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This Is How We Should Fix the Financial System

Jennifer Schonberger
October 6, 2009

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