How Banking Diversification Steered Us Wrong

"Where enterprise leads," wrote British economist Joan Robinson in 1952, "finance follows." But now finance has led industry—into a ravine. It didn't start with the recent missteps of bankers, rating agencies, and mortgage brokers. Finance has been on the wrong trajectory for more than a half-century: The current crisis has deep historical roots in financial theories that regarded diversification as a substitute for due diligence—and in a dysfunctional regulatory system.

Commercial banking's diversification, its expansion beyond traditional lending, has been disastrous. What's needed now is a Glass-Steagall Act for the 21st century—rules requiring banks to focus simply on taking deposits and granting loans. This would protect depositors, limit financial-risk contagion, and allow the FDIC and the Federal Reserve to do what they do best. Others—hedge funds, private equity firms—would face no further regulation.