Lehman BrothersScandalEmil ArtykbaevZhongren ChenJennie NguyenVanish PatelSijan Thapa

Contents• Introduction to Corporate Governance• Governance Theories• Lehman Brothers Profile• Why it is a scandal

• Regulations prior to scandal• Regulation changes in light of the collapse• Effect to the financial stock markets• Bailout comparison and governance relationship

• Conlusion• Questions

Introduction

• Corporate governance is the system by which companies are directed and controlled.

• Corporate Governance parties:a) Shareholders – those that own the companyb) Directors – Guardians of the Company’s assets

for the Shareholdersc) Managers who use the Company’s assets

Four pillars of Corporate Governance:

Accountability

Fairness

Transparency

Independence

• Ensure that management is accountable to the Board

• Ensure that the Board is accountable to shareholders

• Protect Shareholders rights

• Treat all shareholders including minorities, equitably

• Ensure timely, accurate disclosure on all material matters, including the financial situation, performance, ownership and corporate governance

• Procedures and structures are in place so as to minimize, or avoid completely conflicts of interest

Corporate Governance Theories:

Theories

Agency Theory

Stakeholder theory

Stewardship theory

Transaction Costs

Economics

Lehman Brothers

• Founded 1850• Industry: investment service• Headquartered in New York City, US• Three segments are Capital Markets, Investment

Banking and Investment Management• Auditor: Ernst & Young• Before bankruptcy: was the 4th largest investment bank

in US • Bankruptcy protection: September 15,2008• November 16, 2010: US bankruptcy court stated LBHI

directly return $50b plus interest to BOA within 2 weeks

Lehman Brothers

• Before bankruptcy: was the 4th largest investment bank in US • Bankruptcy protection: September 15,2008• November 16, 2010: US bankruptcy court stated LBHI directly

return $50b plus interest to BOA within 2 weeks

Why it was a scandal?• In July 2008: an overdraft of $65b in one of Lehman accounts.• Accounting manipulation: used device called “Repo 105” to

manipulate the financial accounts and made it looks healthier than it was.

• Hiding the truth about the amount of their losses to the public

Cause of collapse• Collapse of the Mortgage Backed Securities• The loss of potential investors• Rejection for bailout from US treasury, leading to negative

market sentiment• Negative knock on effect

Regulations before - Glass Steagall Act

• Stiglitz (2010) argues that markets fail to produce efficient outcomes due to important agency problems and externalities.

• The Glass-Steagall Act was the “last line of defense” against excessively risky and unjustified behavior banks.

• Its repeal ended separation of investment and commercial sides, and created even larger banks that were “too big too fail”.

• The temptation for banks to use the commercial side to engage in proprietary trading is too great (Stiglitz,2010) due to serious conflicts of interest.

Regulations before – Basel I

• Created requirements for banks for capital retention • Minimum 8% of risk weight assets • Problems:

1. Conflict of Interest created from auditing and risk assessment

2. Systematic risk and strong interbank connections/internal practices

• However, there were many flaws which lead to the creation of Basel II due to lack of diversification, focusing only on credit risks as opposed to all risks and over simplifying calculations

Regulations before – Basel II

• Objectives: —Create standards and regulations on

how much capital financial institutions must have put aside.

—Based on three pillars1. Minimum capital is the technical,

quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk

Basel II (continued)2. Supervisor review is the process whereby national

regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system

3. Market discipline is based on enhanced disclosure of risk. Under Basel II, banks may use their own internal models (and gain lower capital requirements) but the price of this is transparency

CriticismsFixed many of Basel I’s problems but became too complex for defining risks, and the approaches for each risk. Pushed for more transparency and policies to accommodate different cultures

Regulations after - Basel III

• Objectives:• Response to the deficiencies in financial regulation

revealed by the financial crisis in 2008.• Continue to raise capital requirements for banks.

• Requirements:• Tier 1 capital requirement ratio will increase from 4.0%

to 6.0%. • The required ratio of equity to risk-weighted assets will

rise from 2.0% to 4.5%.

Criticism of Basel III

• Likely to create tighter credit conditions for small and medium-sized firms, and for start-up businesses• Non-bank financial institutions, such as

investment banks and hedge funds, will play an increasingly active role, as the Basel Committee’s proposals do not concern this increasingly important sector of the financial system

Effect on stock markets• Reduced global stock market values by “$10 trillion in

market capitalisation”• Intensified the downturn that started in late 2007 created

from the subprime mortgage• Source : Investopedia

• Further regulation changes are said to be the ring-fencing of consumer and investment branches of the banking sector. However this can have major implications on the wider banking sector for example, the United Kingdom

Lehman Collapse

Bailout comparison• The US Federal Reserve created Troubled Asset Relief Program

(TARP) to purchase the toxic assets of mortgage backed securities

• Much like quantitative easing, it increases the cash flow for banks so they can increase lending

• USA TARP = $700bn in assistance, but now $475bn• UK Bailout = £1.16tr at peak but £456bn (Sept. 2011)• Both countries have stakes in companies and banks, such as

RBS, Chrysler, AIG and Northern Rock.

• Agency theory problem• Stakeholder theory• Turnbull report connection

Conclusion• Lehman Scandal primarily due to subprime mortgages due to

taking on questionable borrowers • Risk management was the main cause created by all banks

• Effects could have been lowered if Lehman Brothers were given assistance

• Need to further regulations, after much deregulation in the past decade

• Basel III is a step forward in creating non-toxic balance sheets• Maybe there is a requirement to have Glass Steagall Act

reintroduced, as it is risk management like the Turnbull Report (1999)