "tapering" in the Fed's $US85 billion-a-month bond-buying program triggered a spike in Treasury bond yields earlier this year, which has in turn caused speculative capital to quit key regional economies, especially Indonesia and India.
Next week, when some analysts think the Fed will make its first moves to "taper", looms as a potential test for how markets cope with less central bank support.
Five years on from Lehman, the world's financial system is undoubtedly on the mend. Propped up by central bank balance sheets, investors have regained the confidence needed for credit to flow around the world.
Despite fears over central-bank support being withdrawn, markets are a long way from the days when there was indiscriminate panic over the prospect of bank failure.
Australia has also emerged with a more stable system, which is likely to be more resilient in the face of future crisis. Yet it is also subject to tougher regulations, and is a more concentrated industry. According to critics, it is less competitive, which risks stifling innovation.
The role of finance is often likened to grease in the wheels of the economy. At some point in the future, bankers say, this more conservative and tightly regulated financial sector could become a drain on economic growth.
After the shock inflicted on the world five years ago, however, sacrificing slightly slower credit growth for greater safety is a trade-off that governments are more than happy to make.
HOW THE S&P/ASX200 RESPONDED
November 1, 2007
ASX200 hits all-time peak of 6828.7, then plunges 2% the next day as credit and housing market concerns lead to a downgrade of US banking stocks.
11-straight days of losses culminate in 3% drop on January 21. Australian investors panic-sell on the back of a plunge in US markets.
US investment bank Bear Stearns avoids bankruptcy after fire-sale to JP Morgan Chase for $2 a share.
Australian shares drop to 18-month lows.
Lehman Brothers files for bankruptcy, Merrill Lynch is sold to Bank of America and world’s biggest insurer, AIG, is saved by a US$85 billion bail-out. Australian shares drop to three-year lows; Macquarie Bank loses almost a quarter of value in one day. Regulators around the world ban short-selling in bid to stem the losses.
Prime Minister Kevin Rudd guarantees deposits held in Australian banks. The previous week, the Reserve Bank had slashed its cash rate target by a full 100 basis points — a move it would perform twice more in coming months — and the US Troubled Asset Relief Program was signed into law. Australian shares are now 40% lower than November 2007 peak.
March 6, 2009
The ASX200 hits a six-year low, ending a horror week in which $50 billion is wiped from the value of Australian shares — now 55% down from its November 2007 peak. Australian GDP had retreated in the December quarter, stoking fears Australia was headed for recession.