Stress-testing top banks has turned out to be a terrific stress reducer. Like a medical patient who takes off on a euphoric binge after the biopsy comes back negative, bank stocks have staged a heady rally, driving a broad recovery in the markets and talk that the end of the recession may be nigh. But the real significance of the stress tests goes deeper. They answer the perplexing long-range question: When the financial system emerges from this crisis, how can it be prevented from blowing up again?
Without an answer to that question, we are in for a rough time. After their recent thrashing, financiers won't take excessive risks again for a while. Yet bankers' memories are short, and the crisis may ultimately induce more risk. Successive bailouts have revealed that the debts of large financial institutions are backstopped by the government: If those institutions go down, bondholders won't lose money, so they might as well finance risk with no end. In essence, all of Wall Street has been transformed into Fannie Mae and Freddie Mac, the giant housing lenders whose implicit government guarantee led them down the road to ruin.
So we need some serious risk controls, and the question is: What sort? Once upon a time, governments kept the lid on bank risks by regulating structure: Banks that took deposits were not allowed to underwrite securities or branch across state lines. Good luck reviving that approach. Unscrambling banks that have become not merely national but global is beyond the competence of government. In an age when companies are global, the banks that service them are naturally global, too.
Starting in the 1980s, when the old structural controls began to crumble, government came up with the approach of requiring banks to hold capital. It seemed an elegant idea: Capital was the catchall security blanket for all manner of risk-taking, ranging from foreign-exchange trading to plain commercial loans. But how much capital? Mistaken answers to that question explain most financial blowups, in the current crisis and before.