Trying to figure out what went wrong (Part 1 of 2)

Have Congress and President Obama's administration acted so as to prevent another economic collapse like the one our country has just faced? This two-part post will focus on one aspect of the crisis: regulation of America's banking and investment systems. There is no one culprit for us to point to on this issue. Rather, a handful of actors were complicit -- the most dangerous of whom was Wall Street

As Charles R. Morris describes in his book, The Two-Trillion Dollar Meltdown, much of the problem began when, during the tech boom of the '90's, our country's traditional banking system underwent a drastic facelift. In the old days, the number of important financial institutions was limited to commercial banks that were insured by the FDIC, regulated by the Securities and Exchange Commission (SEC), and given strict capital requirements. Capital requirements basically ensure that, when a commercial bank makes a loan, it is backed up by money with which the bank can protect itself against the risk of a default. So, for example, if a commercial bank wants to make a loan to a major corporation for the construction of a new building, its capital requirement would be fairly low, since the corporation's assets are large enough to ensure that a default is unlikely. On the other hand, a loan to an entrepreneur who wants $100,000 to start up a new business will carry a higher capital requirement. Roughly 80% of small business enterprises will fail, so the bank needs to protect itself against that risk by backing itself up with more capital. Capital requirements therefore incentivize the avoidance of risk by lenders, and they also help to prevent the spreading of risk throughout the financial industry.

So what changed? Morris writes that, essentially, this traditional notion of the "banking system" was revolutionized by new financial instruments, high-speed technology, the growing prominence of investment banks, and the trend of specialization throughout the entire credit system. By the time this crisis hit, what is now commonly referred to as the "shadow banking system" was larger than the traditional sector. The shadow banking system was ostensibly contrived as a way to diversify financial risk. But the "shadow" description signified that these financial institutions were outside of the SEC's normal orbit of regulation. The SEC was never given the statutory power to exert meaningful oversight upon this shadow system. It was thought that doing so may not even be possible, given the daunting complexity of the new financial instruments, and the neck-breaking speed with which they flew investments back and forth across the trading landscape (...)

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