Banks need to be treated like children

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NEW YORK (CNNMoney.com) -- Do investment banks need some form of adult supervision?

In the wake of the near collapse of Bear Stearns (BSC, Fortune 500), there has been a lot of chatter about whether financial institutions need to be more closely regulated by the government.

Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee, said in a speech last week that he thinks the Federal Reserve or perhaps a new regulatory agency should oversee commercial banks, investment banks and hedge funds. He also proposed that investment banks be required to create mandatory reserves to protect against losses.

Part of me feels that more regulation would not be the answer. It is anathema to those who feel that a free market like ours should run itself.

But clearly, this is not a completely free market.

If it were, the Fed would not be stepping in with a $30 billion bailout of Bear Stearns...oops, I mean $29 billion following the amended $10 per share takeover offer announced by JPMorgan Chase (JPM, Fortune 500) for Bear this morning.

The Fed and Department of Treasury are demonstrating that they are willing to save the investment banks from themselves, just as parents often bail out their children when they make silly mistakes.

With that in mind, the investment banks need to be treated like kids until they've proved that they can act responsibly.

Now I'm not suggesting that the government go overboard here. We don't need to reinstitute the Glass-Steagall Act, the Depression era law that separated commercial banking from investment banking activities.

This law was repealed in 1999, paving the way for many big mergers in the financial services industry. Some argue that the looser regulation since then is a major reason why many big banks got into trouble.

That's probably overdoing it. No amount of regulation will ever stop Wall Street from completely abandoning risky behavior. Greed usually trumps fear and in the cold calculus that accompanies the calculations of risk and reward, bankers often focus more on the reward, at the exclusion of worrying about the risk.

And history has shown that so-called financial geniuses often engage in risky behavior in times of an asset bubble. They just can't resist the temptation. We've been here before with the blowup and Fed's subsequent bailout of the hedge fund Long-Term Capital Management in 1998. It's happening again now and absent some stricter rules, it will probably happen again.

The goal of any regulation should be to minimize losses so that any spillover of a financial crisis on Wall Street does not bleed over to Main Street.

In a perfect world, bankers should not need to be motivated by concerns about running afoul of the federal government in order to make sound investment decisions.

But as long as the banks show that they are incapable of learning from past mistakes and the government shows that it will step in to rescue them from their foolish decisions, then the government has every right to demand more regulatory oversight. I can think of 29 billion good reasons why the Fed or some other agency should have a more active say in what investment banks can and can't do.

That's why I think Rep. Frank's suggestions are reasonable and hopefully will be a starting point for a healthy debate about what needs to be done in Washington to prevent Wall Street from melting down in such spectacular fashion again.

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