| 15.5°C Belfast

Financial sector is still hurting

The return to record profits and bonuses at Wall Street banks masks major changes inside the global credit markets and the fact that the financial system is still not fully healed, two years after the bankruptcy of Lehman Brothers caused a devastating panic.

Large parts of the so-called "shadow banking system" which provided the funds for lending to home-owners, commercial property investors and consumers remain moribund, and investors' perceptions of the safety of banks have shifted in ways that will make credit more expensive throughout the economy for years to come, analysts say.

The cost of borrowing for banks has shifted higher because investors no longer believe that any bank is definitely "too big to fail", said John Lonski, the chief executive of Moody's Investors Service.

The decision by the US Treasury and Federal Reserve not to use public money for a bailout of Lehman Brothers in 2008 was followed this year by the introduction of a new "resolution authority" which will impose losses on the creditors of failed banks in future.

In the four years before the crisis, banks were able to borrow money at an interest rate just 0.74 percentage points higher than the US government, while other major industrial groups paid 1.07 percentage points more. Now the figure for banks is 2.23 percentage points, compared to just 1.49 points for industrials, according to Barclays Capital figures.

"Because of what happened to Lehman, investors are reluctant to price the debt of banking institutions as if the principle of too-big-to-fail still held," Mr Lonski said. "We are not going back to pre-crisis levels, and as a result the cost of borrowing for banks will be higher and the supply of credit will be less than before."

The cost of borrowing for banks is also higher because of lingering fears for the future of the housing market and other real-estate prices, which could dip down again as the recovery weakens. Asset prices are important because they represent the value of collateral underlying much of the lending of banks and other financial institutions operating in the credit markets.

Weekly Business Digest

Margaret Canning’s selection of the must-read business stories straight to your inbox every Tuesday morning

This field is required

The securitisation markets – the shadow banking system – remains moribund. Just $1.3bn of residential mortgages were packaged up and sold in the first seven months of this year, compared to $1.13 trillion in the full-year 2005. Banks are also unable to package up and sell on loans for private equity deals, as the leveraged loan market is also a fraction of its former self. Securitisations of consumer loans such as credit cards, auto finance and student loans are down to $62bn in the first seven months of 2010, compared to $352bn in the peak full-year 2006.

Lehman filed for Chapter 11 bankruptcy on 15 September, the small hours of a Monday morning, after two days of intense talks between the government and Wall Street leaders failed to find a buyer able to take over the firm.

The catastrophe that followed had no precedent, triggering a run on the shadow banking system. Liquidity evaporated and important parts of the financial system began to shut down, one by one. Hedge funds found their assets in accounts at Lehman in Europe were frozen, so they could not meet demands from their own creditors. A money market fund called the Reserve Primary fund revealed it had lost money on Lehman, triggering a run on the $3.5 trillion money markets from where corporations funded their day-to-day operations. By the end of the week, the Federal Reserve was warning that cash machines could stop working and employees would soon not get paid, unless Congress acted to bail out the system.