Banking lobbyists must be dizzy right now. In the United States they face regulation from Senator Dodd’s Banking Committee and a draconian proposal on derivatives from Senator Blanche Lincoln’s Agriculture Committee. In Britain, each of the three parties contesting the current election has different ideas on how to regulate banks – but they’re all agreed that something must be done. The IMF has proposed two different bank taxes. The G20 finance ministers meet this weekend and may come up with another proposal. Finally, the SEC has filed a civil fraud suit against Goldman Sachs, which if it expands rather than being quickly settled could itself provide some major new bumps in the financial playing field.

There are two problems: most of these attempts at legislation are mutually contradictory, and few of them address the problems that make the financial system so dangerous. In other words, the current attempts to control the financial system might as well have designed by the Three Stooges. Mind you, since there were only three of the comic pratfall team a Stooge-designed system of regulation would presumably have involved a greater level of coordination and thought.

Sensible changes in financial services regulation need to take a clear view of what they are trying to achieve, and a focused minimalist approach to achieving it. None of the above attempts does this. The IMF proposal that banks be zapped with not one but two new taxes, one of which would be applied to both profits and employee remuneration, makes no sense at all (this is of course typical of proposals from that economically superfluous and damaging body.) Its most damaging effect would be on large retail banks with sprawling heavily-staffed branch networks, while small hedge fund operators with a few grotesquely overpaid staff would undoubtedly find some loophole to avoid it. In any case, imposing random additional burdens on the financial sector would merely have the effect of decapitalizing those parts of it such as retail banking and issue underwriting that were low-margin but actually useful. The Roosevelt administration tried decapitalizing the investment banks in the 1930s, through the Glass-Steagall Act. This did huge economic damage, reducing issue volumes in bond and stock markets to levels unseen in a generation, thereby prolonging and deepening the Great Depression.

Instead of zapping the financial sector at random, regulatory reform should aim at the three aspects of modern finance that are economically counterproductive. First, it should cut down the rent seeking in the sector, primarily through reducing the volume and profitability of “fast trading” and exotic derivatives products. Second, it should ensure that the sector’s incentives are aligned so that participants want to control risks properly, and have the tools to do so. Third, it should reduce the excessive focus on short-term trading, which turns the financial markets into a casino and destroys its participants’ ethical standards.

Overall, regulatory reform must be combined with other reforms or it will fail. In particular the Byzantine structure of federal support for the housing market must be dismantled and the subsidization of leverage by ultra-low interest rates and expansive monetary policy, which has distorted the US and global economies for over a decade, must be ended. While Fannie Mae, Freddie Mac and Ben Bernanke still march on unimpeded, the Wall Street problem remains insoluble.

The currently proposed reforms achieve none of these objectives, except tangentially, and have the potential to cause new problems.

The Dodd bill in its current form does not address any of the problems. It formalizes a mechanism for bailouts when the banking system goes wrong, essentially giving up on the problem of preventing the system from crashing in the first place. It does nothing about rent seeking, nothing about incentives and nothing about the sector’s excessive focus on short-term trading. It also adds various silly and damaging bits of bureaucracy, such as a four month inspection requirement for start-ups seeking “angel” venture capital funding.

Senator Lincoln’s proposal to prevent banks with deposit insurance from becoming huge players in the derivatives market is helpful in that it removes the largest single risk from the commercial banking system. Its other proposal, that standardized derivatives should be traded on an exchange, would be helpful if it had no loopholes, but in its emerging loophole-ridden form offers too many avenues for off-exchange derivatives to remain gigantic opaque casinos as they are today. Indeed, by allowing companies to avoid margin requirements through trading off-exchange derivatives, the proposal leaves a gigantic incentive towards opacity.

The IMF’s proposed taxes on banks are “excessive, arbitrary and punitive” as Canada’s finance minister Jim Flaherty said on its announcement. Canada has a well-behaved (albeit excessively oligopolistic) banking sector that avoided the excesses of the bubble and has shown no great enthusiasm for entering the riskier areas of finance even now. Indeed, the Canadian owned brokerage TD Ameritrade has put out an excellent paper asking for controls on “fast trading,” correctly pointing out that the liquidity advantages claimed for that activity are spurious, since it makes prices ephemeral and prevents retail and other investors from getting optimum executions. The IMF’s tax proposals fail to address the structure of banker compensation, or any of the other problems of the sector. Hopefully they will sink without trace.

