Fixing Big Finance

President Obama, aware that the public’s unhappiness with the financial industry has hurt his standing, started his second year in office by attacking Big Finance. “If there’s one thing that has unified Democrats and Republicans, and everybody in between, it’s that we all hated the bank bailout,” the President said in January in his first State of the Union address. “I hated it. You hated it. It was about as popular as a root canal.”

But Obama’s proposed fixes, including a new tax on large financial institutions and a new “Volcker rule” that would prohibit commercial banks from owning hedge funds or proprietary-trading operations, won’t ensure that it never happens again. To protect the economy from financial meltdowns, it’s necessary to understand how we got this financial meltdown - and then the solutions naturally follow.

How We Got Here

The credit crisis and the resulting recession are the work of an invisible hand - not the invisible hand of free markets but of an overwhelming government interference in those markets. Over a quarter of a century, Washington gave the world of finance a terrible privilege: freedom from fear of failure. Until the early 1980s, banks, securities firms and insurers, like all private companies, operated under market discipline. Federal laws prescribed a consistent, predictable way in which they could fail, with investors and lenders taking their warranted losses.

Starting in the early ’80s, though, many banks and securities firms became too big to fail, thus gaining an invaluable advantage in the competition for resources: Lenders knew that they did not have to worry about losses. As a result, creditors no longer transmitted vital signals about the prospects for success or failure.

Financial firms, implicitly subsidized by the government, replaced measured risk-taking with recklessness. Bankers and traders, insulated from the full consequences of their decisions, created instruments that circumvented reasonable government limits on borrowing and exposure. These innovations further sidestepped disclosure requirements. Under four presidents, from Ronald Reagan to George W. Bush, Washington’s response to concerns about inadequate regulation was to say that markets could regulate themselves better than government could.

Paradoxically, though, policies short circuited the ability of markets to self regulate. Washington’s too-big-to-fail policy increasingly hampered their ability to force financial companies to rein in excess. The complex instruments they created gradually increased the risk posed by the failure of even a small financial firm.

Government subsidy of financial failure kept the free market from doing its work in other ways, too. Financial companies lent profligately to American consumers and offered multimillion-dollar bonuses that made it difficult for companies in other fields, like engineering and technology, to compete for talent.

By 2007, the free market had had enough. Fleeing investors and plummeting asset prices exposed the financial industry’s untenable risks. By 2008, Washington had no choice but to step in and virtually take over the industry in an effort to keep the economy from spiraling into depression.

Without changing how Washington approaches Wall Street, the financial industry will continue to operate without clear market signals. The inevitable result will be even more economic distortion, because finance determines who gets capital and on what terms.

Robust financial markets do not imperil capitalism; they support it. To ensure that they can do their job, lawmakers and regulators must reintroduce market discipline. They can do so only by ensuring that the economy can withstand such inevitable failures. The way to do this is through consistent borrowing limits across similar financial instruments, no matter what the perceived risks, as well as disclosure and trading rules that help quarantine risk in a panic.

Lessons from History

The searing experience of the late 1920s and the Great Depression that followed showed that the world of finance, if left unrestrained, threatens the free market itself. In the ’20s, bankers, corporate executives like utility titan Samuel Insull and investors expected only more good times - and acted accordingly. They borrowed against every last dollar of expected profit, and then some. They also trusted themselves to design financial structures many magnitudes more complex than stocks and bonds.

Banks and investment firms lent freely to almost anyone so they could bet on stock and other securities. This fever of short-term speculation affected the long-term business of borrowing and lending. This credit creation is vital, because companies always need to borrow, at least modestly, to grow.

Infusing credit creation with excessive speculation, then, made the entire economy vulnerable. But bankers, largely free of regulation, didn’t understand the risk. “Young men thought they could do anything,” Albert Gordon, an executive who had helped rescue one Wall Street firm, Kidder Peabody, from the depths of the Great Depression, later said.

When something finally went wrong, starting in 1929, it wasn’t only the rarefied financial world that suffered. The bankers had used the public’s savings as fuel for their experiments. People stopped trusting their neighborhood banks, which fell victim to the crisis. Without deposits to lend, surviving banks couldn’t make new loans or recoup their losses on the old ones. The infrastructure of money and credit disintegrated.

