This Is How We Should Fix the Financial System

How do we fix the financial system? How do we ensure that we don't set ourselves up for another crisis? Simon Johnson, professor at MIT's Sloan School of Management, senior fellow at the Peterson Institute for International Economics, and co-founder of The Baseline Scenario blog, offered some ideas during a recent visit to Motley Fool HQ.

Johnson, who is also a former chief economist of the IMF and an authority on financial crises, says it's the structure of the financial sector that's to blame. He says the cause is rooted in the system of incentives and the ownership structure for banks like Wells Fargo (NYSE: WFC  ) , Citigroup (NYSE: C  ) , and UBS (NYSE: UBS  ) . Regulation is also a cause, according to Johnson. "It's a structural issue that has come about because of the way the U.S. economy and the financial sector has changed over the past 30 years," he said.

Johnson also shrewdly instructs us to think about the power structure of finance, not just the efficiency of finance and markets. He points to Thomas Jefferson as someone who had foresight on the power structure of finance. In his day, Jefferson warned about the moneyed aristocracy. Johnson believes Jefferson had a very clear view of power and was afraid of anything that would rise up and challenge elected democratic authority.

"[What happened] is not a random piece of bad luck," Johnson said. "If it's structural, that means you have to fix the structure. Otherwise you really run the risk of repeating this."

Fixing the regulatory structure
Johnson says we should start with things that are directly under the control of the regulator, namely capital requirements. "If you raise capital requirements enough and if you make them steeply progressive enough so that big firms have to have a bigger equity cushion against losses … that will be a big disincentive to size."

On the legislative front, Johnson says the administration's proposed consumer protection agency is the way to go. "It's not perfect, but notice that is the only piece of legislation that big finance and even medium-, little-sized financial firms protest." Johnson argues that since the financial sector has not fought nearly anything else the administration has put forth, it tells us that the other proposed regulations won't make a difference.

Repealing Glass-Steagall
Johnson says repealing the Glass-Steagall Act was an element of a much broader push toward deregulation. Glass-Steagall, which was enacted during the Great Depression, mandated that erstwhile commercial banks like Bank of America (NYSE: BAC  ) couldn’t engage in investment banking, and erstwhile investment banks like Goldman Sachs (NYSE: GS  ) couldn’t engage in commercial banking to minimize risk to the financial system.

"It was part of the capturing of the minds and the ideology of regulators and of Capitol Hill," Johnson said. "So as a symbol of what happened it's very powerful."

However, the defining moment for Johnson was the decision not to regulate derivatives, which was made under the Clinton administration. "If that had gone differently, perhaps now we'd have a safer system," Johnson said. At the time it was thought -- or argued by bankers -- that regulating derivatives would cause the greatest financial crash since the Great Depression. "They were right, but with the wrong side," said Johnson. "That was it. That was deregulation, or failure to regulate."  

Johnson says regulation of derivatives, or the lack of it, will be a big part of the fate of the financial system going forward.

"What I worry about is when [the economy/system] comes back, everyone relaxes, and I call you next year and I say, 'Do you want to have another conversation about crises?' And you say, 'Come on, that's passe. We're beyond the crisis.' That is the road to disaster."

Tell us what you think. Share your thoughts on deregulation and the financial crisis in the comments section below.

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Fool contributor Jennifer Schonberger own shares of Banks of America, but does not own shares of any of the other companies mentioned in this article. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 06, 2009, at 5:52 PM, boomer7573 wrote:

    The proposed consumer protection agency is going to hurt more than help. The small loan industry stands at risk of being put out of business completely. To those that have money and do not have need to borrow a couple of hundred dollars for those unexpected emergenices, this is not a big deal. But for those of us that need these small loan places, this can jeopardize a lot for us. Most banks won't loan under $3000 and those that will have such strict guidelines that a lot of people cannot borrow from them. So when this proposed consumer protection agency deems these small loan companies as unfair due to high interest rates, who will be there to help us if our cars break down, or if we have to buy unexpected medicine that our insurance won't cover? Who is going to be there to loan us money for that?

  • Report this Comment On October 16, 2009, at 2:20 PM, globalsailor wrote:

    I think the real problem is the concept of too big to fail. If a company wants to invest in one trillion dollars of notional derivatives, one, they should report it, and two they should be broken up for holding a monopoly. No company should every have assets that amount to more than 5% of the nations GDP.

    Also, it would be a good idea for the government to stop encouraging subprime loans as well as home-owning in general. Renters are responsible people who try to do good and keep proper balance sheets. Why discriminate?

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