The Guest Blog

Remember 'Lehman Weekend': Don't let up on reforms

Michael S. Barr
Getty Images

The "Lehman weekend" five years ago has taken on symbolic importance as the fulcrum of the financial crisis, but the roots of the crisis were broad and deep—planted in years of unconstrained excess on Wall Street and prolonged complacency in Washington and financial capitals worldwide.

"Shadow banking" permitted the financial sector to engage in highly leveraged, short-funded maturity transformation with too little transparency, not enough capital and little restraint. Large firms became more interconnected and became increasingly reliant on short-term funding from repo transactions, derivatives, money market funds, securities lenders and prime brokerage business. Huge amounts of risk moved outside the more regulated parts of the banking system to where it was easier to increase leverage.

Legal loopholes and regulatory gaps allowed firms to evade oversight. Investment banks, insurance conglomerates and other entities performing the same market functions as banks escaped meaningful regulation on the basis of their corporate form, and banks could move activities off balance sheet and outside the reach of more stringent regulation.

(Read more: TARP didn't save banks, it ruined them: Kovacevich)

Under the guise of innovation, the financial sector piled ill-considered risk upon risk. Derivatives were traded in the shadows with insufficient capital to back the trades. Repo markets became riskier as collateral shifted from Treasurys to poorer quality asset-backed securities.

The lack of transparency in securitization hid the growing wedge in incentives facing different participants in the system and failed to require sufficient responsibility from those who made loans, packaged them into complex instruments to be sold to investors and rated them for sale. Synthetic products—opposing bets—multiplied risks in the securitization system.