What a way to start a Monday morning with news of Lehman Brothers filing for bankrupcy and Merril Lynch being bought by Bank of America.

Hardly unexpected though for Merril Lynch. Many in the industry have been expecting something like this to happen since earlier this year as the result of its losses on bad loans in the US mortgage market and the ensuing credit crunch all over the world. There have been all sorts of rumours about the “bad state” of Merrils.

Lehman Brothers is a bit more of a surprise. Reuters has some commentary about just how unexpected and swift the downfall of the bank has been. Ultimately though, the cause of its collapse is the same as the troubles of Merril Lynch and Bear Stearns earlier this year: link

Looking forward: An interesting thing to ponder is, when the world eventually emerges out of whatever global economic calamity we are yet to fully face, will the investment banks and regulators learn the lessons of the noughties?

Which is to say, will banks ever learn to take the long term view, assess and price their investments fairly and not take unjustified risks? And will their regulators get better at understanding banks’ business risks and strategies and become effective at steering their behaviour to prevent calamities such as the current one ?

Tricky one: Having seen the way this industry works from within, I fear there is no easy positive answer for this.

Investment banking in its current shape and form is driven by traders who chase short term profits because banks give them a very strong incentive to do so through huge banking bonuses. And auditors and regulators all too often do not seem to have the killer instinct of getting to the bottom of dodgy dealings and spotting the rot before it sets in systemically. We have also seen recently that credit rating agencies are not independent and actually give ill considered or biased views on investment portfolios they are assessing (underestimating the riskiness of “credit tranche” transactions being a top recent example).

Frankly, it feels that many lessons of the past get taken on board for a short while then swiftly forgotten at the next “up” of the economic cycle. For instance, lending to risky customers is always on the up when things are rosy, only to cause bad loan writedowns when things turn nasty.

Way forward? I don’t feel that even if banks will emerge out of this upheaval intact, they will learn long term lessons from the current debacle – unless they drastically improve the way their internal risk-and-reward model operates. They will otherwise always continue chasing short term trading gains putting the world financial markets at risk.

Long term financial stability might better be served by the emergence of other types of financial institutions that take their responsibilities to shareholders much more seriously.

The role of regulators in the current crisis is yet to be fully reviewed, but one thing for sure – they need to not only admit to having failed to prevent what has happened (which they have), but offer a convincing strategy, backed up by concrete steps, on effectively strengthening their role in the future.

Without that, we have no safeguard against a repeat performance, and you and I will continue footing the bill.

I welcome people’s feedback and comments on the above comments.

Copyright 2008 by CuriouslyInspired