Why Lehman Brothers Filled for Bankruptcy in 2008

Critically assess the extent to which market failure and behavioural bias theory can explain
bank failures during the 2008 financial crisis, referring to evidence from of at least one bank
failure during that financial crisis.

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Introduction
In 2008 Lehman Brothers filed for bankruptcy which nearly caused the global meltdown of the
world economy. Some agree that the collapse opened a new reality of potential repeat by
mishandling information. The essay will examine the nature of the banking model and how the
risk can cause a bank to fail. Under the theoretical model the rational choice model will further
explain what is expected in financial markets in over and under-pricing, bank regulations and
justifications, and also the nature of heuristics actions and their consequences. By using
evidence, the last section will apply the case study of Lehman brothers to critically evaluate
the economic models applied and their importance and failures.
Background information
One of the main banking functions is maturity transformations that help it to finance long term
assets while accommodating investors’ preferences and short tern investors’ preferences. The
classic business model of banks involves granting long-term loans and collecting deposits upon
maturity. Liquidity transformations are part of the bank earnings but are also characterized by
some form of risk. The bank model can be best described using assets and liabilities. If the
bank assets are almost equal to liabilities, and then the bank may practice liquidity
transformation only to a small degree (Memmel, and Schertler, 2009). Another banking model
can be described using financial structure where demand deposits at a bank are callable before
assets mature. The financial structure is a portfolio meant to protect depositors against
unforeseeable risk. In this model, the bank acts as a ruler in the allocation mechanism (Entrop
et al., 2015). Also, as technology continues to dominate business operations, the technology
acceptance model in the banking asymmetric is no exception. The increase in online banking
transactions means more research in acceptance behaviours (Yousafzai et al., 2003). However,
the banking model is characterized by a risk of credit creation. The inherent fragility may occur
at any time when depositors decide to withdraw their money once distrusts sets in. Also, when
one or more banks experience an insolvency problem, the shockwaves can be sent to other
smaller banks. The ensuing distrusts may lead to deposit withdrawals that reduce bank assets
(Grauwe, 2011). The banking model also involves retail and investment banking which can
significant amount of risks. Investment banking deals with institutional clients by providing
funding and advice in investing in capital markets. On the other hand, retail banking deals with
small businesses and individuals. While retail banks make money through charging fees and
interest from loans, investment banks make money through negotiated fees in the capital

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market transactions. The analysis will focus on Lehman Brothers' investment bank failure and
its role in the 2008 banking crises. The banking crises portrayed yet unexplored negative shock
to the supply of external financial finance. Corporate investments decline during the onset of
crises particularly to firms with fewer cash reserves (Barrell and Davis, 2008).
Theoretical framework
The traditional finance model seeks to understand financial markets in terms of information
available to the rational agents. The model is more appealing when the information available
is appealing to the agents. However, it is not always to get information about the aggregate
stock market, and average returns of various firms thus making it difficult to understand the
framework. Behavioural finance argues that using models can help better understand some of
the financial phenomena that are not fully rational (Hofmann et al., 2008). Investors apply the
expected utility principle using the available information to maximize their expected returns
by weighing the utility of each possible outcome. Contemporary financial regulation has
disclosed key in protecting investors and at the same time regulatory armour. Therefore, given
the predominance of the disclosure rational model, many policymakers conclude that
inadequate disclosures have been the main reason for the 2008 financial crisis (De Bondt et al.,
2008).
In 2008, investors were conflicted in knowing the exact time the stocks are highly-priced and
whether they should sell them prematurely. By analysing micro-economic variables like money
supply, inflations, assets, and dividends investors understood the reversion of market variables
and when they reach the abnormal level. In expectations of high economic growth, market
stability, and favourable interest rates the stock prices are overpriced or can remain high
(Emekter et al., 2018). Underprizing mainly occurs when investors fear to sell their shares at a
loss. Investors hold on to their losing value stock until it is too late. Under-pricing occurs due
to market imperfections and information asymmetry associated with uncertainty. On-demand
side, investors have the same information about the issued security together with expected risks
and returns. On the supply side, the impartial method is applied and there is no formula in the
allocation of shares (Palfrey and Wang, 2012).
Market failure model in justifying bank regulation
Due to the high risk involved in banking, any form of poor management can lead to failure.
Such poorly managed banks attract acquirers who think they can improve management quality.