Stephen: I certainly agree with you that what President Obama has proposed is not a complete regulatory solution; in fact, I made some specific suggestions for additional actions that ought to be taken. I also agree that capital requirements became far too loose prior to the crash, and that what he is proposing would very likely not have prevented the problems experienced at AIG, Lehman, or several other institutions. Finally, I yield to no man in my disapproval of Fannie and Freddie.
But, what a separation between common ownership of government-insured deposits on one hand, and speculative investments on the other, would have substantially reduced was the threat of contagion. As I indicated in the post, the problem wasn’t that, for example, Lehman made (in retrospect) bad bets and went out of business — that’s a normal and healthy part of any free market — but that the bankruptcy of one mid-size investment bank threatened to crash the entire U.S. banking system. It was politically intolerable to simply let a huge slice of Americans watch all of their savings vaporize, and therefore the government had to step in and save integrated financial institutions.
Consider Citigroup as an example. It is a huge, diversified financial institution that, as one line of business, holds deposits from many, many Americans. Bad bets they have made on exotic investments threatened to bankrupt the bank and destroy the savings. In effect, they were holding hostages which prevented the government from simply letting them go bankrupt. What we want is the opposite: clear segregation of financial activities into tiers, so that we can allow bankruptcies rigorously in all but the very specific, highly regulated commercial banking sector. What appears to have been extra-legal pressure exerted by the government on B of A to buy Merrill is a symptom of this problem, rather than a success; it was an example of the inevitable frantic attempts to keep all of the plates in the air during a crisis, created by a failure to delineate clearly the boundaries of the government guarantee.
At some point, of course, any bank, with any restrictions on classes of investment assets can find a way to make wild bets. This is more or less what we saw in the S&L crisis. It will always happen sometimes under any regulatory system as long as human nature remains as it is. But, (1) it is much more feasible for bank regulators to understand and monitor a simpler business model, and (2) limiting the damage by fencing off the government-backed business contains the damage from any bust, and prevents the alternative that we have now: a mushy, quasi-guarantee that will create moral hazard throughout the financial system, and because such a situation is unsustainable, ultimately lead to a more government-controlled and less risk-tolerant financial system.