Bringing Financial Institutions Under Control

By Bob Gerecke
 
It is widely recognized on the left that our financial institutions caused the Great Recession and having been saved instead of controlled by our actions remain on the loose today.  To save ourselves from their depredations what do we need to do?
 
Insurers and investment banks which don't accept insured deposits aren't covered by the Federal Deposit Insurance Corporation, so they don't fall under the Glass-Steagall scheme in which banks had to separate their FDIC-insured and their non-insured financial activities, creating a different corporation for each.  Yet the size and number of the non-FDIC-insured banks' financial transactions with other financial institutions make them systemic risks anyway.  Perhaps breaking all large financial institutions into smaller ones by limiting their size is the only way to eliminate "too big to fail" for both kinds of institution.
 
Eliminating off-exchange derivative contracts would then also be necessary, because if all of the then-smaller financial institutions engage in them, there can still be a domino effect: a then-smaller financial institution might fail more easily if a few of its derivative contracts lose value, and this can bankrupt yet another then-smaller institution which is its creditor in other contracts, and so on.  If the contracts are, instead, issued only by an exchange, the exchange's members will collectively cover a default, thereby spreading the loss widely enough to avoid a domino effect.
 
In addition, the leverage in derivatives, even in those issued by exchanges, is dangerous: at 30:1, a 5% price move causes a 150% gain or loss.  At a minimum, leverage should be severely limited.  It may be even better to eliminate it altogether for financial contracts (but not for agricultural and industrial commodities, where it's needed to enable sellers and buyers to lock in future volumes and prices which they can live with).  In lieu of taking risky financial positions and then hedging them with risky leveraged derivatives, financial institutions will have to take less risk in the first place.
 
The government's existing reviews of financial institutions have attempted to evaluate the risk which they are taking, and the institutions supposedly have a sufficient variety of leveraged bets that not all will lose at the same time, but I doubt that the institutions are revealing the true extent of their riskiness or that the government's  examiners can calculate the net effect of all the leveraged bets and of all the financial risks which these bets are hedging.  In addition, both of these change daily, so it's impossible to keep up with them.
 
Unfortunately, the nature of for-profit institutions provides their executives with great rewards if high-risk gambles are winners but little loss if they are losers. The losses are borne by stockholders and the public.  Therefore, placing strict limits on leverage or outlawing it altogether, with civil and criminal penalties for executives of firms which violate the law, may be the only way to dissuade financial executives from taking excessive risks which may be costly to the whole country.