The Great Recession has ushered in a quarrel between lawmakers and experts of all walks regarding how to revamp financial regulation. It has been more than a year since the government had to bail out the financial system to shore up Bank of America (NYSE:BAC) and Citigroup (NYSE:C), as well as rescuing AIG (NYSE:AIG) and all its counterparts, such as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS). Yet even now, we still haven’t implemented safeguards for the system.

According to Doug Roberts, founder and chief investment strategist of, the mistake lies in the Federal Reserve’s policy course charted 15 years ago. He calls it the “extend and pretend mentality.”

What’s been happening since 1995, Roberts says, was initially intended as a short-term fix, but it has morphed into a long-term strategy that ended up kicking the can ever further down the road. Specifically, the Fed never really let the federal funds rate rise quickly and stabilize the system. The central bank would lower rates in the face of economic turmoil to flood the system with liquidity, fooling everyone into believing the system was fixed. “Instead of coming up with a long-term solution, they’re locked into this cycle where each time they have to keep injecting more and more liquidity instead of dealing with the fundamental underlying problem,” Roberts says.

Now those actions have finally come home to roost, and investors are paying the price.

Rewind the clock
The root of the problem in Roberts’ eyes lies in the Fed’s decision to begin using the federal funds rate (FFR) -- the overnight rate at which banks lend to each other -- instead of the discount rate (DR) as its primary tool to cool or stimulate the economy.

Until the 1990s, the Fed used the discount rate as its primary vehicle to inject liquidity into the system; the agency would loan directly to member banks, with the discount rate as the interest rate on the loan. In this way, the Fed would manipulate the ease or difficulty of borrowing money.

Since the banks were heavily regulated, they had to show their cards to the Fed before they could borrow from the central bank at the discount rate. This allowed the Fed to consistently assess banks’ health. If needed, the Fed made banks shore up their balance sheets and rein in loose lending practices. “The Fed had control over the situation,” Roberts says. “They saw where all the bodies were buried.”

In exchange for this constant regulatory scrutiny, banks had the benefit of profiting off the spread between the FFR and the DR, whereas it was difficult outside of the banking system to make money on the spread.

This all changed in 1995 with the advent of the globalized financial system. In 1994, the Fed started matching the FFR to the DR, and in 1995 the Fed started targeting the FFR and not the DR. The central bank started to rely more on open-market purchases of Treasuries as a way to flood the system with liquidity, since the system was now globalized. Roberts cites the example of the Asian debt crisis in 1997.

Then, in 2003, the discount rate was changed so that it was above the federal funds rate, making it cost-prohibitive to borrow directly from the Fed. “Banks were now placed at a competitive disadvantage to the shadow banking system, since their source of funding was now the same but the banks were subject to regulation,” Roberts says. “This was one of the major reasons why these banks increased their balance-sheet leverage and chased yield with complex investment products, events which were the cause of the current financial crisis.”

Breaking the cycle
How do we fix the system? Roberts says we can’t just return to the old system in which the Fed primarily used the DR as its main target, because we operate in a global financial system now.

Roberts notes that though the idea is still in its early stages, the Fed stated recently that it’s toying with the idea of using accounts established at the Fed to regulate the flow of money. “It’s like the flip side of the discount rate,” he says. “That might be a good start, because you could allow central banks and foreign banks to hold accounts there. So, in other words, what you have to do is make a clear delineation and say, those who those who submit to our system, we’ll give them preferential lending. But if you’re outside of it, then that’s not our problem.”

But that’s easier said than done. There are political ramifications. One of the problems Roberts says we’ve had in the last 10 years is that the U.S. is basically no longer dictating terms in these situations.

The only fix Roberts sees is fundamental reform. “Ultimately, people are saying ‘Reenact Glass-Steagall.’ That’s part of the equation, but then what happens is you have a lot of these people going offshore and then [the problems] just occur somewhere else.”

Roberts says regulating the banks would work if we became a protectionist economy. “But as long as we’re a global economy, you end up penalizing your financial institutions and driving them offshore. What they really have to do is come up with an orderly method of liquidation. [Paul] Volcker [former Fed chief and current chairman of the Economic Recovery Advisory Board] is the first person to talk about this directly. I’m not sure his solutions are going to be adequate or even appropriate for the situation, but it’s a good first step.”

Regulators should act quickly, though, because according to Roberts, until a viable solution is found, “the situation is highly unstable. I would view all bounces in the equity market as temporary, subject to disruption by financial and geopolitical shocks.” 

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Fool contributor Jennifer Schonberger owns shares of Bank of America, but does not own any of the other companies mentioned in this article. You can follow her on Twitter. The Motley Fool has a disclosure policy.