The Three Essentials of Financial Reform

As the White House unveils its long-awaited proposals to prevent another Wall Street meltdown in the future, keep a lookout for three essentials. Without them the Street will revert to its old ways as soon as the coast clears. In fact, now that the government has bailed out the Street, the biggest banks will take even larger and more irresponsible risks because they’re officially too big to fail. So these three reforms are critical.

1. Stop bankers from making huge, risky bets with other peoples’ money. At the least, require they back their bets with a large percentage of their own capital, and bar them from raising money off their balance sheets through derivative trades. Also require they take their pay in stock options or warrants that can’t be cashed in for at least three years, so they’ll take a longer-term view. Best of all would be a requirement that investment banks return to being partnerships and the capital on their books be their own, not yours or your pension fund’s. When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doing. The real mischief started once they started selling shares to the public.

2. Prevent any bank from becoming too big to fail. Separate commercial from investment banking, as they were before the late 1990s. Commercial banks should return to their basic function of linking savers with borrowers. Investment bankers should return to their casino function of placing bets in the stock market and advising you and others about where to place your own own bets. Combining the basic utility with the casino only made bankers far richer and subjected you and me to risks we didn’t bargain for. If separating commercial from investment banking isn’t enough to bring all banks down to reasonable size, use antitrust laws to break them up.

3. Root out three major conflicts of interest. (1) Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings. (2) Institutional investors like pension funds and mutual funds should not be getting investment advice from the same banks that profit off their investments; the advice should come from sources without a financial stake; (3) the regional Feds that are responsible for much bank oversight should no longer be headed by presidents appointed by the region’s bankers; non-bankers should have the major say, and the regional presidents should have to be confirmed by the Senate.

These three reforms will reduce the possibility that you and I and other taxpayers will ever again have to spend billions bailing out bankers who robbed us blind while amassing fortunes. But because that would make it next to impossible to make such fortunes in the future, the big bankers will fight every one of these with all guns blazing, and their lobbyists in full force. They’ll try to inundate you in a blizzard of buzz words. They want your eyes to gaze over, but don’t let them. Keep focused on these three issues. Congress, for its part, may not be much help. It’s awash in money from Wall Street. Big Finance is second only to the health-industrial complex in owning a large portion of the Hill. Barney Frank at House Banking can be relied on to try his best but others in the House and Senate may well roll over. The President wants to do the right thing but he’s spread thin and spending political capital on health care. Tim Geithner doesn’t have the stomach to take on the Street; the plan he announced a few days ago to regulate pay is a bad joke. Expect lots of blather about rearranging boxes on the regulatory organization chart.

Bottom line: Genuine financial reform will be almost as difficult to achieve as real universal health care. Immense private interests are amassed against the public interest in both cases because staggering amounts of money are at stake. But they are the two most important domestic issues right now. Keep careful watch, and weigh in.

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