Lehman Brothers - Analysis of Failure.pdf

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Working Paper Series
Fall of Lehman Brothers – reasons why the failure could not be stopped
Arif Ahmed
South Asian Management Technologies Foundation
August, 2011

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Contents
Abstract ............................................................................................................................................3
Background.......................................................................................................................................4
Genesis of the Problem....................................................................................................................5
The Abettors of Failure.....................................................................................................................9
Controls that failed.........................................................................................................................12
Preventing another Lehman...........................................................................................................16
Conclusion......................................................................................................................................19
Reference .......................................................................................................................................22

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Abstract
Failure of Lehman Brothers marks an important point of modern economic history. In a matter
of eight months a successful and respected financial institution filed for bankruptcy creating a
ripple effect across the banking world spread over various political boundaries. This paper
examines the genesis of the risk and finds that it was well within the limits of executives and
management of Lehman Brother to stop the complete annihilation. It was possible to sustain
despite suffering serious damages if Lehman Brothers did not blindly believed that their next
action will be met by success. A classic example of gamblers fallacy, Lehman Brother underlined
that nobody is invincible to economic reality. The article identifies the controls that could have
prevented the fall and suggests a tool to evaluate chances of capital erosion.
Keyword: Lehman Brothers, Repo 105, Comfort deposits, Liquidity, Valuation, Lehman Breach

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Unit 10 Research Paper
Causes behind failure of Lehman and could that have been prevented
Background
On January 29, 2008, Lehman Brothers Holdings Inc. (Lehman) reported record revenues of
nearly $60 billion and record earnings in excess of $4 billion for its fiscal year ending November
30, 2007. During January 2008, Lehman’s stock traded as high as $65.73 per share and averaged
in the high to mid‐fifties, implying a market capitalisation of over $30 billion. Less than eight
months later, on September 12, 2008, Lehman’s stock closed under $4, a decline of nearly 95%
from its January 2008 value. On September 15, 2008, Lehman moved for the largest bankruptcy
proceeding ever filed (McDonald & Robinson, 2009).
The failure busted a myth about “too big to fail” that was prevalent among the banking
community (Sorkin, 2009). It also busted another myth that it is only the deposit banks that are
liable to fail and not investment bankers (House of Commons, 2010).
The sub-prime crisis may be a name that has been ascribed to the singularly most important
reason behind the fall, but it is the climax. The real story lies in the unchained incentive to
violate cardinal principles of risk management–matching risk exposure with risk appetite. This
has been violated time and again by large corporations be in banking sector or otherwise. The
fall of Lehman Brothers emphasised the absoluteness of economic justice and exposed how
susceptible are banking corporations interlinked across political boundaries.

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Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders,
underlined the danger of investment bank business model which rewarded excessive risk taking
and leverage (Skalak, Golden, Clayton, & Pill, 2011). It also highlights failure of Government
agencies that should have better anticipated and mitigated the outcome.
Genesis of the Problem1
Lehman’s business model was not anything out of the book. A large number investment banks
at various points of time have followed some variation of a high‐risk, high‐leverage model based
on confidence of counterparties to sustain. Lehman maintained approximately $700 billion of
assets, and corresponding liabilities, on capital of approximately $25 billion (Swedberg, 2010).
But the assets were predominantly long‐term, while the liabilities were largely short‐term – a
classic case of asset liability mismatch. Lehman funded itself through the short‐term repo
markets and had to keep borrowing large sums of money in those markets on a daily basis to be
able to open for business. Confidence of counterparties was critical and the moment such repo
counterparties lost confidence in Lehman and declined to roll over its daily funding, Lehman was
unable to fund itself and continue to operate.
In 2006, Lehman decided to embark upon an aggressive growth strategy to take on significantly
greater risk and simultaneously to substantially increase leverage on its capital (Schapiro, 2010).
In 2007, as the sub‐prime residential mortgage business progressed from problem to crisis,
Lehman was slow to recognise that the problem will spill over on commercial real estate and
other business lines. Instead of pulling back, Lehman fell victim to the Gamblers fallacy (Bellos,
2010) and made the conscious decision to increase exposure hoping to profit from a
1
The chronological details have been drawn from volume 1 of the Report of Anton R. Valukas, examiner in the case
of Lehman Brothers Holding Inc., at United States Bankruptcy Court, Southern District of New York.

