Apr 2, 2008

Great Depression lesson

With the Bush administration set to unveil an overhaul of the nation's fragmented financial regulatory system today, and Congress likely to offer a counterproposal in the coming months, it might be tempting to tune the whole debate out. After all, this is a topic unusually rich in detail and complexity.


But the question at its core is really quite simple. Should financial institutions capable of doing great harm to markets or necessitating taxpayer bailouts be left alone to decide what level of risks they wish to undertake? The answer is just as simple: no.


The government learned that lesson in the Great Depression, which was triggered in part by runs at undercapitalized banks. It set up a system requiring banks to maintain sufficient reserves. It also created federal deposit insurance to give people confidence that their money would be safe.


But since then, a parallel universe of unregulated financial institutions has come to be and taken over much of the business of financing. In this universe, the traditional bank lending its own money to people it knows has been replaced by a series of impersonal and interdependent institutions such as investment banks and hedge funds. These firms have turned the basics of banking — lending, borrowing, managing risk — into a system of readily tradable, but impossibly complex, securities.


This system has been a failure. Rather than spreading and diversifying risks as intended, it has enabled certain institutions, such as Bear Stearns Cos., to place enormous bets in housing and other areas, without the government, shareholders, or even top executives fully appreciating the risks involved or knowing whether the institutions have the means to cover their losses. That is a scary proposition given how Wall Street's largest houses can have a domino effect if they fail.


An enhanced government role in overseeing these institutions need not be overly regulatory. Washington should have little interest in signing off on every new financial instrument issued. But if it is going to rush in when large institutions get into trouble, it has an interest in keeping them out of trouble in the first place. This entails requiring them to maintain adequate reserves should their financial conditions rapidly deteriorate. It also entails some way to promote greater transparency and simplicity in credit markets.


There's no sense in allowing so much of the financial world to play by its own rules when times are good and expect a bailout when they are not. That lesson was learned in the 1930s, and needs to be relearned now.