Liquidity, Leverage, and Lehman: A Structural Analysis of Financial Institutions in Crisis

Abstract

The failure of Lehman Brothers highlighted the severe lapses in risk management and regulatory oversight that brought on and intensified the global financial crisis. This paper presents a structural credit risk model that provides useful early warning signals that regulators could have used to predict Lehman's future demise. Our easily implementable, flexible lattice-based model uses equity market information along with a complete depiction of Lehman's liability structure to analyze the term structure of the firm's default probabilities on a month-by-month basis throughout 2008. We find that the evolution of forward default probabilities indicates, as early as March, that the firm would likely lose access to external capital within two years. Our findings support regulators' suspicions that over-reliance on short-term funding and insufficient collateral compounded the effects of dangerously high leverage and resulted in undercapitalization and excessive risk exposure for Lehman Brothers. The model reinforces the importance of the relationship between capital structure and risk management. The contribution extends beyond the clinical analysis of Lehman Brothers' failure. The model can be used as both a diagnostic tool for the early detection of financial distress and a prescriptive tool for addressing the sources of risk in large, complex financial institutions.