FISCAL TIMES

Sheila Bair, the former chair of the FDIC, has five recommendations that she'd like to put to this year's presidential candidates to make Wall Street reform more meaningful and effective.

Bair has had a lot of time to think about what went wrong in the time leading up to the financial crisis and in the years we have spent struggling to emerge from its shadow. The long story can be found in her newly published book, "Bull By the Horns." You'll want to read this — even if you don't want to, you probably should. In the meantime, it's worth considering the reforms that she feels President Barack Obama and former Massachusetts Gov. Mitt Romney are overlooking or oversimplifying.

Why does it matter? In Bair's view — and remember, this is a regulator who saw the crisis building from her first days at the helm of the FDIC in early 2006 — the financial system today is far from stable. Big banks may be solvent, generating profits and surviving mandatory stress tests, but we haven't yet come to grips with many of the problems that produced the crisis.

Too many regulators fall victim to one of several flaws, Bair suggested in a speech to the National Association for Business Economics yesterday. Some of them over- or under-regulate (usually at the wrong point in the cycle); they devise impossibly complex rules; they are "closet free-marketers" proposing convoluted rules to prove it's impossible to regulate financial institutions, or they are "captive" regulators who, without any corruption or malfeasance, have simply subordinated their judgment to that of the organizations they are charged with overseeing.

The result is a regulation like the Volcker rule, which she calls "enormously complex and prescriptive." She applauds the objective — preventing banks from using depositors' capital to trade on their own behalf, among other things. But she warns, "I don't think it will work. There are lots of exceptions and it will be impossible to enforce."

Given the job of finance tsar for a day, she would replace it with a one-sentence rule that would capture the essence of what she believes Paul Volcker set out to accomplish. "I would have a rule that you can't base compensation on trading profits." That, of course, would mark — or help to create — a sea change in the way regulators approach Wall Street firms and other financial institutions, and in the way Wall Street views itself. It would result in nothing less than a change in Wall Street's culture, something that the intensely logical and pragmatic Bair clearly feels is long overdue.

Bair suggests five steps for the winner of the presidential election to take to enact stronger reform.

1. Break up "too big to fail" banks

In Bair's eyes, the presence of giant institutions and untested "living wills" is one of the factors making today's financial system unstable. Don't draw any comfort from the banks passing the government's stress tests, cautions Bair; those tests focus on credit risk, not interest rate risk, and at a time when the Fed is artificially keeping lending rates at near zero, that's a flaw.

2. Publicly commit to end bailouts

So those bailouts have made money for the Treasury. That's fortunate — but there's no reason to assume we'll be as lucky the next time. What we should have learned from the post-2008 bailouts is that while we couldn't avoid those bailouts, we should never allow ourselves to be put in that position again. "The market needs to punish the boneheads," Bair said. Just because the bailouts were profitable isn't a good reason to give Wall Street an indefinite option to "put" its losses to the Treasury and to taxpayers. "Will the candidates appoint people who believe that since the bailouts made money," future rescues may not be such a horrible option?

3. Cap leverage at large banks

"Bank capital levels maybe isn't a mainstream issue, but it should be," argued Bair. Putting a limit on a bank's ability to take on risk via leverage is the only way to ensure that no matter what "idiotic new innovation" Wall Street becomes infatuated with, that obsession will have a limited ability to destroy their institutions, much less the financial system as a whole. We may not be able to stop bankers from behaving badly, but we can curb the fallout.

4. End speculation in credit derivatives

Bair pointed out that we can't buy fire insurance on someone else's house, and for a very good reason. How is speculating using credit derivatives any different? During her tenure at the FDIC, she found that hedge funds that were shorting the mortgage market via credit default swaps and had a vested interested in seeing housing values collapse were among the players who fought reforms that might have helped fix the market before it was too late.

"There's no doubt in my mind" that credit default swaps are weapons of mass financial destruction, Bair said, referring to Warren Buffett's memorable description of these instruments, although she admits this will be the toughest of her five changes to bring about.

5. End the revolving door between regulators and banks

This particular door is the one that separates regulators from the institutions they regulate and, Bair says, is part of what is responsible for the phenomenon of the "captive" regulator. When regulators are conscious that, with one push of the door, they could end up working for the organizations they are today regulating — or vice versa — "it corrupts the mindset" and results in their regulating organizations they are pre-disposed to think well of.

"If you did this, you would end up with a much more stable regulatory system" — and a more stable financial system, Bair argues. But the debate has start now.

Bair acknowledges that this may be a difficult environment in which to try to effect change in the way regulators think — both they and the institutions they are trying to oversee have lost credibility with the public. "Regulators bear some fault for the lack of progress on reforms, but they have just been hammered by the industry," she says.

You may quibble with Bair's specific proposals, but it's hard to fault her hard-headed and common-sense approach to diagnosing the problems that still remain. And it's impossible to question her conclusion: that a key ingredient in the quest for stability, economic growth and prosperity is a stable and well-regulated Wall Street.

It's too bad, however, that Bair says she isn't throwing her hat in the ring for any of the jobs that likely will come open next month when we know who has triumphed at the polls. She says that after stints at the Commodities Futures Trading Commission, Securities and Exchange Commission and FDIC, she is through with regulating Wall Street. But the years she already has devoted to that task have left her with a clear understanding of what works, what doesn't and what we should be doing to ensure we don't have a repetition of 2008.