A contrarian's view of financial reform: Why bother?

FORTUNE -- Putting aside Republicans who are now programmed to object to anything the Democratic Congress tries to pass, it's pretty hard to find a critic of financial reform these days -- at least one with the guts to voice their criticisms out loud and in public.

Kevin Mellyn, author of Financial Market Meltdown: Everything You Need to Know to Survive the Global Credit Crisis, is one such critic. Mellyn has over 30 years experience in the banking and consulting industries, working for everyone from the likes of Manufacturers Hanover Trust to consulting firms A.T. Kearney and the Mitchell Madison Group. I had the opportunity to catch up with him in early July to talk of the roots of the crisis, the attempts at reform, and just why he thinks the answers to all our problems can be found in a book that was published in 1873.

So what do you think of the financial reform bill that Washington is debating?

It's a disaster. 2,300 pages. A financial reform bill should be ten pages long. Or maybe eight. Rules should be general and simple. Because the real answer always depends on circumstances.

You also need a central bank that can act decisively. And you have to treat things in a systematic way. You can't be making it up as you go along, the way that Paulson and Bernanke and Geithner were doing in 2007, 2008, and 2009.

The idea that you can create a regulatory regime -- like the one that came out of Washington -- that will solve the problem of human folly is folly in itself. What you need to do is have a system in which you make money or lose money, based on the decisions you have made. The ignorance of these people -- Frank, Dodd, Blanche Lincoln, the lot -- is just astonishing.

That said, financial illiteracy in Congress is a theme that stretches all the way back to Andrew Jackson. So nothing new there. Of course, it's understandable if not entirely sensible. In a democracy like we have, the political upside of demonizing and blackmailing banks is irresistible.

But they're looking to protect the little guy, aren't they? What's wrong with that?

The current bill has us on the road toward crony capitalism. Access to capital will be a function of electoral politics, not your ability to repay. It's extremely important that capital be allocated for better or for worse depending on the borrower's ability to repay. Political pressure to broaden access to credit was a root cause of the bubble and Washington is still at it.

Ultimately the whole financial system is based on people paying what they owe. Bailing out improvident borrowers at the expense of investors and taxpayers is an outrage. There need to be heavy consequences all around for bad financial decisions.

That's not going to happen. What's the real issue, then?

The primary case of the bubble of 2007-2008 was state intervention into the real estate system. By that I mean the pumping up of the GSEs -- Fannie Mae and Freddie Mac -- as well as the political mandate to trash lending standards. What's remarkable is that any discussion of the government's role in the crisis has entirely disappeared. Meanwhile, they continue to prop up the real estate market without letting it bottom.

The second cause, I would argue, is the low interest rate philosophy practiced by the Federal Reserve during the Greenspan era to prop up the financial system. Of course, in a popular democracy, it's almost impossible for a central bank to do the right thing, which is to let markets purge themselves when they need to. But the notion of the 'Greenspan Put' -- that the Fed was ready to bail out the financial system, no matter how egregious its mistakes, was a disaster. And the third would be the securitization of consumer credit. Financial innovation, as Walter Bagehot said, is always a terrible mistake.

Your book is pretty much an homage to Bagehot, the one-time editor in chief of The Economist and author of the 1873 book Lombard Street. What is it about his thinking that you think is still relevant today?

He basically explained in simple concrete terms how the financial world worked. He said that there is little we can do to change practice -- people are imperfect, there will always be speculation, there will always be bubbles. His solution? You need to work the imperfect system you have better rather than change it.

The real mistake that most people make is thinking that these things we call "systems" -- the financial system, the health care system -- were ever actually designed. They are "accidents of history." We are dealt certain cards by history, and we make the best of those we are dealt. Bagehot was an acute observer of just how things came to be. You can't redesign these things. We just need to make them function better.

No one is confronting the truth that what just happened is not really anybody's fault. It's just what happens to complex systems from time to time. And therefore any attempt to "fix" the system is just going to make it worse.

It's nobody's fault? What about the people that bet the farm at AIG (AIG, Fortune 500) and Merrill Lynch?

Let me be clear. We should be perfectly ready to make people pay the price for being stupid. We should also demand that banks have more capital if they want to take these kinds of risks. But what is not being talked about is the government distortions in the market. And the lack of market discipline.

What do I mean by government distortions? Let's start with deposit insurance. Instead of doubling it to $250,000, I think it should be knocked down to $10,000. People who give money to a bank should be concerned about the financial health of that bank. Open-ended guarantees of banks and their customers only serves to make the next crisis worse.

And why don't we lose the interest deduction of mortgages? And why have we allowed people who can't afford it to even have credit in the first place?

So what do you think the government's role in the banking system should be?

Money is no more and no less than the amount of deposits in our banks. That's what the government should be safeguarding. I agree with Paul Volcker that there's a very good case to be made for making banks segregate capital they use to do anything else from that held against deposits. I admire what Volcker did as our central banker. In fact, he is one of the few that I mention favorably in my book. I think he was very brave to break the Great Inflation. And I think he's right that banks shouldn't be trading with the leverage of being a deposit taker.

Banks should be banks, in other words.

Right. You know, much of this problem emerged when we started demanding non-utility returns from banks. Deposit banks need to return to basic banking, paying utility returns in the form of dividends. And we don't need any more high-riding CEOs taking home gigantic paychecks for doing what amounts to a pretty simple job.

So Jamie Dimon doesn't deserve $17 million a year?

Look, Jamie Dimon has done a great job given the cards he was dealt at JP Morgan (JPM, Fortune 500). He avoided some of the worst pitfalls of this crisis through his focus on a fortress balance sheet. If you have lots of capital and control your risks, you can make the universal banking model work. He made it work. HSBC (HBC) made it work. Barclays (BCS) made it work. But how much do you want a system that depends on people being that lucky or talented? He made a nearly impossible to manage model work.

Do you think they should have broken up the big banks?

I think it's too late to do that. And I'm not even sure we want to. Actually, banking systems tend to become very concentrated over time when not prevented by politics. Concentration breeds stability. Look at Canada. There are four or five banks up there controlling the whole market, and it's proven a lot more stable than that in the U.S.

Most bank failures in the U.S. are actually smaller banks that became too heavily exposed to local real estate. It's an interesting point. You can have a competitive banking system or a stable one. It's very hard to have both. The situation in Canada might result in a slightly crappier deal for consumers, but in return for that, they get stability.