In thinking about what is needed to repair our financial system, I keep four real-world facts in mind.
1) At the beginning of the 20th Century the greatest market volatility was agricultural and banks provided 80% of all business capital. At the beginning of the 21st Century, the Real Estate market is the greatest source of volatility and banks provide less than 20% of all business capital.
2) The Federal Reserve system has only worked for a few decades of its existence. The Fed was created in 1913, was irrelevant to bank failures in the 1930s, didn't have functioning market tools until 1948, was effective only in the mid-1950s to 1970s, had no effect on 1970s stagflation, didn't prevent the Savings & Loan failures of the mid-1980s, never gained effective control over bank financed derivatives, and had no mitigating impact on the 2008 financial collapse.
3) The American financial reforms have little positive effect when initially introduced and often have negative consequences. The Saving and Loan collapse of 1985 lead to the reclassification of all S & Ls as banks. In the guise of banks, the former S & L s failed again in 2008. The two government agencies designed to protect mortgage generators and holders both failed (Freddy and Fannie).
4) A superior institutional leader is not protection against financial problems. Only a well designed institution is capable of avoiding financial crisis. While the world was on the gold standard, no nation could escape the contagion of recession and depression regardless of the government leaders. The same has been true in 2008, (with the exception of China). A repair of the financial system must be built into institutions and not be reliant on superior leaders.
With these caveats in mind, long term financial stability is going to require several institutional components.
First is the decoupling of the financial system from the commercial production system. In the present environment banks begin calling corporate loans as soon as the banks see their own capital decline. This is a direct transmission of financial problems to the commercial world. When financial markets begin to fail, corporations are immediately forced to reduce output, reduce staff and increase unemployment. The solution is to establish several large banks that are federally underwritten and (a) cannot reduce or call corporate loans unless the underlying assets supporting the loans are declining. (b) These same banks would be required to make only fully-secured traditional bank loans, without participation (no sharing of profits or gains from the loans) in the loans. (c) These same banks would have non-interest paying deposit accounts insured up to $1 billion.
Second is creation of a multi-tiered risk and regulatory system. The key element is to create tier one, the level with the lowest risk, similar to treasury notes, bills and bonds. This would be a government insurance and regulatory package that would guarantee pensions, insurance policies, annuities, credit unions and comparable funds that operate at minimal risk levels. The regulatory authority would pre-approve all financial types of instruments that could be used by the insured funds.
Together, these institutional creations will create a relatively stable financial environment for corporations and individuals. It would de-couple financial crises from the commercial world and would offer consumers and citizens a realm of personal security.
A separate blog deals with fraud in the system and executive compensation.