Lehman Brothers’ collapse a decade ago changed the financial services industry and brought about stronger regulation around the world. Now efforts to relax those regulations have emerged in both the US and UK – amid a turn towards protectionism in both jurisdictions.
Will the past decade’s changes be enough to mitigate the effects of a future downturn and prevent a similar financial collapse? Hogan Lovells partners from the US and UK discussed the current and near-term regulatory environment for financial institutions during a recent media roundtable.
Government Agencies and a Post-Lehman Approach
Following the collapse 10 years ago, the regulatory landscape shifted from one of risk avoidance to total risk aversion. The industry was focused on recapitalizing and renewed regulatory oversight. The Dodd-Frank Act passed, and the Department of Justice (DOJ), Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) increased their roles in monitoring financial institutions, becoming key players in the post-collapse clean-up. The industry had very little transactional activity and very little growth.
The DOJ increased the number of investigations, identifying systemic issues within institutions, and through the so-called “Yates Memo” which sought to prosecute individuals and not merely organizations – attempted to avoid the notion that it had succumbed to the mantra of “too big to jail” by focusing prosecutions on the individual, rather than merely the organization. The CFTC, which played a relatively minor role as a financial services enforcement agency pre-2008, led many of the investigations and enforcement actions, starting with LIBOR. The CFTC also became a more important regulator in derivative markets, as Dodd-Frank granted the commission authority over swaps. Dodd-Frank also spawned the Consumer Financial Protection Bureau (CFPB), the first federal financial consumer protection agency in the US, which during the Obama Administration became an aggressive regulator of banks, other lenders and other financial services companies.
While stronger laws, regulations, and institutions may have been necessary at the time of the collapse to stabilize the economy and the financial sector, the heightened emphasis on regulatory enforcement drastically slowed financial industry innovation, reducing transactional activity and hampering growth. In response to the increase in enforcement, traditional banks focused on managing risk and compliance, and (seemingly) little else.
A decade later, these regulations have been relaxed – at least in the US – and US banks have become much stronger; they are better capitalized than before the crisis and are making strong profits. The current period of growth has resulted in banks expanding their products and footprints.
Going forward, we expect to see banking regulators focus on corporate governance. The CFPB, having pivoted during the Trump Administration to its core activities, will try to define “abusive practice,” rather than rely on a vague and undefined term, to support investigations and enforcement actions. Those describing themselves as consumer advocates are concerned about these trends, but some states may pick up the perceived slacks through the activities of state Attorneys General and “mini-CFPBs.”
On the business side, deposit gathering in the US will remain a battleground for banks, including new entrants (e.g., Goldman Sachs’ Marcus and Barclays’ new US offering). On the M&A front, we will continue to see massive consolidation at all levels of asset classes.
Additionally, the emphasis on organic growth post-Lehman focused banks on looking for ways to grow through deposits including digitally, with larger banks becoming more competitive in acquiring customers.
Make Way for Financial and Lending Alternatives
After the financial crisis, many banks developed a zero-risk attitude – which opened the door for alternative lenders and financial service companies who were more willing to take risk. Financial alternatives, specifically FinTech companies, rushed to fill the market gap that was left as banks focused on complying with new regulation and regaining their reputations. With regulatory sandboxes in place and a proven product, FinTech companies gained market share from traditional banks – and the increased prevalence of FinTech has created an interesting debate on how the new financial service should be regulated. It’s a conversation that will continue into the next decade.
A similar scenario occurred in lending as direct lenders and non-traditional lenders, such as Quicken Loans, Caliber, and Rocket Mortgage, provided a product traditional banks were too risk-averse to offer. Direct lenders are not held to the same regulation as traditional banks, resulting in substantial growth. Like FinTech, the debate about non-traditional lending regulation will continue.
It was not only a focus on financial compliance that made way for nontraditional financers and lenders, it was also in part due to the lack of trust in banks and a lack of values that engendered a transparent and customer-centric culture. Following the collapse, banks reassessed their internal cultures and how they treated customers in hopes of regaining customer trust. Meanwhile, nontraditional financers capitalized and made sure to put culture and the customer first and foremost.
Cleaning up the Mess
While nontraditional lenders and financers capitalized on the banks’ renewed focus on regulation, enforcement agencies such as the DOJ, SEC, and CFTC were left to investigate who was responsible. Post-Lehman, large regulatory investigations increased, first related to securitization of mortgages. But increasingly, anti-trust and manipulation theories were pursued in relation to LIBOR and other financial benchmarks as well as allegedly unlawful trading practices in various financial markets.
While many claim the DOJ and regulatory enforcement agencies did not do enough to prosecute those considered responsible for the collapse, the sentiment inside the agencies was entirely different. Following the collapse, DOJ lawyers worked diligently in their investigations, but because criminal law requires proof of intent, successful prosecutions of individuals were relatively uncommon.
The question now is: Has enforcement policy changed enough so that prosecutors could successfully try individuals responsible for another collapse? The struggle to prove individual intent will probably continue to make difficult prosecution of offenses allegedly occurring in complex financial markets.
Looking Forward
Ten years after Lehman, the financial system appears relatively stable. Yet, with great uncertainty in both geopolitics and the regulatory environment, and as nontraditional financial services gain prevalence, the ability to maintain financial stability through regulatory enforcement is disputed. Even with the changes in the past decade, the question of how prepared financial institutions are to handle an all-but-certain economic downturn in the next decade remains.
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