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

77 Pages Posted: 16 Jun 2013 Last revised: 7 Mar 2015

Ren-Raw Chen

Gabelli School of Business, Fordham University

N.K. Chidambaran

Gabelli School of Business, Fordham University

Michael B. Imerman

Lehigh University; Princeton University

Ben J. Sopranzetti

Rutgers Business School: Newark and New Brunswick

Date Written: May 30, 2014

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.

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

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

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, August 2014, Volume 45: pp. 117-139; Fordham University Schools of Business Research Paper No. 2279686. Available at SSRN: https://ssrn.com/abstract=2279686 or http://dx.doi.org/10.2139/ssrn.2279686

Ren-Raw Chen

Gabelli School of Business, Fordham University ( email )

113 West 60th Street
Bronx, NY 10458
United States

N.K. Chidambaran

Gabelli School of Business, Fordham University ( 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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