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counter‐cyclical strategy. In order to accommodate the additional exposure, Lehman repeatedly
exceeded its own internal risk limits and controls by significant margins.
Near collapse of Bear Stearns in March 2008 pointed out that Lehman’s growth strategy has not
only been misplaced but has put its’ survival was in jeopardy. The markets were shaken by
Bear’s demise, and Lehman was widely considered to be the next bank that might fail.
Confidence was eroding and Lehman pursued a number of strategies to avoid failure and
maintain confidence, including reporting misleading picture of its financial condition.
One of the ways to maintain investor and counterparty confidence was to get favourable ratings
from the principal rating agencies to. Lehman understood that while the rating agencies looked
at many things in the rating process, net leverage and liquidity numbers were of critical
importance (Gardner & Mills, 1994). Lehman required favourable net leverage position to
maintain its ratings and investor confidence. Lehman announced a quarterly loss of $2.8 billion
at end of the second quarter of 2008 (Ward, 2010). This was the result of a combination of
write‐downs on assets, sales of assets at losses, decreasing revenues, and losses on hedges.
Following a crafted strategy, Lehman underplayed the loss by claiming that it had
1. Significantly reduced its net leverage ratio to less than 12.5,
2. Reduced the net assets on its balance sheet by $60 billion, and
3. A strong and robust liquidity pool.
Lehman did not disclose was that the balance sheet was designed using an innovative
accounting device known as “Repo 105” to manage its balance sheet (Kass-Shraibman &
Sampath, 2011). This accounting device temporarily removed approximately $50 billion of
assets from the balance sheet at the end of the first and second quarters of 2008. In an ordinary

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repo cash is raised by selling assets with a simultaneous obligation to repurchase them the next
day or several days later and such transactions are accounted for as financing with the assets
remaining on the balance sheet of the issuer. In a Repo 105 transaction, since the assets were
105% or more of the cash received, accounting rules permitted the transactions to be treated as
sales rather than financings and the assets could be removed from the balance sheet (Albrecht,
Albrecht, Albrecht, & Zimbelman, 2009). Lehman Brothers used this accounting rule to its
advantage and reported net leverage was 12.1 at the end of the second quarter of 2008, while
the net leverage would have 13.9 if they were treated as ordinary repo transaction (Syke, 2010).
Since Lehman used Repo 105 for no reason other than to reduce balance sheet at the
quarter‐end, this was not a Repo 105 transaction in substance and should not have been
accorded the special accounting treatment. Effectively instead of selling assets at a loss, Repo
105 transaction achieved reduction of assets without having a negative impact on equity and
consequently on leverage ratios. The only purpose or motive for [Repo 105] transactions was
reduction in the balance sheet and that there was no substance to the transactions.
Lehman did not disclose its large scale use of Repo 105 to the Government, rating agencies,
investors, or even to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware
of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting
transactions (Davies, 2010).
In mid‐March 2008, after near collapse of Bear Stearns, teams of Government monitors from
the Securities and Exchange Commission (“SEC”) and the Federal Reserve Bank of New York
(“FRBNY”) were stationed at Lehman, to monitor its’ financial condition with particular focus on
liquidity (Congressional Oversight Panel, 2010).

