Last week I gave a talk at the Levy Institute’s 19th annual Hyman P. Minsky Conference, held at the Ford Foundation. The occasion forced me to clarify my thoughts about financial reform; so here’s a version of what I said.

When health reform passed and the subject shifted to financial reform, I know that I wasn’t the only policy wonk/pundit who groaned a bit. Health reform, for all the complexities of its details, was a pretty clear issue; there was almost a theorem-theorem-lemma feel to figuring out what had to be done, leading you to something like the actual reform we got. Yes, there should have been a public option. But the basic structure of the issue was clear.

Financial reform is a much messier debate. It doesn’t break down simply on some left-right axis, although that’s there too. Instead, there are a bunch of competing views of what the problem is all about. In fact, by my count there are six such views. They’re not all mutually exclusive, but it matters which of the six you place at the top of the list.

Now, I have a personal opinion: basically, I believe in view #2, with some allowance for #3 and #4 too. But before I defend my version, let me lay out the list of candidates for explaining the mess we’re in. Later on, I’ll also describe three visions of financial reform, again along with my personal preference.

So: what’s the problem? Here are the views I see out there.

1. Size: Our largest financial institutions have just gotten too big
2. Shadows: The rise of shadow banking, institutions that fulfill banking functions but evade the regulatory regime, has undermined stability
3. Opacity: We’ve come to rely on complex financial instruments that neither regulators nor the private sector
4. Predation: Financial firms deliberately misled consumers and investors
5. Government intervention: Public policy pushed lenders into making bad loans, especially to the poor
6. Monetary mismanagement: The Fed did it by keeping interest rates too low for too long, and/or policymakers panicked in 2008 and spooked the markets

Let me now discuss each of these at a bit more length.

Size:Clearly, there was a massive increase in financial concentration, with a few true behemoths emerging. It’s easy to argue that this creates moral hazard, because the giant firms know that they’re too big to fail – which is also an easy slogan to remember. The idea that size is the problem has gained a lot of credibility from Paul Volcker, who personally embodies the truth of too big to fail (if you’ve ever met him); more seriously, Volcker has argued strongly that the repeal of Glass-Steagall, allowing financial firms to grow big in part by merging conventional banking with investment activities, set the stage for the crisis.

My view is that I’d love to see those financial giants broken up, if only for political reasons: it’s bad to have banks so big they can often write laws. But I’m not sold on the centrality of too big to fail to the crisis, for reasons best explained in terms of the second doctrine.

Shadows: I’m very much a Diamond-Dybvig guy – that is, I think of financial crises in terms of the Diamond-Dybvig model of bank runs. The basic idea is that what banks do – what makes them useful – is the way they let investors satisfy their desire for liquid, short-term assets while using most of those investor funds to finance illiquid, long-term projects. The key is the law of large numbers, which lets banks keep only a fraction of deposits in liquid form.

The problem, as Diamond and Dybvig pointed out, is that such institutions are vulnerable to runs: if something leads investors to fear for the soundness of a bank, they will all try to withdraw their funds – and in so doing can break even a fundamentally solvent institution. The solution, said D&D, was deposit insurance. Of course, this leads to possible problems of moral hazard, so deposit insurance has to be further supported with bank regulation.

All of this, however, failed to take account of shadow banking – the rise of institutions that were banks in the Diamond-Dybvig sense, engaging in liquidity and maturity transformation, but weren’t classified as banks for regulatory purposes. Hyman Minsky, by the way, saw this coming: he wrote at some length about the rise of what he called “fringe banking”, by which he meant essentially the same thing Paul McCulley of Pimco meant when he coined the phrase shadow banking. And so we recreated the vulnerabilities of the pre-1930s banking system.

Now here’s the thing: there’s nothing in this story about too big to fail. Indeed, the banks in the Diamond-Dybvig paper are atomistic. And it’s worth remembering both that Lehman wasn’t all that big and that the great banking collapse of 1930-31 began at a Bronx-based bank that was only the 28th-ranked bank in America.

Opacity: Warren Buffett’s warning about derivatives as weapons of mass financial destruction looks prescient. To update an old joke: what do you get when you cross a Godfather with an investment banker? Someone who makes you an offer you can’t understand. It’s easy to argue that the emergence of securities and contracts with obscure, hidden risks contributed to the crisis.

Predation: Clearly, a substantial amount of subprime lending was predatory – as Ned Gramlich argued, the most complex, confusing loans were offered to those least able to analyze them. There was probably also a substantial amount of deliberate selling of mortgage-backed securities to investors who didn’t grasp the risks. And there may be more issues regarding vampire squids and all that. [Note: the talk was given before the Goldman news broke].