The party leaders at the British General Election have generated two useful contributions to the debate. One is Gordon Brown’s support for a transactions tax, which directly addresses one of the financial system’s major problems. The other was Nick Clegg’s remark, when asked to denounce bankers (his father was a banker and indeed a former colleague of mine at the merchant bank Hill Samuel) that the older generation of bankers is outraged by the sector’s recent activities. Quite right – and it reminds us that the current mess is not inevitable, if we can find the right solution. Regrettably the Tory leader David Cameron has yet to say anything useful on the subject, but there is always hope, I suppose!

Finally the SEC’s civil fraud suit against Goldman Sachs, whether or not ultimately successful, has thrown a valuable spotlight on the appalling ethical standards of the modern Wall Street, and the compete disregard for client and investor interests that is inevitable in institutions whose top management are bonus-remunerated traders. Jeff-Skilling-like 25-year jail sentences for Goldman top management would seem excessive for an institution whose activities differed little from its competitors (they were also excessive for Skilling, but that’s another story.) Forcing Goldman into bankruptcy, like Drexel Burnham in 1990, would also seem a waste of the many talented people who work there. Nevertheless, if the suit results in a Goldman win or a mere wrist-slap of a fine, without as a minimum dismantling Goldman into a proper investment bank and a hedge fund, then an enormous opportunity will have been wasted.

Having examined the various wrong answers, some of which seem bound to make it into law, we can be fairly confident of the right ones.

• The Fed must be Volckerized, to ensure that never again does it engage in a decade of populist bubble-blowing. With sound money and solidly positive real interest rates, the economic incentive to leverage is minimized
• Fannie and Freddie must be shut down, and the government must get out of the home mortgage business, except if it wishes to provide marginal help for the truly impoverished (which activity must be fully accounted for on a mark-to-market basis, to prevent unexpected taxpayer liabilities from building up.)
• We need a Tobin tax, perhaps at only 0.01% ad valorem on all trading, to reduce or eliminate “fast trading” and other rent-seeking “skimming” of the market.
• We need a bank breakup as suggested by Paul Volcker so that derivatives operations and proprietary trading are separated from deposit taking activities (debt and equity underwriting, the original targets of the Glass-Steagall Act, seem much less harmful.)
• We need derivatives cleared across exchanges, and standard derivatives traded across exchanges. That will prevent the construction of networks of counterparties as at Bear Stearns and AIG, that might require the rescue of an otherwise doomed institution. It will also minimize rent seeking from opaque trading activities. Companies that are foolish enough to want to “hedge” themselves in the derivatives market (which hedging under FAS155 mark-to-market accounting almost always results in wild swings in reported profits that are completely impenetrable to shareholders) can put up with the costs and risks of the margin system.
• Dividends must become tax deductible for corporations. This would level the tax playing field between debt and equity, while ensuring that management pays most earnings to shareholders rather than keeping them for empire-building.
• The Basel Committee that is attempting to salvage the international Basel II capital standards must instead move to a Basel III that mandates a high level of capital, probably 8-10% at the Tier 1 level, based on all assets without “haircuts” for mortgages and government debt. It must also mandate risk management “litmus tests” for large banks that reverse the incorrect Gaussian assumptions of the failed Value-at-Risk system. Risk distribution “tails” must be assumed to be both “fat” and “long.” (My apologies to non-technical readers here; not only could I write a book about this, I have, together with Professor Kevin Dowd. “Alchemists of Loss” will appear from Wiley’s shortly.)
• Profit-based remuneration and stock options, whether in banks or corporations, must be paid out only over a 5-year period and subject to recapture if losses appear. (As a free-marketer, I hesitate to recommend laws setting pay standards, but at least for an interim period of say 10-years, they appear necessary to correct existing pathologies.)

That would be a set of legislative and other changes that would solve the endemic current problems in the world’s financial system. It is of course vanishingly unlikely to be implemented. Instead, we are doomed to be regulated by Curly, Larry and Moe.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)