How Banking Diversification Steered Us Wrong

The mess we're in started with financial theories that substituted banking innovation for due diligence and sensible regulation

"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.

How did the banks' recklessness, masked as innovation, evolve? Until the 1930s, economists had two views of uncertainty. John Maynard Keynes and Frank Knight (who then dominated the University of Chicago's economics department) treated uncertainties as elements that couldn't be quantified.Followers of the 18th century mathematician Reverend Thomas Bayes, on the other hand, quantified uncertainties as if they were bets placed on a roulette wheel. Throughout the 1940s and beyond, the Bayesian view gained the upper hand. Its conquest of scholarly journals helped mathematical modeling leap into financial practice. The idea was that all uncertainty could be reduced to probability distributions. Case-by-case judgment? Unnecessary. Returns could be maximized for the least risk simply by diversification.

In 1974, economist Paul Samuelson, who spearheaded this triumph of mathematical economics, famously challenged investors in an article published in The Journal of Portfolio Management. The world of "practical operators," he wrote, was yielding to a "new world of the academics with their mathematical stochastic processes." Scholars understood that valuing individual securities was a wasted effort, he said. So should ordinary investors. Eschew stockpicking. Instead, buy a diversified portfolio.

The Samuelson challenge was enormously influential. It inspired Vanguard Group founder John C. Bogle to launch the first stock index fund in 1976. By November 2000 it was the largest mutual fund ever, with $100 billion in assets.

The mantra of diversification also took hold in the credit markets. In 1970, financier Bruce R. Bent launched the first U.S. money-market fund; today nearly 2,000 such funds manage a total of about $3.8 trillion. Following the lead of stock index funds, the money-market funds eliminated the cost of case-by-case judgment. Their portfolios of short-term debt instruments were certified by credit rating agencies, which themselves were relying on modeling rather than due diligence. The lending model of commercial banks—encumbered by the cost of having loan officers and committees make judgment calls—could not compete.

As we now know, blind diversification didn't always work in money-market funds. In September 2008, losses on debt issued by Lehman Brothers "broke the buck" at Bent's pioneering Reserve Fund, causing share value to fall below $1.

How does regulation fit into the picture? Through the unintended consequences of rules that date back to the Great Depression. The Glass-Steagall Act of 1933, which banned banks from stock investing and created the FDIC, protected depositors from imprudent bankers and bankers from jittery depositors. But the FDIC also freed banks from the challenge of earning the confidence of depositors. And eventually, as money-market and bond funds eroded banks' lending franchises, bankers used the regulatory canopy to take complex, dangerous risks. Regulators apparently succumbed to the idea, peddled by financiers and modern theorists, that if a little financial innovation was good, a lot must be great—even if it was far outside their capacity to monitor.

By 1999, when Glass-Steagall was repealed, banks were free to consume innovative, derivative products. Eventually they became sprawling, too-complex-to-manage enterprises whose balance sheets and trading books were little more than wishful guesses. CEOs appeared to turn a blind eye to reckless bets—not a bad policy, since they were richly rewarded for short-term profits. (The sharp rise in income at the top of America's pay scale owes much more to bad financial regulation than to the small decline in high-bracket personal income tax rates.)

As the current crisis unfolded, regulators stampeded into helter-skelter bailouts that hold little promise and reek of cronyism. When small businesses wobble, lenders ask their owners to put every cent they have back into the enterprise and to sign personal guarantees. Putting bankers to such trouble isn't part of the Troubled Asset Relief Program, fashioned by Wall Street luminaries.

Now comes President Obama, who believes "old institutions cannot adequately oversee new practices." Already, trading of credit derivatives is being moved to regulated exchanges. Nobel laureates are suggesting an FDA-like body to vet new financial products. And as new bank holding companies, Goldman Sachs (GS), Morgan Stanley (MS), and General Motors Acceptance Corp. (GM) are now subject to Fed supervision. But where is the spare capacity? Regulators are already overstretched. The Fed is still struggling to master the art of central banking in a globalized economy and to properly supervise the bank holding companies already under its purview.


Here is my modest, quasi-libertarian, proposal: To prevent future meltdowns, let's revive the radical idea of narrow commercial banking. Let's tightly limit bank activity to taking deposits and making loans—loans that bankers and regulators who aren't theoretical mathematicians can monitor. (Simple hedging to reduce the risks of making long-term loans with short-term deposits would be allowed.)

Anyone else—investment banks, hedge funds, trusts—would be allowed to innovate and speculate, free of additional oversight. But they wouldn't be permitted to trade with or secure credit from regulated banks, except through prudent, well-secured loans. None of this would require new agencies or more regulators.

Such new limits might alarm those who claim the "sophistication" of our financial system is a prime source of U.S. prosperity. But while a modern economy needs financial basics—risk capital, credit, insurance—it's foolish to believe that the bells and whistles created in the past few decades have been a net plus. Does anyone really think the financial sector now receives more than 30% of domestic corporate profits—double its share 25 years ago—because it has made improvements of that magnitude in mobilizing or allocating capital?

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