Ask the reason for the collapse of Lehman Brothers, and you will find much of the answer in two words: Dick Fuld. Mr Fuld has been the imperious chief executive of Lehmans, the fourth-largest investment bank in the United States, since 1994. A curious cross between Gordon Gekko and Tony Soprano, Mr Fuld was an unapologetic mogul of Wall Street: he put down his colleagues in public; he was good at straight-talking, but not so practised at straight-listening; and ultimately he deluded himself and those around him that, having seen off a brush with bankruptcy in the late 1990s, he and his bank had taken the precautions necessary to weather any financial storm. At Lehmans’ annual general meeting last April, he said: “The worst of the impact on the financial services industry is behind us.”

Two months later, his bank revealed $2.8 billion in quarterly losses. Yesterday, with its share price down 94 per cent in a year, the bank filed for bankruptcy (see page 1). The human costs include the redundancy of 24,000 employees.

Regardless of the economic climate, and whatever excuses that may be offered about unexpected events, what has happened at Lehman Brothers was avoidable. Mr Fuld could have ensured more prudent management of the bank. A board other than Lehmans’ compliant one might have supervised him more closely or ousted him: after the failure of Bear Stearns in March, it ought to have been the prime concern of the Lehmans board to anticipate and prevent a similar outcome. Lehman Brothers held assets of around $40 billion in US real estate – the same type of mortgage-backed securities that had undermined Bear Stearns.

In the new circumstances, Lehmans needed capital to survive. It might have gained a lifeline from selling itself or divesting its fund management arm, Neuberger Berman. Korea Development Bank was one serious suitor, but last week it broke off negotiations to buy a stake of up to 50 per cent stake in the bank. Fuld and Lehmans’ board proved to have wholly unrealistic expectations of the genuine value of the bank.

Underlying that misjudgement was a catastrophic failure to understand the fragility of the Lehmans business model or the nature of a financial marketplace that had all changed – and changed utterly. The iconic financial failure of the 1990s was that of a hedge fund, Long-Term Capital Management, whose investment strategy turned out to be, in effect, a single bet on the direction of interest rates, employing huge amounts of borrowed money. A decade later, Lehmans did something very similar. It took a huge bet on the US real estate market. Even after the onset of the credit crisis, the bank intensified this exposure rather than scaled it back. Lehmans did this in the hope of emulating the profitability of the big players in investment banking: Goldman Sachs, Morgan Stanley and Merrill Lynch. The strategy has instead ended in pure failure and the destruction of a bank with a 158-year history.

The immediate effect of Lehmans’ bankruptcy has been sharp falls in global stock markets – especially in bank stocks – and a flight to safer assets such as gold. The longer-term impact is unclear but ominous. At the weekend, Alan Green-span, the former Chairman of the US Federal Reserve, said the US was in a “once-in-a-century” financial crisis. If anything, he understated it.

The Western financial system is entering uncharted territory. The Great Depression of the 1930s might have been avoided by easier monetary policy. The stock market crash of 1987 did not lead to recession precisely because central banks recalled that precedent and slashed interest rates. But the credit crisis of 2007-08 is a more intractable problem.

While the Federal Reserve has been active in the past year in cutting interest rates and providing support to markets by various initiatives, these steps cannot on their own remedy the fundamental weakness that the credit crunch reveals. This is that large parts of the financial system are technically insolvent after suffering huge losses in the US housing market. Banks treated housing as collateral for loans on the assumption of ever-rising prices. And of course house prices could not forever outstrip the capacity of wage and salary earners to pay those prices.

Last-ditch negotiations to find a buyer for Lehmans foundered at the weekend when it became clear that the US Government would not devote taxpayers’ money to a guarantee for the bank’s real-estate assets. Potential buyers of Lehmans – Barclays bank and Bank of America – would thus have been acquiring a huge volume of assets that were in effect unsaleable and of extremely doubtful value. The decision of Henry Paulson, the Treasury Secretary, was prudent and justified, but it made a deal impossible to attain.

Less newsworthy than Lehmans’ bankruptcy but no less important was the acquisition yesterday of the brokerage Merrill Lynch – a household name in the US – by Bank of America for $50 billion. This indicates that while Lehmans’ failure might have been avoided by a more farsighted chief executive, it was not unique in the weakness of their business model. Investment banks typically borrow short-term in the money markets, and lend long-term. With a collapse in confidence, these institutions have become acutely vulnerable. So while the debacle now being played out in Western finance is not a crisis of capitalism, it does signal a severe weakness in banking as it has been practised in the past two decades.

The banks had a policy to reduce their vulnerability – securitisation. The policy has not worked. The theory of securitisation – packaging debt into marketable instruments and selling them to investors – was that it would enable society to take on a higher level of risk. That risk could be diversified by spreading it across a wide investor base. In practice, however, what has happened is more like contagion. Assets that cannot reliably be valued have been packaged with good assets; the package has then been misvalued by agencies whose job it is to assess credit-worthiness; and the financial instrument has then been sold on to unsuspecting investors.

The ructions on world financial markets may seem remote from the world of everyday commerce. But the impact may prove severe. Banks serve an essential purpose. They are the intermediary by which scarce capital can be allocated to productive uses, thereby making society richer. But now the banks have forfeited public trust by gambling with investors’ capital. Lehmans is the first bank to go under; it may well not be the last.

Perhaps this will prove a minor squall. The markets may absorb the collapse of Lehmans, rival banks may scoop up its old clients and, having learnt its lesson, the financial system may move on. More likely, though, there will be a period of seizure. If the public loses confidence in the integrity of the financial system, the economy might seize up entirely. A mood of pessimism may lead every actor – consumers, bankers, borrowers, producers, investors – simply to wait to see what happens next. And while they are waiting, of course, what happens is that nothing happens.

What does all this mean for the rest of us? What happens next? The answer is opaque. Traders are uncertain about who is left exposed to Lehmans. Banking bosses are uncertain about what it means for the industry. Policymakers and regulators are left hoping for the best. And that is what is most frightening.