Heading Off the Next Financial Crisis

A public good is something that the free market tends not to provide on its own, to the detriment of society. Pollution laws and police departments are classic examples. In the case of finance — and of the crisis of the past two years — this missing good has been strong regulation. A weak system of regulation allowed Wall Street firms to take on enormous debt. Those debts let the firms make more and riskier investments than they otherwise could have, lifting their profits. But when the value of the investments began falling, the firms had little margin for error. They were like home buyers who made a tiny down payment and soon found themselves underwater.

It was tempting to let the banks fail. They certainly deserved it. But big bank failures often cause terrible damage. Credit dries up, and the economy can enter a vicious cycle of falling asset prices and job losses. That is what began to happen in 2008. To get credit flowing again, the federal government came to the rescue with billions of taxpayer dollars. It was a maddening story line: the government helped the banks get rich by looking the other way during good times and saved them from collapse during bad times. Just as an oil company can profit from pollution, Wall Street profited from weak regulation, at the expense of society.

If there has been a theme to the Obama administration’s disparate domestic policies, it has been to invest more in public goods. The administration has increased spending on schools, highways and scientific research and tried to play a more active role in energy policy and health care. “They’re all a necessary part of the network of what makes market economies work,” Timothy F. Geithner, the Treasury secretary, told me recently, “and we have not been good enough about doing them in recent years.” A big part of that network, Geithner added, is financial re-regulation.

To reduce the odds of a future crisis, the Obama plan would take three basic steps. First, regulators would receive more authority to monitor everything from mortgages to complex securities. This is meant to keep future financial time bombs, like the no-documentation loans and collateralized debt obligations of the past decade, from becoming rife. Second — and most important — financial firms would be forced to reduce the debt they take on and to hold more capital in reserve. This is the equivalent of requiring home buyers to make larger down payments: more capital will give firms a bigger cushion when investments start to go bad. Finally, if that cushion proves insufficient, the government would be allowed to seize a collapsing financial firm, much as it can already do with a traditional bank. Regulators would then keep the firm operating long enough to prevent a panic and slowly sell off its pieces.

Will this work? It is difficult to know. No one can be sure where the next bubble or crisis will come from or, as a result, how to prevent it. You can make a plausible argument for many different forms of regulation, and there has been plenty of debate over the various details of re-regulation. How should derivatives be regulated? Should a consumer-protection watchdog be an independent agency or part of the Federal Reserve? Which agency should be responsible for seizing a failing firm?

With that being said, the Obama plan has a lot to recommend it. It would close many of the most obvious holes in the regulatory net. Congress could conceivably overcome its partisan divisions and pass an important bill this summer. If it does, the biggest reason to be nervous about the plan will not be any one of those details that has received so much attention in recent months. It will be something more fundamental. Whatever the regulatory apparatus, it will still be operated by regulators. Regulators will have to set capital requirements, decide when to close a struggling firm and find a balance between protecting consumers and still letting them make choices. The legislation does not spell out many of these details, and neither President Obama nor Ben Bernanke, the Fed chairman, has been especially clear about them. They have not offered much guiding philosophy beyond promising us that regulators will do better next time.

In a way, this issue is more about human nature than about politics. By definition, the next period of financial excess will appear to have recent history on its side. Asset prices will have been rising, and whatever new financial instrument that comes along will look as if it is safe. “When things are going well,” Paul A. Volcker, the former Fed chairman, says, “it’s very hard to conduct a disciplined regulation, because everyone’s against you.” Sure enough, both Bernanke and Geithner, along with dozens of other regulators, overlooked many signs of excess over the past decade.

One way to deal with regulator fallibility is to implement clear, sweeping rules that limit people’s ability to persuade themselves that the next bubble is different — upfront capital requirements, for example, that banks cannot alter. Thus far, the White House, the Fed and Congress have mostly steered clear of such rules.

So it is worth asking whether the current re-regulation plan has enough of a backstop. Even if Wall Street stays one step ahead of Washington, even if future regulators allow too many loopholes in the capital requirements, even if the government does not seize the next Lehman Brothers until too late, can re-regulation still serve the public good?