Government intervention: A large part of America’s political spectrum believes, as an article of faith, that do-gooding politicians caused the crisis – that the Community Reinvestment Act forced banks to lend to minority groups, and that Fannie/Freddie were responsible for the bubble.

I won’t spend much time on this, since it’s easy to refute. The CRA was around for almost 30 years before the problems in subprime began to develop; anyway, most subprime lenders weren’t even covered by the act. And the worst of the housing bubble developed at a time when Fannie and Freddie, under pressure over accounting scandals, were actually withdrawing from the market.

Nonetheless, it’s important to know that a lot of people believe that Barney Frank did it – and nothing will convince them otherwise.

Monetary mismanagement: Leaving aside the neo-Austrians and the likes of Ron Paul, there are some serious economists who blame monetary policy for the bubble, and also argue that bad handling of the Lehman aftermath made things much worse than they needed to be; I’d mention John Taylor in particular.

My counterargument would be that while it’s certainly possible to make the case that monetary policymakers made mistakes, it’s hard to accuse them of sheer idiocy. There were good reasons for low rates in 2002-4; to argue that the Fed should have tightened is to argue that it should have ignored a weak economy and disinflation that seemed to threaten actual deflation, in favor of what at the time were hypothetical concerns about asset prices. As for the argument that Henry Paulson and company bobbled the response after Lehman, we can discuss the particulars; but my view is that a financial system that works only if we always have wise, well-spoken public officials is a system we can’t rely on.

So with these various doctrines in mind, what can we say about financial reform?

Actually, let me first pose a question. It seems to me that to judge proposals for reform, we have to ask why we managed to do so well for so long. There was a long era, what Gary Gorton calls the Quiet Period, when banking panics were virtually absent. How did we do that?

Deposit insurance was certainly part of the answer. But how did we mostly avoid, until the savings and loan scandals, the moral hazard such insurance can create? Regulation, especially limits on leverage, surely helped. But Gorton and other have suggested that an important part of the story was the simple fact that banking wasn’t very competitive: with limits on the interest banks could pay, coupled with barriers to entry, banks had a large franchise value – and this made bankers reluctant to take risks that could kill the cash cow that kept laying golden eggs, or something like that.

If that’s true, the reforms now on the table probably won’t be enough. Back to that in a minute.

At this point I’d identify three forms of reform proposal.

One version basically calls on the government to rely on market discipline: it should swear by all that’s holy never to bail out financial firms again, and rely on the threat of failure to keep bankers from taking on excessive risk. You hear this mainly from the likes of Mitch McConnell, but some of what Paul Volcker has said also seems to lean in this direction.

But it’s an illusion, of course. In 1930 we let banks fail – and the result was the Great Depression. In 2008 Paulson tried letting Lehman fail – and within days he was staring into the abyss. We are not going to let systemically important financial firms fail, nor should we. As a commenter on my blog said, failure is not an option – it’s a CDS.

A second version of reform calls for a full recreation of the Quiet Period banking system. We’ll reinstate Glass-Steagall, protect the depository institutions, and let the investment banks sink or swim.

Again, I don’t think this is realistic. Shadow banking isn’t going away. Like it or not, repo and other short-term debts now play a role in our economy comparable to that of bank deposits, and pretending that stabilizing depository institutions is enough just won’t fly.

Which brings me to the third version, which is more or less what the Frank and Dodd bills are trying to do: don’t literally recreate the Quiet Period system, but try to create a 21st-century version thereof.

Rather oddly, there hasn’t been much discussion of formally extending something like deposit insurance to the short-term liabilities of shadow banks; but as it stands, there’s probably enough of an implicit guarantee to do the job. Add in resolution authority, so that shadow banks can be easily seized just like depository institutions, and you’ve got something like a super-FDIC.

But what about prudential regulation to limit the moral hazard? Limits on leverage are an obvious necessity – but I am worried about how easily they can be enforced. Derivatives reform, necessary in its own right, could help here, reducing the options for hiding exposure, but you still have the feeling that determined bankers could evade the rules.

Anyway, what if the stability of the Quiet Period rested largely on franchise value? The problem here is that no policymaker can explicitly call for restoring that aspect of the financial world: let’s make the banks fat, happy, and sleepy is not a slogan anyone wants to run on.

I guess you could argue that the de facto results of the crisis – a more concentrated, less competitive banking system – have actually recreated some of the missing franchise value. But again, nobody is going to adopt maintaining this state of affairs as a deliberate goal.

So where does that leave us? For sure we have to try to update financial regulation for the 21st century, and for sure doing so will help avert the worst in the future. But I have to admit that I’m not wildly optimistic about just how successful we’ll be.