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Lehman publicly asserted throughout 2008 that it had a liquidity pool sufficient to weather any
foreseeable economic downturn, but did not publicly acknowledge that by June 2008 significant
components of its reported liquidity pool had become difficult to monetise. Even on September
10, 2008, Lehman publicly announced that its liquidity pool was approximately $40 billion
though but a substantial portion of that total was either encumbered or otherwise illiquid. From
June on, Lehman continued to include in its liquidity reports substantial amounts of cash and
securities which it had placed as “comfort” deposits with various clearing banks (National
commission on the causes of the financial and economic crisis in the United States, 2011).
Technically Lehman could recall those deposits but if they would have done so, their ability to
continue its usual clearing business would have been in doubt. By August, substantial amounts
of “comfort” deposits had actually become pledges which Lehman could not have withdrawn.
By September 12, two days after it publicly reported a $41 billion liquidity pool, the pool
actually contained less than $2 billion of readily monetisable assets.
Earlier, on June 9, 2008, Lehman pre‐announced its second quarter results and reported a loss
of $2.8 billion, its first ever loss since going public in 1994. Despite that announcement, Lehman
was able to raise $6 billion of new capital in a public offering on June 12, 2008. But Lehman
knew that new capital was not enough against the liquidity crisis it was facing.
On September 10, 2008, Lehman announced that it was projecting a $3.9 billion loss for the
third quarter of 2008. Although Lehman had explored options of selling out but had no buyer
(Wiliams, 2010) and only announced survival plan they had was to spin off troubled assets into a
separate entity. By the close of trading on September 12, 2008, Lehman’s stock price had

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declined to $3.65 per share, a 94% drop from the $62.19 January 2, 2008 price (New York
magazine, 2008).
It appeared by early September 14 that a deal had been reached with Barclays which would
save Lehman from collapse. But later that day, the deal fell apart when the parties learned that
the Financial Services Authority (“FSA”), the United Kingdom’s bank regulator, refused to waive
U.K. shareholder‐approval requirements and the deal fell through (Posner, 2010). Lehman no
longer had sufficient liquidity even to fund its daily operations and on September 15, 2008, at
1:45 a.m., Lehman filed for Chapter 11 bankruptcy protection (Paul, 2010).
The Dow Jones index plunged 504 points on September 15. On September 16, AIG was on the
verge of collapse and the Government intervened with a financial bailout package that
ultimately cost about $182 billion (Carter, Clegg, Komberger, & Schweitzer, 2011). On
September 16, 2008, the Primary Fund, a $62 billion money market fund, announced that –
because of the loss it suffered on its exposure to Lehman and its share price had fallen to less
than $1 per share. On October 3, 2008, Congress passed a $700 billion Troubled Asset Relief
Program (“TARP”) rescue package (Janda, Berry, & Goldman, 2009).
The Abettors of Failure
Lehman failed because it was unable to retain the confidence of its lenders and
counterparties which was prompted by the insufficient liquidity it had to meet its current
obligations. Lehman was unable to maintain confidence because a series of business decisions
that had led to heavy concentrations of illiquid assets with deteriorating values like residential
and commercial real estate. Confidence was further eroded when it became public that

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attempts to form strategic partnerships to bolster its stability had failed. There also was
contribution of reported losses of $2.8 billion in second quarter 2008 and $3.9 billion in third
quarter 2008, without news of any definitive survival plan.
The business decisions that brought Lehman to its crisis may be, with the advantage of
hindsight, be termed as erroneous but they were well within normal business judgment rule –
however faulted that might have been. There could have been alternative responses, but the
response provided was also legitimate. But the decision not to disclose the effects of those
judgments and taking shelter behind accounting rulebook was certainly improper action of
senior officers overseeing and certifying misleading financial statements. Questions of
professional misconduct are also raised against Lehman’s external auditor Ernst & Young
primarily for its failure to question and challenge improper or inadequate disclosures in those
financial statements (Davies, 2010).
Research findings (Allen & Peristiani, 2004) demonstrate that the market responds to
the potential for conflicts of interest as commercial bank advisors provide lending to acquirers
in return for merger advisory fees. The advisor’s implicit (or explicit) promise to provide credit is
viewed as a potential conflict of interest by the market and weakens any perceived profits
resulting from merger advisory fees; i.e., losses on future loan commitments (as well as related
adverse reputational effects) may more than offset merger advisory fees. Lehman Brothers
failure was not pointed out by analysts till the crisis had sunk in deep.
A banking panic is a systemic event because the banking system cannot honour
commitments and is insolvent. Unlike the historical banking panics of the 19th and early 20th
centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier

