From Northern Rock to Lehman: who should share the blame?

Martin Jacomb assesses the extent of the damage to the banking system so far — and the effectiveness of responses by central banks, regulators and lawmakers

Will it be short and sharp, or drawn out and deep, with lasting damage? A recession is upon us, but no one knows its path. Its course and its force are, like Hurricane Gustav’s, unpredictable.

It is already more than a year since it all started. Banks everywhere have made enormous losses; some, even important ones such as Lehman Brothers in New York, have collapsed, and more may do so. They are being blamed for the catastrophe. But it is not as simple as that.

A decade of the miraculous combination of low interest rates and low inflation inevitably led to banks lending ever higher volumes to riskier borrowers. Conditions in credit markets awash with easy money were made to seem even more benign with the growth of securitisation. This is the process whereby banks bundle up a package of loans, such as residential mortgages, and then slice these up into tranches of differing quality, so that these tranches can then be sold to investors outside the banking system. Banks were thus enabled to expand the volume of their lending which made up for the lower returns they were able to earn in an era of low interest rates. It also supposedly diversified risk. Everyone thought that this made the banking system safer; even Alan Greenspan made pronouncements to this effect.

However, when the underlying lending started to go bad (in the US mortgage market) many of these securitised loans turned out not to have been effectively disposed of but to have remained the responsibility of the banks which originated them. Many senior managers, paid big salaries and bonuses based on the volume of business and ‘apparent’ profitability, had not grasped the reality.