Three Steps to Financial Stability

Our financial crisis began - and has sustained itself - because of government policy.  In some respects we have been governed too much.  In other respects government has abdicated its responsibility.  Here I offer three easy steps to financial stability:

1. Let's go forward to the past.
2. Anyone writing insurance should be regulated as an insurance company.
3. Anyone providing financial advice should be a fiduciary.

The elegance and simplicity of these solutions lies in the lessons of history.  We have the answers.  In fact we have applied the correct solutions and then discarded them.

1. "Forward to the past" refers to returning to once-effective but now-discarded legislation to keep banks safe from speculators.  Banks lending money to buy stocks brought about the great depression.  The money from the loans drove up the price of stocks.  When the bubble burst, the loans weren’t repaid and the banks failed, placing us in a depression.

Congress enacted the Glass Steagall Act in 1932 to address this situation.  Glass Steagall did one very important thing.   It required complete separation of banks (commercial banks) from brokers (investment banks).  FDIC insurance, available only to banks, made one of its conditions that those banks not enter the speculative investment banking business.  In his role as Chairman of the Federal Reserve, Alan Greenspan actively and successfully lobbied against Glass Steagall, arguing that the world was a safer place than in 1929, and the separation of banks and brokerage firms was no longer necessary.  When he succeeded in his quest the entire economic world nearly melted down.

Paul Volcker (Greenspan’s predecessor) had long argued against dismantling Glass Steagall.  Banks, he said (I’m paraphrasing) are a safe place for people to put their money.  Brokerage firms are where one goes to risk money in the quest for greater returns.  The two serve different, useful, necessary purposes.  Combining them compromises the safety of banks.

In response to the economic meltdown of 2008 – 2009, rather than going back to the simple, elegant, workable solution provided by Glass Steagall, our government did the most insane thing imaginable, turning Goldman Sachs and Morgan Stanley into banks, giving them unlimited access to the Fed desk.  Then they strongarmed Bank of America into buying Merrill Lynch.  While this saved Goldman, Morgan Stanley and Merrill (tough luck Lehman and Bear Stearns), it created the potentially explosive situation in which all the major brokers are banks.  Since that time the focus has been on creating a new agency to watch over these combined entities to keep them from blowing up the economy.  Rather than interfere with the broker’s businesses, they should simply cut them loose, and require the banks to be banks again.

2. The next issue has to do with CDS, or credit default swaps.  A CDS is default insurance for bonds.  Once again, enter Alan Greenspan, who approved of these arrangements, telling us that default swaps  made the markets safer for us all.  Bear Stearns, Lehman Brothers and AIG (an insurance holding company) made a killing insuring the lowest quality mortgage bonds.  However, they didn’t call it insurance, and they clearly didn’t have reserves set aside to cover their exposure.  To make matters worse, the same brokers would happily loan up to 90% of the value of these low quality bonds.  When the house of cards began to fall, the  government intervened hours before we were going to be treated to the demise of Goldman Sachs and Morgan Stanley.  

My proposal would would simply require that anyone who insures a bond has the money to back it up.  Credit default swaps (CDS) are insurance policies, in which one party pays another to guarantee that if a bond fails, the other person will cover the loss.  This is clearly insurance, yet it was sold - and still is sold - by non-insurance companies such as a non- insurance arm of AIG and by the major brokerage firms.  Anyone who sells CDS should have to register as an insurance company, establish reserves and keep track of their policy obligations.  This would either make CDS a respectable business or put them out of business.  Don't bother me with the details, just get it done.  Its the right thing to do.

3. Only fiduciaries should give investment advice.  This third solution would further segregate the financial world.  Also in response to the great depression, Congress enacted the Investment Company Act of 1940. The 40 Act requires any person or company who registers with the US Securities and Exchange Commission as an investment adviser to adhere to a Fiduciary Standard in dealing with its clients.  This means that they must always put their clients best interests ahead of their own, and disclose all conflicts of interest, including compensation.  Where conflicts occur, they require resolving them in favor of the client.


Brokers aren't subject to this obligation.  The standards required of brokers are pitifully inadequate to protect the public, yet brokerage firms pay unbelievable amounts of money to politicians and lobbyists to keep their standards low.  Expanding the application of the investment company act of 1940 to brokerage firms would force them to separate once again, into two distinct businesses.  One would be the investment banking operation, raising capital and creating new investment products.  The other business would be the advice-giving ranks of brokers, who would quickly move from commissions and high pressure sales techniques to charging fees and selling knowledge.  The best would thrive; the least qualified would drive taxis and dispense advice from the driver's seat.


For a Reuters video of me explaining the fiduciary standard.  http://66.147.244.51/~pillarfi/pillar/brokers-could-face-tougher-standards-adviser-says%E2%80%A6/