The United States Federal Reserve buildingFour years after the near-meltdown of the global financial system, the world is no closer to an adequate system of financial regulation than it was in 2008. Attempts to regulate the market for derivatives have been stymied by a mixture of determined resistance from the industry and the technical difficulties of defining and regulating such complex and opaque financial instruments. The “shadow-banking” system, associated with investment banks, hedge funds and other speculative financial institutions, is as large and dangerous as ever.

Right now, the only thing preventing a new bubble and bust is the memory of the last one. And with the return of massive profits and bonuses to Wall Street, that memory is fading fast. Already, observers are noticing a renewed appetite for risk, fueled in part by the low returns available on relatively safe investments such as U.S. Treasuries.

As in most unwinnable wars, the time has come when the best option is, in the immortal words of Republican senator George Aiken (speaking of Vietnam) to declare victory and get out. But what does getting out mean, as far as the shadow-banking system is concerned?

Divide and Prosper

The problem with the shadow banks is not that they are “too big to fail” but that they are too interconnected to fail. The failure of an investment bank, no matter how large, is not a problem if it does not imperil the core functions of the financial system—taking deposits and lending to finance housing and business investment.

The answer is to separate these functions as completely as possible. Banks that benefit from publicly guaranteed deposit insurance should be excluded from any form of financial activity beyond the core functions of saving and lending.

Guaranteed banks should be precluded from operating as part of the shadow-banking system, not just through direct speculation but also from sharing ownership through holding companies and from exposing themselves to risk through loans or other forms of credit to shadow banks. Such institutions should be required to raise all their funds (not merely their equity) from high-wealth private investors capable of assessing the associated risks and bearing whatever costs result from failures.

On the other side of the fence, governments should give a binding guarantee not to rescue investment banks and hedge funds that get into trouble. Everyone involved in these institutions should be fully liable for losses, just as they get the full benefit of profits.

This is not a new idea. Economists as diverse as Milton Friedman and James Tobin advocated it under the name “narrow banking.” The same idea was behind the Glass-Steagall Act, which not only established the Federal Deposit Insurance Corporation but also sought to make deposit insurance viable by prohibiting commercial banks protected by the FDIC from engaging in securities trading. The gradual erosion of this prohibition culminated in the Gramm-Leach-Bliley Act of 1999, which formally repealed Glass-Steagall.

Narrowing the Risk

For evidence that narrow banking might work, compare the impact of recent failures in the shadow-banking system with that of collapses in the stock market.

In 1998, bad bets made by a previously obscure hedge fund, Long Term Capital Management, almost caused the collapse of the global financial system. Ten years later, a complex web of derivatives caused the real thing. A complete shutdown of the global economy was staved off by massive injections of central-bank money and fiscal stimulus. However, the rescue effort crippled the capacity of central banks to manage the economy and caused grave damage to the finances of the governments concerned.

Between these two crises, there was a stock-market crash of epic proportions, caused primarily by the bursting of the dotcom bubble. Between March 2000 and October 2002, the S&P 500 index fell from 1553 to 768. The index for the NASDAQ exchange, which was seen as a vital source of funding for the technology sector, fell from over 5000 to around 1100. International stock markets also crashed, though not as severely. The destruction of wealth associated with this crash was around $5 trillion.

Yet the stock-market crash had hardly any impact on the broader financial system and only a modest effect on the economy. The U.S. economy experienced a recession, but it was one of the mildest in recent history, with unemployment peaking at 6 percent. The biggest damage done by the crisis was the propagation of belief in the “Greenspan put,” that is, the idea that whatever crisis occurred in financial markets, the Federal Reserve would always find some way to rescue it.

It’s true, of course, that the stock market crash of 1929 was a major cause of the Great Depression. But this was only because, in the absence of deposit insurance, customers correctly feared that the crash was a signal of impending bank failures. The resulting bank runs brought down sound and unsound banks alike.

Proposals for narrow banking would require a complete restructuring of the financial sector, with the result that banking in the ordinary sense would become (as it was in the decades after Glass-Steagall) a boring, low-risk activity with the returns and salary structures of a public utility. Those looking for higher returns would have to do so in the knowledge that bad judgement or bad luck could wipe them out with no prospect of public assistance. Unsurprisingly, this is a prospect viewed by the financial sector, and the politicians it owns and controls, with unalloyed horror. Nevertheless, it is the only solution to the problem of shadow banking.

John Quiggin is a Federation Fellow in Economics at the University of Queensland, Australia, and an adjunct professor in the Department of Agricultural and Resource Economics, University of Maryland, College Park.

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