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episodes, depositors ran to their banks and demanded cash in exchange for their deposit
accounts. Unable to meet those demands, the banking system became insolvent. The current
panic involved financial firms stifling other financial firms by not renewing sale and repurchase
agreements (repo) or increasing the repo margin, forcing massive deleveraging, and resulting in
the banking system being insolvent. Subprime related products were shocked by the decline in
housing prices, but the location of these risks was not known. Worried that their banks were not
solvent, and concerned about the liquidity of their collateral, repo depositors increased repo
haircuts, essentially demanding more equity financing of the collateral. Banks could not get
enough new investment though the sale of equity or new debt, and decided to sell assets, since
they could not suspend convertibility. Earlier episodes have many features in common with the
current crisis, and examination of history can help understand the current situation and guide
thoughts about reform of bank regulation. New regulation can facilitate the functioning of the
shadow banking system, making it less vulnerable to panic (Gorton,2009).
The subprime lending crisis demonstrated that regulators will extend their safety net to
support large companies that have close links to major financial institutions. In view the large
liquidity support for major securities firm, market participants now believe that the federal
safety net will be used to support any company whose failure could threaten the stability of
financial market. Consequently it is reasonable to expect that safety net subsidies will be
extended into the commercial sector if commercial firms are allowed to establish large-scale
baking operations (Wilmarth, 2008).

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Controls that failed2
The major areas where controls failed in Lehman Brother include the following:
1. Business and Risk Management: Majority of decisions that Lehman Brothers took were
not out of ordinary. However there was a gross failure in terms of relating the decisions
to their risk bearing capacity. Further financial reports were camouflaged to deceive
investors. In 2006, Lehman adopted a more aggressive business strategy by increasing its
investments in potentially highly profitable lines of business that carried much more risk
than Lehman’s traditional investment banking activities (Baker, 2010). Through the first
half of 2007, Lehman focused on committing its own capital in commercial real estate
(“CRE”), leveraged lending, and private equity like investments (Schapiro, 2010). These
investments were considerably riskier for Lehman than its other business lines because
they were acquiring potentially illiquid assets that it might be unable to sell in a
downturn. Lehman shifted from focusing almost exclusively on the “moving” business –
a business strategy of originating assets primarily for securitisation or syndication and
distribution to others – to the “storage” business – which entailed making longer‐term
investments using Lehman’s own balance sheet. However, Lehman’s management
informed the Board, clearly and on more than one occasion, that it was taking increased
business risk in order to grow the firm aggressively. The board was also informed that
the increased business risk is causing higher risk usage metrics and ultimately firm‐wide
risk limit overages. The fact that market conditions after July 2007 were hampering the
firm’s liquidity was also conveyed to the board.
2
The description of various internal management functions have been drawn from volume 2-5 of the Report of
Anton R. Valukas, examiner in the case of Lehman Brothers Holding Inc., at United States Bankruptcy Court,
Southern District of New York.

