The Urgency of U.S. Financial-Sector Reform: Why Paul Volcker Is Right

The financial industry has become a menace to U.S. society. Its ability to create credit has bought it undue political influence, enabling the industry to deregulate itself and to engage in such excesses that only a massive infusion of taxpayers' money has saved it from extinction.

It should be broken into small pieces and very tightly regulated. Credit creation is too dangerous to be left to the discretion of bankers.

The reenactment of Glass-Steagall would be a good place to begin. The banking, insurance, stock broking and investment banking businesses should be completely separated, as they were following the last great banking calamity of the early 1930s.

The ability of financial institutions to play off one regulator against another was an institutional failure that allowed the credit bubble to form. A complete regulatory overhaul should be implemented so each business has one and only one regulator.

Next, banks should be turned into utilities — small ones. Their activities should be restricted to taking deposits and extending traditional loans. Uniform ceilings should be imposed on the size of their lending portfolios, as well as on deposit rates, management compensation — and most importantly, the banks' return on assets.

Any profits in excess of those regulated returns should be returned to depositors as dividends. Strict capital-adequacy ratios should be enforced, while securitization and off-balance-sheet items should be banned.

These precautions, in combination with very tight regulatory oversight, would eliminate excessive risk-taking and ensure a sound banking system that is too regulated to fail.

The investment banking business should be completely separated from the commercial banking industry and also subjected to size restrictions. The size of each firm should be restricted — so the industry comprises 100 or more medium-sized companies rather than ten dominant players, as in the recent past.

Caps should also be imposed on the size of the "trading books" of investment banks, as well as on the investment portfolios of hedge funds and other investment firms to prevent market manipulation.

The derivatives industry should be radically downsized. All derivatives should be traded through exchanges, and substantial margin requirements should be enforced on every transaction. The Commodity Futures Trading Commission should tightly regulate the business to prevent derivatives from being used to manipulate commodities prices or to facilitate accounting fraud.

The use of derivatives for speculation in commodities by non-end users should once again be banned. The insurance industry should be barred from using derivatives and forced to conduct its business prudently, as it did 20 years ago, before derivatives came into widespread use.

The goal should be to greatly reduce the size of the derivatives industry in order to reduce the extraordinary and unprecedented threat it poses to the real economy. Investment banks that cannot survive without speculating in derivatives should be allowed to fail.

Offshore banking centers and tax havens should be shut down. American banks and investment companies should be given the choice of conducting business in the Cayman Islands (for instance) or the United States, but not both.

Similarly, the subsidiaries of U.S. financial institutions in London and elsewhere around the world should be forced to comply with the same laws and be overseen by the same regulators as their parent companies in the United States. Should they decide to relocate abroad, those institutions should be banned from conducting any business in the United States.

Under those conditions, not many would leave, and for those that do, good riddance. Offshore tax havens that facilitate tax fraud could be put out of business by cutting the travel and telecommunication links between them and the rest of the world.

Out-of-control credit creation and unregulated cross-border credit flows, which began wreaking havoc around the world 40 years ago, have now thrown the world into a New Depression. They must be brought under control. There are no technological or theoretical impediments to accomplishing this, only political ones.

Finally, financiers must be banned from any positions within the government from which they could influence legislation related to the regulation of the financial industry. Most crucially, bankers should not be allowed to take positions in the U.S. Treasury Department, which at times has taken on the appearance of being a fiefdom of the investment banking industry.

The revolving door between Wall Street and Washington must be closed, locked and perhaps even bricked up. Lawmakers and regulators should not be allowed to accept jobs in the financial industry after leaving their government posts. People accepting government jobs in any way related to finance should be made aware that by doing so, they are giving up the possibility of ever working in the financial industry.

The risk of conflict of interest is just too great. Wall Street tycoons must be banned from positions of power in Washington for the same reasons.

Regardless of the intentions or motivations of those past or future (or in some cases both past and future) financiers who, while serving in Washington, oversaw the deregulation of the financial industry, this crisis demonstrates that their judgment was disastrously incorrect.

Once all of these financial-sector reforms are made, the complexity of the finance industry will be reduced to the point where it will not require a Wall Street wizard to manage it. Economic stability is unlikely to be restored until non-bankers are made responsible for controlling the banks.

Editor’s Note: This feature is adapted from CORRUPTION OF CAPITALISM by Richard Duncan, published by CLSA Books. Copyright 2010 Richard Duncan. Reprinted with permission of the author.