Abstract

http://ssrn.com/abstract=2279686
 


 



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


Ren-Raw Chen


Fordham University Schools of Business

N.K. Chidambaran


Fordham University - Schools of Business

Michael B. Imerman


Lehigh University; Princeton University

Ben J. Sopranzetti


Rutgers Business School: Newark and New Brunswick

May 30, 2014

Journal of Banking and Finance, Forthcoming
Fordham University Schools of Business Research Paper No. 2279686

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.

Number of Pages in PDF File: 77

Keywords: Structural credit risk models, Financial crisis, Risk management, Lehman Brothers, Default probability, Liquidity

JEL Classification: G01, G02, G12, G21, G24, G28

Accepted Paper Series


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Date posted: June 16, 2013 ; Last revised: July 2, 2014

Suggested Citation

Chen, Ren-Raw and Chidambaran, N.K. and Imerman, Michael B. and Sopranzetti, Ben J., Liquidity, Leverage, and Lehman: A Structural Analysis of Financial Institutions in Crisis (May 30, 2014). Journal of Banking and Finance, Forthcoming; Fordham University Schools of Business Research Paper No. 2279686. Available at SSRN: http://ssrn.com/abstract=2279686 or http://dx.doi.org/10.2139/ssrn.2279686

Contact Information

Ren-Raw Chen
Fordham University Schools of Business ( email )
113 West 60th Street
Bronx, NY 10458
United States

N.K. Chidambaran
Fordham University - Schools of Business ( email )
United States

Michael B. Imerman (Contact Author)
Lehigh University ( email )
Bethlehem, PA 18015
United States
610-758-6380 (Phone)
Princeton University ( email )
Sherrerd Hall
Princeton, NJ 08544
United States
609-258-1889 (Phone)

Ben J. Sopranzetti
Rutgers Business School: Newark and New Brunswick ( email )
100 Rockafeller Rd
Piscataway, NJ 08854
United States
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