It’s been a year and a half since the banking system came crashing down in the fall of 2008, forcing Merrill Lynch into the arms of Bank of America (NYSE: BAC), Wachovia to Wells Fargo (NYSE: WFC), and Washington Mutual to JPMorgan Chase (NYSE: JPM).

The House passed financial reform legislation in December, and Sen. Chris Dodd (D-Conn.) finally presented the Senate’s proposal on Monday, following a long slugfest of negotiations with his Republican counterparts. Still, we have a long way to go until we receive passage of comprehensive financial reform. Respected Stanford economist John Taylor recently shared his views on financial reform with me.

Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at the Hoover Institution. He is well-known in economic policy circles for coining the Taylor Rule, a monetary-policy rule that offers guidance as to how to tinker with interest rates to control inflation and maintain economic growth. He served as Undersecretary of the Treasury for International Affairs during the George W. Bush administration, and he was also a part of the President's Council of Economic Advisors, first as a senior economist during the Ford administration and then as a member during the George H.W. Bush years. He is also the author or editor of numerous books, including, most recently, Ending Government Bailouts as We Know Them.

Here is an edited transcript of our conversation.

Jennifer Schonberger: In terms of addressing the “too big to fail” problem, you believe in a clear operational definition and measure of systemic risk for financial institutions. How should we define that?

John Taylor: We should define it using data on how firms are connected and interconnected to each other. So that interconnection -- one bank could be lending to another bank -- is part of the concern people have when they say things are “systemic.” When we look at those data -- and there aren’t much available, unfortunately -- you don’t see as much of an interconnection as people think. But until we get better measures of that connection, it seems to me that we really can’t define it very well.

So what I’m arguing for is really a systematic study of the definition so that it can be applied in practice, but we’re not there yet. When people cry out [that] there’s systemic risk, you don’t know how to define that, and that causes all sorts of distortions. So I think we have ways to define it, but it requires a lot of analysis and data collection to make it more specific.

Schonberger: Will any of the financial reform legislation currently under consideration in Congress be effective in addressing the underlying problems of the financial crisis?

Taylor: I think that expanding the resolution authority that the FDIC has for banks is a mistake. The experience during the crisis shows if you give so much discretion to a government agency to define or decide when a firm needs to be intervened [with], that it causes a lot of uncertainty. What would be much better is if you had a rules-based, or law-based, process.

So rather than what is being proposed with an expanded resolution authority, I think the bankruptcy code is a better way to proceed. There are some proposals to have what is sometimes called a Chapter 11-F -- Chapter 11 for financial institutions -- that deals with some of the systemic issues that people are worried about. It’s a much better approach than giving discretion to a government agency to decide when a firm should be intervened [with].

Schonberger: Incidentally, where do you come down on the Volcker Rule?

Taylor: The Volcker Rule, unfortunately, has been defined in many different ways, and that needs to be resolved. I think there is definitely a reason to restrict the amount of risk-taking for an institution that has access to the Federal Reserve’s discount window or access to guaranteed deposits. You need to reduce that. Of course, we do have ways to reduce that. I think increasing the capital requirements generally for those institutions, to the extent that works, is worthwhile. If you can find a way to specify the proprietary trading, and whether that’s risky or not, then that should be part of it as well.

Schonberger: Do you think we also need a hard size-cap on banks?

Taylor: No. We already we have the 10% of deposit rule. People are thinking about modifying that. But I don’t think a hard cap is really practical, and they’ll always find ways to get around that. So something close to what we already have should be sufficient for that.

Schonberger: We recently interviewed Simon Johnson, former chief economist of the IMF, and he said the financial industry has captured the government. How much of what has happened comes down to big finance embedded in the halls of government? And if that power structure is not amended, if that’s even possible, will we continue to be prone to the same issues?

Taylor: I think that you need to look at the specific cases. So let me give an example, which I think is worrisome. Certain regulators, in particular the presidents of some of the Federal Reserve district banks, are appointed with a lot of influence from the entities that are being regulated -- the commercial banks and financial institutions. And I’ll focus on New York for the time being. So there’s obviously a setup here where the regulated institutions influence the regulator, and I think that’s a problem.

I think the Federal Reserve structure, where you have the district banks creating a degree of independence outside of the Washington-New York nexus, is good. It’s good to have Kansas City and St. Louis. It gives a good structure of independence and decentralization. But when you have that system, in particular in New York, which is appointed that way, it raises questions.

So there are various ways to deal with this. One example is, in the Federal Open Market Committee, don’t grant the New York Fed’s presidents a more significant role compared with other presidents. That might offset some of these pressures.

Schonberger: In your new book, Ending Government Bailouts, Paul Volcker says he thinks there is a correlation between financial engineers and the number of damaging failures in the market. Do you agree?

Taylor: No. I have much respect for the financial engineering and the sense in which that has benefited people for many years. ... I do think that you need the regulations that are out there and [to] have them enforced properly. That has to do with risk-taking and, largely, transparency. And if you deal with that -- hardball with the government and this “too big to fail” problem -- then I think you should allow people to make the trades and engage in bilateral contracts that reduce risk. Then you have people absorbing the risk that others don’t want to hold. That’s all very beneficial.

Schonberger: Would you apply your approach, then, to the possible regulation of credit default swaps (CDS), which obviously played a large role in Greece and here domestically with AIG (NYSE: AIG), Goldman Sachs (NYSE: GS), et al., in the financial crisis?

Taylor: I think the proposals to deal with CDSs on trading on exchanges or through clearinghouses make sense and deal with many of people’s concerns. You can’t do that for the very specialized CDSs. I do think CDSs have proved a useful function ... As I go to the heart of the financial crisis, it seems to me that it wasn’t due to credit default swaps.

Schonberger: Right. You argue it was more the lack of transparency, of a road map for the ad hoc bailouts. You argue the government created greater uncertainty.

Taylor: Yes. Absolutely. And in some cases, where people thought there was regulation -- for example, the commercial banks, the most heavily regulated institutions, weren’t being regulated in a way people thought. They allowed the off-balance-sheet [structured investment vehicles] to exist, and that creates more uncertainty, because if people feel these are regulations on the books, then they should have some faith in those rules to be enforced. In some sense, what’s most important is you set the rules, such as regulation, enforce those in a transparent, consistent way, and then the market knows what’s going on and people can make choices, and you’ll have a much more stable system.

Several other experts have shared their opinions on financial reform. Which approach do you think is best?