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Opinion

Lehman Was Not Alone – Measuring System Risk in the 2008 Crisis

By Robert Engle

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The best answer is not to get in this situation in the first place. And that is why financial regulatory reform is so important.

On September 15, 2008, Lehman Brothers filed for bankruptcy and ushered in the worst part of the recent financial crisis. Today, we still discuss whether taxpayer money should have been used to rescue Lehman. My colleagues at NYU and I have developed measures of systemic risk, and this fifth anniversary affords us a good opportunity to look at what these measures would have indicated to Treasury Secretary Paulson if they had been available at that time.

The answer is quite surprising.

We estimate the amount of capital that a financial institution would have to raise in order to continue to function normally if we have another financial crisis like the one in 2008. This is interpreted as a capital cushion to protect against a decline of 40% in the broad equity market over the six months after this occurs. The rationale is that if all financial firms have an adequate capital cushion there cannot be a financial crisis. If one firm needs to raise capital under such circumstances, it is likely that the market can provide it or competitors can absorb its market share. But if many firms try to raise capital in the middle of a financial crisis, there is no source except the government.

Read full article as published by the Institute for New Economic Thinking

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Robert Engle is the Michael Armellino Professor of Management and Financial Services and the Director of The Volatility Institute.