Maybe this is a silly question, but what constructive purpose did allowing banks to take on more risk ever serve? It seems to accomplish nothing other than inflating bubbles and bonuses. Presumably, banks taking on more risk means more enterprises and newbie homeowners are given a chance, but recent history suggests that they are only given a chance to fail, while banks collect fees and bailout cash. Mark Thoma asks a similar question: "If there’s little or no social benefit from allowing banks to grow beyond a certain size, and it’s not clear that there is, and if there is a potential cost, why take a chance?"
The necessary reforms seem obvious. Economist Simon Johnson argues that
The consensus technocratic assessment is simple: We are smack in the middle of a doomsday cycle of repeated boom-bust-bailout (our version; the Bank of England’s take). The core issue – banks considered “too big to fail” – was not resolved in or after the crisis of 2008-09; if anything, as these banks have increased in size, the problem is now worse. We are therefore doomed to run headlong into another crisis.
Paul Volcker's outline of financial reform in the NYT at least attempts to address some of the problem. Here's his justification of what's known now as "the Volcker rule," which would prohibit banks from proprietary trading (i.e. investing their own capital in various markets in which they typically serve as intermediaries): "Adding further layers of risk to the inherent risks of essential commercial bank functions doesn’t make sense, not when those risks arise from more speculative activities far better suited for other areas of the financial markets... Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution." Eliminating prop trading at least begins to move big banks toward disentangling some of their vast interconnectedness.
Paul Krugman wrote a column yesterday suggesting the U.S. emulate Canada's boring banking system, which regulates risk much more stringently.
Over the past decade the United States and Canada faced the same global environment. Both were confronted with the same flood of cheap goods and cheap money from Asia. Economists in both countries cheerfully declared that the era of severe recessions was over.
But when things fell apart, the consequences were very different here and there. In the United States, mortgage defaults soared, some major financial institutions collapsed, and others survived only thanks to huge government bailouts. In Canada, none of that happened. What did the Canadians do differently? ...
The United States used to have a boring banking system, but Reagan-era deregulation made things dangerously interesting. Canada, by contrast, has maintained a happy tedium.
More specifically, Canada has been much stricter about limiting banks’ leverage, the extent to which they can rely on borrowed funds. It has also limited the process of securitization, in which banks package and resell claims on their loans outstanding -- a process that was supposed to help banks reduce their risk by spreading it, but has turned out in practice to be a way for banks to make ever-bigger wagers with other people’s money.
Reading through all of this makes me want to see what the justification is for doing nothing, as will most likely happen.