It took a decade for the economy to recover from the shock. FDR and his policy wonks inevitably committed errors that contributed to the delay, but they also designed regulations to protect financiers from themselves and to protect the economy from financiers. Because failing banks had helped bring on the Depression, policymakers created a mechanism for banks to fail in an orderly fashion without imperiling the economy. Guarantees of small banking deposits through the new Federal Deposit Insurance Corporation (FDIC) were not a safety net for banks. They were an assurance that small depositors wouldn’t lose their savings when banks did fail, with bigger depositors and other lenders taking their losses. These regulations made it less likely that masses of people would once again suck the economy’s lifeblood - money and credit - out of banks. By saving small depositors and thus the overall system from panic, regulators ensured that bad banks could continue to go out of business, allowing the market to help discipline their risk-taking.

Regulators also forced financial institutions to decide whether they wanted to be in the securities business or the banking business. This gave banks some insulation - but not immunity - from short-term shocks.

Washington wisely did not banish risk-taking altogether. FDR understood that financial sophistication had helped drive growth after World War I, attracting the world’s money to U.S. shores. Instead, policymakers imposed clear, consistent limits on risk-taking in the securities business, which remained freer than the banking business. New regulations prohibited investors from borrowing excessively to buy securities whose values could swing wildly. The government also imposed an obligation of full and fair disclosure, requiring companies selling stocks or bonds to the public to explain the financial, business and economic risks that the companies and their investors faced.

Taken together, these reforms enabled the financial and business worlds to continue to innovate and take risks, so long as those risks didn’t endanger the broader economy. The system worked well, more or less, for over half a century, helping propel American capital markets to even greater dominance after World War II.

But in the 1980s, the regulatory infrastructure started to decay. In 1984, the government stepped in to rescue a large commercial bank, Continental Illinois, extending protection not just to the bank’s insured depositors but also to all its other lenders, including corporate depositors whose accounts exceeded FDIC limits as well as global bondholders. The event set a now familiar precedent: “too big to fail.”

Spiraling Out of Control

Uninsured lenders to big banks no longer worried that they would lose their investment; the government would intervene if things spiraled out of control. As a result, financial innovation proceeded without the natural checks and balances of market forces. Banks became adept at turning their insulation from disorderly failure into insulation from market discipline.

Innovations, mostly in the world of credit, blurred the ’30s line between banking and the securities industry, making the business of credit creation more vulnerable to short-term gyrations. Politicians and regulators recognized that separating commercial and investment banking had largely become irrelevant, because more and more of the world’s credit depended on investment- banking capital markets anyway. But instead of regulating the investment world to address the risk that capital markets’ exuberance and panic posed to the economy’s supply of credit, Washington did the opposite: It allowed commercial banks to embrace investment-banking activities.

The financial world also found ways to avoid borrowing limits. Because Depression-era regulations kept them from borrowing unreservedly to speculate on stocks, financiers created derivatives that escaped the regulations. Experiments with making tradable securities out of long term debt - from junk bonds at an investment bank, Drexel Burnham Lambert, to mortgage-backed securities at a hedge fund, Askin Capital Management, caused miniature explosions that Washington should have seen as warnings but instead regarded as aberrations. Similar eruptions in unregulated derivatives competed, just as vainly, for attention.

vIn 1998, a mix of the two - unbridled derivatives creation and speculation on long-term credit - created a near disaster. An obscure hedge fund, Long-Term Capital Management, proved that it, too, was too complex to fail. The fund’s opaque endeavors, enabled by unregulated borrowing, nearly brought down the economy. Three years later, Enron demonstrated how easy it was to use innovations to create credit out of nothing but blind trust and proved how eagerly the nation’s biggest financial firms had enabled such spurious credit creation. Enron’s collapse showed how quickly it could all fall apart when trust vanished.

The government treated failures the increasingly fragile system served up as discrete matters best addressed with one-off, extraordinary solutions, from weekend financial rescues to criminal prosecutions. Mainstream thinkers said that financial markets didn’t need much regulation. Alan Greenspan, who took the helm of the Federal Reserve in 1987, told lawmakers and the public that financial companies, powered by a rational motive not to lose money, could police themselves and one another, using financial innovations to decrease, not increase, risk. The financial world operated increasingly freely under a long-running illusion that elegant modern theories and technologies made all manner of credit perfectly safe. Yet with each innovation, financiers left themselves even less room for error, were the tiniest thing to go wrong - just as they had done in the ’20s.