[ II. How We Got Here ]

For more than a half-century starting after the Great Depression, the United States enjoyed what the economist Gary Gorton calls the quiet period of banking. Before the Depression, financial panics were a regular part of life. They occurred about once a decade. People would get nervous about the health of their bank and, en masse, begin withdrawing their money. The bank, however, had lent the money to other families and businesses and did not have anywhere near enough cash to allow the withdrawals.

In the wake of the bank panics of the early 1930s, the Roosevelt administration and Congress passed two crucial reforms as part of the Glass-Steagall Act. In one, the federal government set up a new agency, the Federal Deposit Insurance Corporation, that would insure deposits and guarantee that savers would get their money back even if their bank went bust. In the other, banks were restricted to traditional lending. They could not use their deposits to speculate in stocks and were no longer allowed to underwrite securities. Together, the two rules shored up the two sides of a bank’s business — its relationships with savers and with borrowers — and reduced the odds that a bank would go under. The quiet period was born.

It began to end in the 1980s. Banks started facing new competition for both savers and borrowers. Households could put their money in mutual funds like those offered by Fidelity and Vanguard, which offered better returns than savings accounts and sometimes with little risk. Meanwhile, companies, which had once relied on bank loans for financing, could more easily borrow from bond markets.

These changes clearly brought some benefits. As Daniel K. Tarullo, a Fed governor appointed by Obama, has said, the New Deal regulations “fostered a banking system that was, for the better part of 40 years, quite stable and reasonably profitable, though not particularly innovative in meeting the needs of depositors and borrowers.” In the more competitive new system, borrowing costs fell. Credit cards, debit cards, A.T.M.’s and online banking brought convenience to consumers. The relatively high returns of the stock market became available to a wider group of people than before. Venture-capital firms turned ideas into companies.

But there was a fatal flaw in the new system. The banks’ new competitors received scant oversight. They were not directly bound by Roosevelt’s restrictions. “We had this entire system of outside banks that had no meaningful constraints on capital and leverage,” Geithner says. Investment banks like Lehman Brothers were able to make big profits in part by leveraging themselves more than traditional banks. To use the down-payment analogy again, it was as if Lehman were allowed to put down only 3 percent of a house’s purchase price while traditional banks were still making larger down payments. When the house’s value then rose by just 3 percent, Lehman doubled its investment. A.I.G., similarly, created a highly leveraged derivatives business that regulators essentially ignored.

In response, the traditional banks started advocating for deregulation, so they, too, could plunge into mutual funds and help companies sell stock. In 1999, the Clinton administration and a Republican Congress repealed most of Glass-Steagall, officially allowing traditional banks to engage in other, more risky investments. Even so, the banks’ new competitors — investment banks, insurers, hedge funds and other firms that collectively became known as shadow banks — continued to face less scrutiny and to grow rapidly. Thanks to their leverage, they could make enormous profits by being just a step ahead of ordinary investors or simply by riding a bull market. “The profits these firms make are so out of proportion with any contribution they make to the economy,” Volcker told me not long ago.

Eventually, so-called shadow banking made up roughly half of the American financial system. It also helped recreate the same preconditions for a panic that existed before the 1930s. The highly leveraged firms were vulnerable to panics. This time, the panic would come not from individual depositors — who were still insured by the F.D.I.C. — but from other financial firms. A central part of modern finance is something called the repo market, in which firms lend one another huge sums of money every day. If traders suddenly begin to worry that a second firm borrowing from their firm is in trouble, they immediately demand more collateral on the loan. Once one lender begins asking for more collateral, others get nervous and do the same. It is much like a bank run, this time conducted by phone and computer rather than at a bank’s front door. In September 2008, JP Morgan Chase and Citigroup did this to Lehman, effectively dooming it. Lehman’s collapse then set off a panic around the world.

The deregulation of the last few decades has come in for a lot of blame for the current financial crisis. It deserves some blame, too. If Citigroup and Bank of America were still operating under the New Deal rules, they might not have flirted with bankruptcy. But take a minute to think about which firms had the biggest problems. They were the shadow banks: stand-alone investment banks like Lehman, Bear Stearns and Merrill Lynch; and other firms, like A.I.G., that were not banks at all. They were never fully covered by the New Deal regulation, and they were not the ones most affected by the deregulation.