One year ago, following the collapse of Lehman Brothers, the $3.4 trillion money market fund industry essentially froze up when The Reserve Fund "broke the buck." That was the real start of the financial crisis, as this blog has suggested in the past.
The best detailed description how this event caught the Fed and the Treasury Department off-guard is now the recent extensively researched article by Bloomberg reporters.
There is a lesson to learn (or relearn, if you have forgotten three hundred years of financial market history) from the article: in a complex financial world with many players, an unexpected, catalytic event can lead to a rush for liquidity which threatens to overwhelm not just all the players, but the customers and spectators as well.
The real danger now is that governments will over-react with poorly thought-out legislation and regulation that will create even greater problems down the road.
While some of the suggestions for reform are sensible (such as requiring larger banks to hold more capital), the list of "further steps" that the G-20 heads of state and ministers are supposed to consider in Pittsburgh later this month contains the potential for substantial amounts of mischief and unintended consequences, e.g. "global standards on pay structure" and "oversight for systemically important firms." (The latter item has taken on concrete form in the proposed legislation to have the Federal Reserve designate "Tier I" firms, as discussed in my previous blog.)
At Least Lehman Brothers Was Allowed to Fail. Despite much talk of the "mistake" in letting Lehman Brothers fail, there are some astute observers (see Niall Ferguson in yesterday's Financial Times) who point to that event as a much-needed reminder that very large institutions can fail - and all managers, shareholders and creditors of other financial institutions should keep this always in mind.
Never permitting another Lehman-type bankruptcy is the worst possible policy goal of financial reform. As Ferguson points out, "the real tragedy is that the failure of Lehman has left Wall Street's survivors both bigger in relative terms and more secure politically . . . if only we had learnt from Lehman that no bank should be 'too big to fail', we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year's crisis."
Ferguson is a bit too gloomy, and no doubt the attempt to ensure "a level playing field" around the globe will slow down truly ill-advised initiatives. But never underestimate the ego of determined politicians to "do something."