‘Bankers had accomplished the opposite of what they, and regulators, had thought they were doing. They hadn’t created safety out of danger, but danger out of safety, eventually turning the most sober investment that many people make - the purchase of a home - into a risky bet. The financiers made mortgage lending seem risk-free, meaning that money became available for anyone to get a mortgage for any house, regardless of ability to repay the debt. When more money is available to buy something, the price of that item goes up. Once the risks emerged and the easy credit tightened, the plunge proved more disorienting than the rise.

By 2008, sober-minded people feared that the government would not be able to prevent another Great Depression. Policymakers from both parties, starting in the Bush administration, felt that they had no choice but to use trillions of taxpayer dollars to protect failed firms and their lenders from tremendous losses. Much of the financial industry now depended on its ability to hold the economy hostage just to stay afloat.

Sensible Solutions

The financial crisis should not have come as a surprise. Nor are creative solutions necessary to prevent another such catastrophe. The same regulatory philosophy that protected the post-Depression economy and created the conditions for prosperity would have prevented the postmillennial financial meltdown. It can work again, if policymakers apply it to the financial system that exists today.

First, no private company in a free market economy should be too big or too interconnected to other institutions to fail. The government must once again create a credible, consistent way in which failed financial companies can go out of business, with lenders and shareholders taking losses according to their pre-defined place in line.

The government cannot credibly stick to such a policy, though, until it re-imposes clear, well-defined limits on borrowing across similar financial firms and instruments. Only when market participants realize that the economy would be able to withstand inevitable financial business failures, will markets believe that “too big to fail” really is dead. Washington should not give financial firms a break on capital requirements for investments that it deems risk-free, as it has with certain AAA-rated securities. Such a regulatory system makes the economy vulnerable to one top-down mistake, and thus primes the financial industry for future bailouts.

Trading and disclosure rules, too, are critical. Insurance giant AIG required a bailout in 2008 in part because it could make hundreds of millions of dollars’ worth of promises with no consistent capital to back them up. AIG did not make those promises on regulated exchanges; investors had no idea where the risk lay. When it made itself all too apparent, they pulled their money out of the entire financial industry until they could find out, creating a global run on capital markets that only wholesale government guarantees could slow.

Problematic Proposals

Where do the White House’s recent proposals fit into these prescriptions? Unfortunately, President Obama’s proposed tax on large financial institutions will only entrench the markets’ belief in “too big to fail.” After all, if Washington is comfortable in the idea that Wall Street firms can fund their next bailout too, that bailout will come. But the idea that Wall Street can fund its immunity from consistent market discipline is a false one: No private industry can do that. A permanent bailout fund for Wall Street would need trillions upon trillions of dollars to do what the federal government has done over the past two years, from guaranteeing money-market funds to purchasing mortgage-backed securities. The bailout fund would itself present a systemic risk to the economy.

Former Federal Reserve Chairman Paul Volcker’s proposal to resegregate commercial banking from some investment-banking activities, particularly proprietary trading and hedge-fund management, would be appropriate if the economy had not evolved long ago to depend on the investment banking side for the supply and maintenance of credit. Prohibiting commercial banks from certain capital-market activities is not sufficient. Moreover, prohibiting commercial banks from some activities without regulating the same activities in the capital markets just drives more of the nation’s credit to them.

On protecting the economy from the risks that modern capital markets present, reform from Washington has so far been slow and fraught with loopholes. One thing is clear, though: Political will to avoid future bailouts is strong. Americans don’t want their government picking winners or losers. Just the opposite: The public wants the government to do its job of rationally regulating financial markets so that financial markets can then rationally manage the private distribution of capital, funding good businesses that power the economy.

The nation finds itself in its current weakened position largely because of a crisis created by a financial system that grew freer and freer of the most important regulation of all: regulation by the free market itself. It’s sad that we could have prevented the crisis, but it’s also good news - because now we know how to prevent the next one.

This piece originally appeared in Chief Executive Magazine

This piece originally appeared in Chief Executive Magazine