How to Fix Wall Street before Another Collapse

10/20/2009 03:46 pm ET | Updated May 25, 2011

Twelve months removed from the forced bailout of financial institutions by US taxpayers, Goldman Sachs is back to paying its employees an average annual salary of $700,000, and Citi continues to struggle. Pardon my ignorance, but this sounds exactly like the state of Wall Street before the financial crisis. After all the TARP money, various government guarantees of debt and money lent at below market rates to avert another Great Depression, there still have yet to be any substantial steps taken to reduce systemic financial risk. In fact, many of the government's actions that were supposedly designed to reduce risk may increase the chances of another major crisis.

Our economy is now more dependent than ever on a few large financial institutions. In turn, those financial institutions are more critically dependent on profits from their proprietary and increasingly risky trading divisions. To make matters worse, Goldman Sachs and Morgan Stanley have become eligible for FDIC insurance on deposits and FDIC guarantees on debt. In effect, we, the taxpayers, are continuing to provide a level of insurance against losses on highly leveraged speculative investment banking activities. These are the exact type of historical regulatory decisions and actions that led to the most recent financial crisis.

Regulation is the obvious way to reduce the growing risk. To truly solve the problem, however, we need a new approach to writing the rules that govern the financial industry. Recent efforts at additional regulation by Congress have been focused on extremely specific and often esoteric issues. Because the industry's complexity and speed of change, the inherent risks are difficult to address on a rule by rule basis. Our regulators need to design a system that is principle based.

There are two primary principles that need attention. Regulatory authorities should focus on reducing the amount of risk in the system and also providing a method to limit the damage when a problem arises. The best method for reducing the amount of risk in the financial system is not to pass regulations raising capital requirements or limiting maximum leverage; those are too easily skirted with off balance sheet entities and other financial shenanigans. Instead, the goal ought to be to diminish risk that exists in the heart of the financial system. The primary focus should be the FDIC-insured commercial banks, which regulators should force to divest their investment banking, insurance, and other more speculative divisions. This is not an original idea, of course, and was included in the Glass-Steagall acts originally passed in 1933 and later repealed in 1999. In light of the events of the last year, it seems obvious and logical to enact legislation which prevents FDIC-backed institutions from using their insured deposits to make bets on illiquid and high risk assets. Many of these speculative investments that failed last time were placed with leverage of up to 30:1.

The second issue, which may even be more essential, is the need to limit damage to the system when there is a problem. The U.S. financial markets are extremely complex and fast moving. In an ecosystem this dynamic, attempting to predict where the next crisis will erupt is a fool's errand. Fortunately, we already have an elegant and proven model for how to prevent an unpredictable crisis from spreading uncontrollably: fire prevention. Prior to the 1900's, there was a high risk of catastrophic fires similar to those that caused widespread damage in Chicago, London and Boston. There was simply no way to predict where the next fire would start or what the cause would be. Therefore, it was determined that the best way to handle this situation was to accept that fires were inevitable and devise a system to prevent their rapid spread. This was accomplished by developing building codes that required either a specific distance or a firewall between structures. The goal of these additional restrictions was obviously to keep a fire from jumping from building to building. The innovations of fire hydrants and automatic sprinklers improved the safety infrastructure.

Implementing this model on Wall Street is likely to involve limits on company size. However, containing the fire to a single company does not help if that company is the size of Citi. Furthermore, there will need to be limits on the amount of investments between different Wall Street firms to prevent the crisis from jumping from "building to building." Finally, the proper role for the government is a team of "firefighters" that is deployed quickly with expertise in much the same manner that the FDIC uses teams to handle failed banks. These rescuers can rush in and either extinguish or control a burning company to prevent widespread panic.

None of these steps is easy nor are they likely to be popular in an industry that has spent the past decade consolidating and expanding. The question has to be asked, however, as to what responsibilities belong to our politicians and regulators if they are not obligated to prevent a repeat of the worst financial crisis since the Great Depression.

Regardless of industry objections.