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2. Valuation: Lehman Brothers evidently did not follow proper valuation procedures and
some valuations were unreasonable for the purpose of solvency analysis (Bruemmer &
Sandler, 2008). This increase in Lehman’s net assets was primarily caused by
accumulation of potentially illiquid assets which were not highly liquid especially during
a downturn. By one measure, Lehman’s holdings of these illiquid assets increased from
$86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the
first quarter of 2008. Under GAAP, Lehman was required to report the value of its
financial inventory at fair value. However from beginning in the first quarter of 2007,
Lehman adopted SFAS 157, which established the fair value of an asset as the price that
would be received in an orderly hypothetical sale of the asset (Carmichael & Graham,
2011). As the level of market activity declined in late 2007 and 2008 the valuation inputs
became less observable and some of the assets of Lehman became increasingly less
liquid. Lehman progressively relied on its judgment to determine the fair value of such
assets. In light of the dislocation of the markets and its impact on the information
available to determine the market price of an asset, investors, analysts and the media
focused on Lehman’s mark‐to‐market valuations. The Office of the Chief Accountant,
Divison of Corporate Finance (2010) highlighted the lack of confidence in Lehman’s
valuations was also evident in the demands for collateral made by Lehman’s clearing
banks throughout 2008 to secure risks they assumed in connection with clearing and
settling Lehman’s tripartite and currency trades, and other extensions of credit. The
uncertainly as to the fair value of Lehman’s assets also played a role in the negotiations
between Bank of America and Lehman regarding a potential acquisition of Lehman by

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Bank of America. Bank of America put together a diligence team at some point around
September 10 or 11, 2008, and it became quickly apparent to them that, without
substantial government assistance, the deal would not be beneficial to Bank of America.
The sticking point for Bank of America was huge difference in Lehman’s valuation of its
assets (Wiliams, 2010).
3. Repo 105: The way this financial tool was used was indeed fraudulent in nature and
Lehman Brothers focused on form over substance. In late 2007 and 2008, Lehman
employed off‐balance sheet devices known as “Repo 105” and “Repo 108” transactions,
to temporarily remove securities inventory from its balance sheet, usually for a period of
seven to ten days, and to create a materially misleading picture of the firm’s financial
condition. Repo 105 transactions were nearly identical to standard repurchase and
resale (“repo”) transactions that any investment banks use to obtain short‐term
financing. However there was a critical modification. Lehman accounted for Repo 105
transactions as “sales” as opposed to financing transactions based upon providing
greater collateral or higher than normal haircut (Albrecht, Albrecht, Albrecht, &
Zimbelman, 2009). By describing the Repo 105 transaction as a “sale,” Lehman removed
the inventory from its balance sheet. Lehman regularly increased its use of Repo 105
transactions in the days prior to reporting periods to reduce net leverage and balance
sheet. Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105
transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in
these transactions, Lehman did not disclose the known obligation to repay the debt.
Lehman used the cash from the Repo 105 transaction to pay down other liabilities,

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thereby reducing both the total liabilities and the total assets reported on its balance
sheet and lowering its leverage ratios. Thus, Lehman’s Repo 105 practice consisted of a
two‐step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo
105 cash borrowings to pay down liabilities and reducing leverage. A few days after the
new quarter began, Lehman would borrow the necessary funds to repay the cash
borrowing plus interest, repurchase the securities, and restore the assets to its balance
sheet. Lehman never publicly disclosed its use of Repo 105 transactions, the accounting
treatment for these transactions, considerable escalation of its total Repo 105 usage, or
the material impact these transactions had on the firm’s publicly reported net leverage
ratio (Syke, 2010).
4. Misstatement: In addition to its material omissions, Lehman misrepresented in its
financial statements that the firm treated all repo transactions as financing transactions
–not sales – for financial reporting purposes. Starting in mid‐2007, Lehman faced a crisis
as market observers began demanding that investment banks reduce their leverage. The
inability to reduce leverage could lead to a ratings downgrade, which would have had an
immediate, tangible monetary impact on Lehman In mid‐to‐late 2007 (Wiliams, 2010).
Top Lehman executives from across the firm felt pressure to reduce the firm’s leverage
for quarterly and annual reports. By January 2008, Lehman ordered a firm‐wide
deleveraging strategy, hoping to reduce the firm’s positions in commercial and
residential real estate and leveraged loans in particular by half. Selling inventory,
however, proved difficult in late 2007 and into 2008 because, starting in mid‐2007, many
of Lehman’s inventory positions were difficult to sell without incurring substantial losses.

