A Systems Approach to Financial Reform

January 23, 2012

I spoke last Thursday at the Congressional Progressive Caucus Policy Summit in Baltimore on how our work at Capital Institute might have relevance to the 2012 Congress’s financial reform agenda. These are the hopes I shared for how policy could shape the Future of Finance:

“Good Afternoon, and thank you for offering me the opportunity to address you on the subject of Financial System Reform.  The Glass-Stegall Act was thirty-four pages.  Dodd-Frank is 849 pages.  And I’m going to talk about what must follow in seven minutes!

You all know the core issues.  What I would like to offer is a fresh lens through which to view them.

Currently the fight is framed as an ideological debate between those who believe in so-called ‘free markets’ and those who believe stricter government regulation is necessary to control the unruly, and at times, sociopathic behavior of banks.

The debate is of course corrupted, but the false choice between markets and regulation is a frame that drives radical change, not thoughtful policy.  And, barring an unprecedented shift in American culture, the free-marketers will win in the long run.

To solve this problem, we must reframe the issue as a system design problem, not an ideological debate.

When engineers design a power grid, they do not launch into an ideological debate.  They apply well-understood systems design principles.

When our financial system is looked at through this systems lens, several fundamental design flaws emerge.  I will address three:

1.  The system is too big

2.  The system is not resilient

3.  The system does not generate the outcomes we need it to generate


Sustainable systems have a hierarchy.  Since the purpose of finance is to serve the needs of the real economy, there is an appropriate scale for finance in relation to the real economy.

Much of the financial system bloat originated with the elimination of the Glass-Stegall and McFadden Acts, which unleashed competitive pressures on profit margins for both commercial banks and investment banks.  Banks responded by increasing volume, which in finance means ever-greater speculative trading and ever-greater leverage.   Excessive speculation and leverage need to be understood as pollution, dumping systemic risk on society that has a real cost, as we know only too well.

Following the ‘polluter pays principle,’ we should first

·     Tax excessive speculation through a Financial Transaction Tax and a modification to the capital gains tax; and we should

·     End the subsidy to debt by significantly restricting the deductibility of interest expense. This will both shrink the financial sector and reduce leveraged speculation thereby reducing their associated societal costs.


Economics is about optimizing efficiency.  Systems that are sustainable balance efficiency with resiliency.

The last 25 years of technology-driven financial innovation and globalization, enabled by deregulation, can be seen as an unprecedented shift away from resiliency toward efficiency until the system became too brittle and collapsed.  Bad behavior made it worse than it needed to be, but the system was built to crash.

To build resiliency into our financial system, we need to

·     Reduce the leverage in the system as previously discussed

·     Wall off FDIC-insured depository institutions inside simpler, stable ‘utility-like’ banks

·     Dis-incentivize firms from being Systemically Important Financial Institutions (SIFIs) by creating onerous governance and tax burdens, and capital requirements that create ‘diseconomies of scale and diseconomies of complexity.’

·     Follow the Swiss and don’t pass the responsibility for capital and liquidity requirements to the BIS whose approach is flawed and whose interests are not necessarily aligned with those of US citizens.


Finally we turn to flaw #3:  The system does not generate the outcomes we need.  This one is the hard one.  To quote that great American Progressive and holistic thinker Dwight D. Eisenhower,

‘Whenever I run into a problem I can’t solve, I always make it bigger.’

We find ourselves at a pivotal point in the history of capitalism.  The system has become unacceptably inequitable, and for the first time, biospheric limits make exponential economic expansion impossible.

Yet, consumers, corporations, and governments are held hostage by a few gigantic banks.  The banks have lost their way; they have broken the trust.

Finance is needed now to fuel the most profound economic transition in the history of civilization, yet we see no sign of financial statesmanship from Wall Street.  Though I am reluctant to suggest this, I see no alternative to bold public-private experimentation to manifest the purpose-driven financial system we need.

Fortunately many models exist, ready to be scaled up.  Some successful examples include:

·     Ethical banks committed to socially and environmentally responsible business, modeled on Triodos Bank in the Netherlands

·     Cooperative banks that align customer needs with bank purpose, while profits are secondary

·     Loan funds dedicated to social and/or environmental purpose

·     Community development equity funds and other ‘impact investment’ funds and investors seeking to align capital with purpose

·     Public banks such as the Bank of North Dakota dedicated to collaborating with place-based private banks

Regulation through Feedback Loops

In fairness to limited-government advocates, regulation can and often does make a mess of things.  It’s very difficult to regulate, even without the complication of capture.  The politics of regulatory oversight does not help matters.  Regulation that works must be built with systems design in mind.

Critical to any sustainable system design are self-regulating feedback loops that keep the system stable.  We need to address the feedback loops first, and then apply regulation as reinforcement.

For example, human beings (a great example of natural systems) are designed to get tired after nightfall, encouraging essential sleep for growing children without their mothers telling them when to go to bed.  But mom’s regulatory hand is still there for reinforcement when necessary!

Similarly, when investment banks were private partnerships, with unlimited liability to the partners, there was a powerful feedback loop in place to check irresponsible behavior.  We need to identify these critical feedback loops as a top priority.

I suggest as a priority agenda item for the Progressive Caucus the scaling up of this holistic and restorative finance system through bold yet responsible public-private collaboration, focused on regional infrastructure banks, with the public sector supporting the leadership already being demonstrated in the true ‘free market.’  I suggest the reinvention of finance!”