A Radical Plan to Reform the Financial System

In early January, Ben Bernanke defended the Fed's handling of the recent financial crisis. The lesson he drew was simple: better regulation could have prevented it.

This is correct. Regulation could be better and smarter. Regulators could eliminate banks' intentional evasion of regulatory oversight. They could solve the too-many-cooks-in-the-kitchen problem, in which an overabundance of regulators and a lack of coordination frustrate effective supervision of the system.

But sometimes it's not enough to impose new regulations on the status quo; sometimes a bit of regulatory "creative destruction" is in order. Many of President Obama's reform proposals are good, but they don't go far enough. There are more drastic changes that can and should be imposed in the coming years, including breaking up big banks and imposing new firewalls in the financial system. There is an even more radical idea: use monetary policy to prevent speculative bubbles.

What follows is a glimpse of the possible future of finance—if policymakers and politicians recognize that confronting crises requires radical reform.

Smaller Is Better

There's a very simple way to curtail the power of the big firms that helped cause the crisis: break them up. The recent crisis highlighted the "too big to fail" problem. The collapse of Lehman Brothers and the resulting cardiac arrest of the global financial system revealed that many institutions had become so large, leveraged, and interconnected that their collapse could have systemic and catastrophic effects.

The ranks of the TBTF club contain few traditional banks. Most belong to another species: big broker dealers like Morgan Stanley and Goldman Sachs; AIG and other insurance companies; government-sponsored enterprises like Fannie Mae and Freddie Mac; and hedge funds like Long-Term Capital Management. While the crisis left fewer such firms intact, those remaining are often larger, thanks to the consolidation that followed the panic.

Not only are such firms too big to fail, they're too big to exist, and too complex to be managed properly. They should be pushed to break themselves up. One way of doing this would be to impose higher "capital-adequacy ratios," which is a fancy way of saying that these institutions should be forced to hold enough capital relative to all the risks posed by their different units. This requirement would reduce leverage and, by extension, profits. The message: bigger isn't better.

For their part, the TBTF firms consider themselves essential to the world economy. Thanks to their scale, we're told, they offer "synergies" and "efficiencies" and other benefits. The global economy can't function without them, they say.

This is preposterous. For starters, the financial-supermarket model has been a failure. Institutions like Citigroup became gargantuan monsters under the leadership of empire builders like Sanford Weill. No CEO, no matter how adept, can manage a global institution that provides thousands of kinds of financial services. The complexity of these firms, never mind the exotic financial instruments they handle, makes it mission impossible for CEOs—much less shareholders or boards of directors—to keep tabs on every trader.

Even nominally "healthy" firms like Goldman Sachs pose a threat. Not that you would know it listening to the firm's CEO, Lloyd Blankfein, who in early 2010 defended handing out record bonuses by claiming, "We're very important. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. We have a social purpose."

Spare us. Like other broker dealers, Goldman Sachs has a long history of reckless bets and obscene leverage. It was at the center of the investment-trust debacle that exploded in 1929, ushering in the Great Depression. It spent the succeeding decades operating in a relatively prudent fashion. But that changed in the late 1990s, when Goldman went public. Since then, it has helped inflate speculative bubbles, ranging from tech stocks to housing to oil. After the SEC eliminated leverage restrictions for investment banks, Goldman's leverage ratios soared to all-time highs, making it vulnerable when the crisis hit.

Like its competitors, Goldman was up to its neck in risky securitization, and while it's true that it saw the subprime bust coming earlier than others, its survival has little to do with its savvy. It lived through the crisis because the federal government propped it up again and again. All told, Goldman probably took upwards of $60 billion in direct and indirect help, then took even more after converting to a bank holding company, when it got access to TARP funds.

Yet its close brush with annihilation doesn't seem to have left its ringleaders chastened. They've wriggled free of restrictions on compensation by returning the TARP funds. Now they're back to pursuing high-risk proprietary trading strategies. For these reasons, Goldman should be broken up.

Glass-Steagall on Steroids

In the wake of the recent crisis, distinguished thinkers like former Fed chairman Paul Volcker have argued for a return to the Glass-Steagall legislation of 1933, which separated commercial banking from investment banking. This firewall eroded in the 1980s and 1990s, finally disappearing altogether in 1999. The result was the current system, in which a firm like Citigroup or JPMorgan Chase can be a commercial bank, a broker dealer, an insurance company, an asset manager, a hedge fund, and a private-equity fund all rolled into one. That meant banks with access to deposit insurance and lender-of-last-resort support pursued high-risk activities that resembled gambling more closely than banking.

Returning to Glass-Steagall would be good but not good enough. What we need is a 21st-century version of the legislation that creates new firewalls. It would move beyond a simple separation between commercial and investment banking and create a system that can accommodate—and separate—the many different kinds of financial firms now in existence, as well as curtail the sort of short-term lending that made the financial system "too interconnected." Accordingly, commercial banks that take deposits and make loans to households and firms would belong in one category; investment banks would belong in another. Investment banks would be forbidden to borrow from insured commercial banks via the short-term, overnight "repo financing" that proved so fragile during the recent crisis.

That's a start. Given that so many of the shadow banks got themselves into trouble by borrowing on liquid, short-term bases and then sinking that money into long-term, illiquid investments, regulators must restrict their ability to do it even further. That means banning investment banks and broker dealers from doing any kind of short-term borrowing. This would make the financial system less interconnected, and less prone to chain reactions.

In order to stabilize the system even further, all banks—including investment banks—should be forbidden from practicing any kind of risky proprietary trading. Nor should they be permitted to act like hedge funds and private-equity firms. They should confine themselves to raising capital and underwriting offerings of securities.

Financial firms will howl at this prospect. Let them.

Pop Speculative Bubbles

In 1996 Fed chairman Alan Greenspan gave a speech that warned of the dangers of "irrational exuberance." Market watchers concluded that he was on the verge of raising rates, and global markets plunged. Chastened, Greenspan never again issued public warnings as the tech bubble grew to monstrous proportions. Aside from a rate hike of one quarter of 1 percent in 1997, he did not raise interest rates again until the middle of 1999.

The bubble eventually burst in 2000, and Greenspan's Fed responded by slashing interest rates from 6.5 percent to 1 percent between 2001 and 2004. The rising tide of easy money helped cushion the bursting of the tech bubble, but it fed another, bigger bubble in housing. Here, too, the Fed did nothing. There's a familiar pattern: the Fed lets bubbles form and asset prices go through the roof; then, when the bubble bursts, it tries every trick in the book to alleviate the damage done.

This approach generates moral hazard on a grand scale. Investors now have every reason to conclude that central banks will do nothing to stop a speculative bubble from growing—and in fact may even encourage it, becoming cheerleaders for the "new economy" or the virtues of homeownership—but will do everything in their power to limit the damage. This is extraordinarily problematic. If investors believe the Fed will save them, they'll take even more risks the next time around.

Apologists for the status quo argue that central banks can't intervene against rising asset prices because of "uncertainty." This is nonsense: uncertainty doesn't stop central bankers from targeting inflation; it shouldn't stop them from countering bubbles, either. Moreover, policymakers have available certain tools that can at least give some measure of whether asset prices are spiraling out of control. And, models aside, there's always common sense. If central bankers look at share prices of tech stocks doubling and tripling within the space of a few months and still can't see a bubble—well, perhaps they should consider another line of work.