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Moreover, selling sticky inventory at reduced prices could have led to a loss of market
confidence in Lehman’s valuations for inventory remaining on the firm’s balance sheet
since emergency sale pricing would reveal the valuation errors (Office of the Chief
Accountant, Divison of Corporate Finance, 2010). In light of these factors, Lehman relied
at an increasing pace on Repo 105 transactions in late 2007 and early 2008. Research
findings indicate that banking ties increase analysts’ reluctance to reveal negative news,
and that reform efforts must carefully consider the incentives of affiliated and
unaffiliated analysts to initiate coverage and convey the results of their research
(O.Brien, McNichols, & Lin, 2005)
Preventing another Lehman
Could fall of Lehman Brothers been avoided or another recurrence prevented? On a
scenario divorced from the circumstances under which Lehman operated, it can definitely be
claimed that such accidents are avoidable. Lehman did not follow the prudent path of financial
management and corporate governance, though according to their corporate governance
guideline they were committed to industry best practices (Yong, 2009). The question lies
whether such organisations are structurally equipped to do so. The faculty of risk management
have grown in importance because actual results are not always the expected action (Vaughan,
1982). The advantage of working in an uncertain decision horizon is that one is free to interpret
the future since however low may be the chances of an optimist occurrences, there still is a
chance of it occurring. The only judgement that can be questioned is whether there was
adequate risk absorption capability before embarking on a strategy that has a low probability of
occurrence.

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In the specific case of Lehman Brothers, the gradual slipping into the danger zone could
have been spotted and arrested by enforcing any of the following mechanisms.
1. Risk Appetite: The risk exposure and risk appetite is required to be in a ratio
reflecting the risk attitude of the institution. Change in the attitude is a strategic
issue and is to be decided by management and not executive. In case of Lehman,
evidently these were decided by executives and as a lag feature to accommodate
a decision to use Repo 105 for financing the balance sheet. In fact, collapse of
Lehman Brothers lead to a reassessment of risk exposure arising from the credit
default swaps (ASEAN Studies Centre: Institute of Southeast Asian Studies, 2008).
2. Stress Testing: Stress test for extreme values would have alerted Lehman about
the point of breakdown, an activity that Lehman paid scant attention to
(Schapiro, 2010). Reporting of the breakdown point and close observance of its
progress towards that could have resulted into evasive action being taken earlier.
Failure of Lehman Brothers underlined the importance of newer stress testing
approaches including testing for destruction (Kemp, 2011).
3. Capital adequacy: Asset exposure especially that of risky assets needs to be
complemented by adequate capital (McNeil, Frey, & Embrechts, 2005). Though
Lehman raised capital during the crisis those were to accommodate the risky
assets already on the balance sheet and not for future assets. Capital adequacy is
also to be computed for off-balance sheet assets using a credit conversion factor
(Carmichael & Rosenfield, Accountants’ Handbook: Special Industries and Special
Topic, 2003).

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4. Liquidity Management: An honest maturity profile statement would have shown
alarming duration gap for Lehman (Carrel, 2010). Either this was not done or
overlooked by the concerned executives. Lehman also contradicted view of
analysts who pointed this out. Whenever long terms assets are funded by short
term sources, the duration gap analysis will raise alarm to highlight up the
danger. Risk based management system should include analysis of duration gap
(Asan Development Bank, 1999).
5. Fair valuation and asset recognition under IFRS: International financial reporting
standards require fair valuation of financial assets which are held for trading
(Dick & Missioner-Piera, 2010). Fair valuation takes into consideration impact of
illiquid market especially in cases of banks (Congressional Oversight Panel, 2009).
This valuation is supposed to be driven by market situation and perception of
management. In addition, as asset is recognised only when the reporting entity
has right to its future benefits including cash flows (Epstein & Jermakowicz,
2010). The cash which was actually a substitute for a repo was not to be regarded
as asset of Lehman under the definition of the accounting standards. However
Lehman chose to stick to the legal definition of ownership and reported those as
their assets.
6. Corporate Governance: Finally a proper corporate governance plan that would
have highlighted the fraudulent activities of Lehman was completely absent (Sun,
Stewart, & Pollard, 2011). The decisions at were taken more to ward off short
term problem at the cost of long term stability – an issue closely related with

