Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors. The programs--national and international--covered some or all of the following nine areas:

(1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity"
(2) to strengthen the quality and effectiveness of prudential regulation and supervision;
(3) to build the capacity for undertaking effective macroprudential regulation and supervision;
(4) to develop suitable resolution regimes for financial institutions;
(5) to strengthen the infrastructure of financial markets, including markets for derivative transactions;
(6) to improve compensation practices in financial institutions;
(7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs;
(8) to find appropriate ways of dealing with the shadow banking system; and
(9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.

However, three years after the failure of Lehmann Brothers, there remain significant impediments to avoiding the need for government intervention to protect large financial intermediaries.  Everyone knows that some large European financial institutions have of late encountered problems. So it is critical that we focus on strengthening the financial architecture, so that the struggles of one institution or a group of them no longer poses risks to the broader global economy. 

[My testimony at the time] has supported this myth that we did have a way of saving Lehman... I regret not being more straightforward there because clearly it has supported the mistaken impression that in fact we could have done something.

The Federal Reserve was not aware that Lehman was using so-called Repo 105 transactions to manage its balance sheet. Indeed, according to the bankruptcy examiner, Lehman staff did not report these transactions even to the company's board. However, knowledge of Lehman's accounting for these transactions would not have materially altered the Federal Reserve's view of the condition of the firm; the information we obtained suggested that the capital and liquidity of the firm were seriously deficient, a view that we conveyed to the company and that I believe was shared by the SEC and the Treasury Department.

MR. BERNANKE …At one point, we got an offer from Bank of America. They said, “We’ll buy them if you’ll finance” -- I’m making up numbers now, but rough order of magnitude –- “if you’ll finance an $80 billion portfolio for $80 billion,” except its actual market value was $50 billion. So in other words, they wanted a $30 billion gift, essentially, in order to make that acquisition. We did not have the legal authority to do that, not to mention the political backing.

Vice Chairman Thomas: And you wouldn’t have done it, anyway.

MR. BERNANKE: That’s right. And it would have been a bad decision, anyway, because we had so much -– so many other firms already on the brink, coming down the pike. So I will maintain to my deathbed, that we made every effort to save Lehman, but we were just unable to do so because of a lack of legal authority.

Had there existed the authority and procedures to resolve Lehman outside of bankruptcy proceedings, there may have been a much more orderly “wind down” of Lehman’s operations. Of course, the Lehman failure suggests that even with resolution powers in place this would have been a very challenging situation – Lehman would have been difficult to wind down, in part because of the scope of its global operations.

[C]ritics suggest the failure of one of these institutions could be very disruptive and worsen the crisis, citing Lehman as an example. I am not at all advocating the approach taken with Lehman. Rather, I am arguing for a timely, managed and orderly resolution of large, insolvent institutions, with their basic functions continuing under new management.

Historical experience shows that, once begun, a financial panic can spread rapidly and unpredictably; indeed, the failure of Lehman Brothers a day earlier, which the Fed and the Treasury unsuccessfully tried to prevent, resulted in the freezing up of a wide range of credit markets, with extremely serious consequences for the world economy. The financial and economic risks posed by a collapse of AIG would have been at least as great as those created by the demise of Lehman. In the case of AIG, financial market participants were keenly aware that many major financial institutions around the world were insured by or had lent funds to the company. The company's failure would thus likely have led to a further sharp decline in confidence in the global banking system and possibly to the collapse of other major financial institutions.

The Federal Reserve made its decision to lend based on a judgment that a failure of AIG would cause dramatically negative consequences for the financial system and the economy—consequences worse than what occurred in the aftermath of the failure of Lehman Brothers. We stand by that judgment today. In the case of Lehman, some of the most severe repercussions related to the difficulties in coordinating cross-border insolvency regimes and in coordinating the insolvency regimes among different types of institutions within the organization's corporate structure. In light of AIG's unparalleled global footprint—operating in more than 130 countries around the globe—and the multiplicity of different types of financial services entities within its structure—including insurance providers, foreign banks, consumer lending companies and OTC derivatives affiliates—the factors that proved unmanageable in the Lehman insolvency threatened to be much more severe in AIG's case.

[I]t is unlikely that the failure of additional major firms could have been prevented in the wake of the failure of AIG. At best, the consequences of AIG's failure would have been a significant intensification of an already severe financial crisis and a further worsening of global economic conditions. Conceivably, its failure could have resulted in a 1930s-style global financial and economic meltdown, with catastrophic implications for production, income, and jobs.

I asked that the AIG-FP payments be stopped but was informed that they were mandated by contracts agreed to before the government's intervention. I then asked that suit be filed to prevent the payments. Legal staff counseled against this action, on the grounds that Connecticut law provides for substantial punitive damages if the suit would fail; legal action could thus have the perverse effect of doubling or tripling the financial benefits to the AIG-FP employees.

Our judgment has been and continues to be that, in this time of severe market and economic stress, the failure of AIG would impose unnecessary and burdensome losses on many individuals, households and businesses, disrupt financial markets, and greatly increase fear and uncertainty about the viability of our financial institutions.  Thus, such a failure would deepen and extend market disruptions and asset price declines, further constrict the flow of credit to households and businesses in the United States and in many of our trading partners, and materially worsen the recession our economy is enduring.

If there's a single episode in this entire 18 months that has made me more angry, I can't think of one than AIG. AIG exploited a huge gap in the regulatory system; there was no oversight of the financial products division. This was a hedge fund basically that was attached to a large and stable insurance company, made huge numbers of irresponsible bets, took huge losses. 

From the Q&A session

Lacker said he was not about to express any regret about letting Lehman Brothers fail, an event many analysts see as pivotal in the evolution of the financial crisis.

 "I am not going to second guess the decisions that have been made," he said, and he added he is giving his fellow policymakers the benefit of the doubt, assuming they made the best judgment given the information available at the time. 

 However, the subsequent confusion among market participants following Lehman's failure and the AIG bailout is something that all policymakers appreciate very deeply, he said. "I think that's what motivated the pursuit of a comprehensive solution," he said.

From audience Q&A session, as reported by Market News

Attempts to organize a consortium of private firms to purchase or recapitalize Lehman were unsuccessful. With respect to public-sector solutions, we determined that either facilitating a sale of Lehman or maintaining the company as a free-standing entity would have required a very sizable injection of public funds--much larger than in the case of Bear Stearns--and would have involved the assumption by taxpayers of billions of dollars of expected losses. Even if assuming these costs could be justified on public policy grounds, neither the Treasury nor the Federal Reserve had the authority to commit public money in that way; in particular, the Federal Reserve's loans must be sufficiently secured to provide reasonable assurance that the loan will be fully repaid. Such collateral was not available in this case. Recognizing that Lehman's potential failure posed risks to market functioning, the Federal Reserve sought to cushion the effects by implementing a number of measures, including substantially broadening the collateral accepted by the Fed's Primary Dealer Credit Facility (PDCF) and Term Securities Lending Facility (TSLF) to ensure that the remaining primary dealers would have uninterrupted access to funding.