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shareholders interest. However, in Lehman Brothers people, including
institutional investors, were all busy to protect their own interest and left the
corporate interest aside. An industry specific conceptualisation of corporate
social responsibility (CSR) needs to take into account the defining characteristics
of an industry as well as social perception of the industry. In banking, CSR is
affected by the nature of the product. Governmental influence gives banking CSR
a special dimension. Banks need to develop special strategies which would show
that they take account of wider societal concerns which arise from their business
activity (Decker, 2004). Universal banks aided and abetted violations of corporate
governance rules and federal securities laws by officers of Enron and WorldCom.
Bank officials also repeatedly disregarded risk management policies established
by their own banks indicate that GLBA’s current regulatory framework is not
adequate to control the promotional pressures, conflicts of interest and risk-
taking incentives that are generated by the commingling of commercial and
investment banking. A comprehensive reform of the supervisory system for
universal banks is urgently needed and must become a top priority for Congress
and financial regulators (Wilmarth, 2007).
Proper articulation and observance of these controls could have prevented the fall of
Lehman Brothers. However, it cannot be assured that another Lehman Brother would not
happen and that is where proper risk management practice plays a critical role.
Conclusion

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In banking, the business sources money from promoters in form of capital and
depositors or from others sources. These are utilised to lend money or to invest in securities or
in investment banking assets. Thus if an asset become non income and cash inflow generative,
the promoters are supposed to bear the loss. If the bank is undercapitalised for its lending and
investment pattern – the depositors take the hit – that is when bankruptcy settles in.
Finance allows designing tools that can decide on holding of low risk and high risk assets.
One of the ways would be to look at the maximum possible loss that the asset portfolio is
expected to run into. The point of crossing over from the safe zone to the danger zone can be
computed as the difference between the following two:
1. Summation of the present value of the expected realisable future value of the assets
carried in the balance sheet and present value of future expected cash inflow from the
assets, and
2. Summation of the present value of the expected future liquidation value of the liabilities
(excluding capital) carried in the balance sheet and present value of future expected
cash outflow against those liabilities and management cost.
The difference will be divided by the realisable value of the capital of the corporation. Let us
call this point “Lehman Breach”. If the result is less than 1 we have crossed the danger point.
This point onwards will hurt the investors in capital of the corporation. This is where a capital
infusion will be required to keep the corporation healthy. Unfortunately, unless this infusion
comes in very quickly, the investors will sell out and book the loss, making the present realisable
value of capital go down rapidly.

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If the Lehman Breach value is less than zero, the breach will also hurt other parties
represented by the liabilities of the corporation. This is usually a one way road to irrevocable
bankruptcy unless the Government comes into rescue directly or through some intermediaries.
The higher the Lehman Breach value, greater is the capability of the corporation to accept risk.
What would be worrying is that organised crime groups are increasingly targeting
legitimate business and committing economic crimes (Marine, 2006). Failure of Lehman was an
act of error of judgement and, at the worst, a failure of corporate governance. In the event such
events start forming a part of criminal activity, the existing control mechanisms which are
designed to tackle bonafide errors, may be found incompetent.
Each panic teaches us something new and this accumulating experience should in time
enable us to prolong the interval of recurrence if not eventually to prevent the recurrence
entirely, just as epidemics of disease, formerly thought inevitable, are now prevented
(Marburg, 1908). It is for us to apply the lessons judiciously.

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