This is the second part of a two part special series on the banking industry. This series examines the banking industry and the deregulation that led to the current economic crisis, and what steps need to be taken to rebuild the financial industry. The first part examined the excess and hubris of the financial industry, and the need to link pay to performance, and this second part will examine the nature of the banking industry, the "crisis of confidence" and how America can get our financial industry back on track.

It's not that the banks are too big to fail. People ask what is the difference between other industries and the banks? Why should one receive bail-outs and other not? The question lies in the nature of their businesses.

Modern day financial systems are fundamentally based on confidence. When you pull a dollar bill out of your wallet and go down to the local convenience store, why should the shop keeper exchange it for a candy bar? After the candy bar is a physical item, can provide sustenance, and the dollar bill is a just a piece of paper. The shop keeper must have faith, have confidence, that his suppliers, workers, and others will accept the dollar bill in exchange for their goods and services. We accept this as a simple truth and fact, but it took centuries for us to get to this place. It was only recently that we went off the gold standard when the shopkeeper could exchange the dollar for actual gold held in Fort Knox. The knowledge that the dollar was exchangeable for gold, which has intrinsic value as a precious medal, that made the dollar valuable. If we woke up one day, looked into our wallets and universally said, “these are nothing but paper” and refused to accept them - our modern day economic system would collapse.

It takes a further leap of faith for that shopkeeper to give the dollar bill to a bank, who gets no more than a few blips on a computer screen in return. The banker will then turn around combine his dollars with other depositors and lend those dollars out to someone else, who may use it to start or grow a business. The bank trusts the person receiving the loan will repay that loan, which will be used to provide the shopkeeper his money back. This is essential to our modern day society. All this requires trust and confidence in our financial system. We all know the Jimmy Stewart classic story in "It's a Wonderful Life" when the citizens of Bedford Falls have a run on George Bailey's Savings and Loan. A collapse of trust, and the system collapses.

Today's modern society is built on a sound financial system. The government plays an important role in the financial system and has two primary responsibilities. First, they ensuring the integrity of the dollar, and secondly they must regulate and ensure the confidence and integrity of the financial system. The first is relatively easy. Using fiscal, monetary, and even cracking down on counterfeiters, they can ensure the dollar maintains its value and is trusted around the world. Two thirds of all US $100 bills are held outside the US, largely held by individuals that believe the integrity of the US dollar is greater than any other currency. One need look no farther than Zimbabwe to see what happens when people lose faith in their currency. The second is tougher. To maintain confidence in the system, there needs to be a set of rules, and these rules need to be uniformly enforced. For example, after the Great Depression the FDIC was created to get people to trust banks again. After all, people put money in a banks, the banks fell on hard times and went out of business and the depositors were wiped out. The logical result was a loss of faith and confidence in the banking system and a refusal to deposit money in banks. Without that, banks didn't have money to lend, and the whole system ground to a halt.

Much of today's issues and problems can be traced back to allowing Lehman Brothers to fail. It wasn't a so much that Lehman failed, but the way in which it failed. As a small business I am often granted small amount of unsecured credit. For example, I may order office supplies and be billed later. If I don't pay, the supply company refuses to do business with me and either writes off the cost or sues me. If I need larger amounts of credit, creditors will likely require me to pledge certain assets or collateral - giving the bank the right to take and sell those assets if I am unable to pay my loan. The larger the company, the stronger the balance sheet, the more credit will be extended without securing the loan to collateral.

Today's banks and investment banks (which have become virtually indistinguishable these days since repeal of Glass-Stiegel) operate with similar credit. The larger the institution, the larger the amount of unsecured credit was issued. I can make a deal with you based on the strength of your balance sheet - unsecured credit. A deal only works when there is someone answering the phone when it comes time to wind up the deal. When Lehman failed, suddenly the entire banking system lost confidence. If I do a deal with someone, who knows if they will be there tomorrow? Who knows if I will be there? Suddenly, all deals needed to be backed with collateral, which meant there was no leveraging. It was a "one to one" deal - I would need to make sure your collateral was unencumbered, that I had first right to the collateral, likewise you would want me to post unencumbered collateral. The fundamental problem is that our financial system requires leverage. The aforementioned run on the Bailey's Savings and Loan was because if at any one time everyone requests their money, there isn't enough money there. It requires trust. If there is trust, at any one time people won't all ask for their money simultaneously and the system works.

With Lehman there was a failure in the system. Had it been sold off to someone who would pick-up their obligations (as Bear Sterns was) faith and confidence may have remained in the system. Credit would not have frozen up and money, the lubricant of the modern economic system, would have continued to flow. Over and over we hear from the talking heads about a "crisis of confidence", "deleveraging", and "lack of credit". We at the PartyofCommonSense.org applaud the initial attempts at a bailout, and bemoan the loss of time with the Republican dragged their heels. On the day they voted against the bailout, the DOW tracking the stock market fell 777 points. The hope was that quick action would have restored confidence and financial institutions would keep faith in their trading partners, but this didn't happen. Certainly the bailout package wasn't enough money to fix the problem and the bailout didn't include a comprehensive plan to deal with the toxic assets, but the hope was that if enough people believed we were on the mend, we'd be able to coast to a soft landing rather than the rocky road we've traveled in 2008 and the beginning of 2009.

There is a proper role of government with financial instruments and companies. Take the simple example of insurance. Insurance provides a valuable service to society. It allows risk to be spread around, and when something catastrophic occurs, it provides the resource to rebuild. Obviously, having homeless and businesses unable to rebuild can be a devastating drag on society. However, insurance requires trust. Those paying their policies have to believe that the insurance company isn't just taking premiums when times are good, and then will simply go out of business and refuse to pay when calamity hits. It takes the government to provide oversight and regulation to provide that confidence that makes the insurance industry viable. This includes requiring insurance companies to maintain certain capital, and to spread risk via a network of reinsurers, to ensure that there will be sufficient capital to pay claims resulting from a large Katrina-style disaster.

Of course, we are going to get into difficulties when the government stops enforcing the rules. Credit Default Swaps, a form of unregulated derivative, collects a premium that will payout if a bond fails in certain period of time. As the saying goes, "if it looks like a duck, walks like a duck, and quacks like a duck, then it's a duck". This sounds an awful lot like insurance. In fact, it is no mistake that hundreds of billions in Credit Default Swaps were issued by AIG, the large and failed insurance company. However, since derivatives were unregulated, no one was checking to see if there enough assets to cover potential losses - and of course there were nowhere near enough assets in AIG to payout when calamity hit. Not surprisingly, without regulation, we have a company took in premiums when times were good, paid themselves extraordinarily well, and when time got tough - went out of business (or would have, if the government hadn't stepped in).

It is high time that we go back to enforcing the rules. Separate boring commercial banking activities (taking money in and paying one rate of interest and loaning it out at a higher rate of interest, keeping the difference) and investment banking. The SEC needs to reexamine its role and begin to start to act as a regulator with oversight responsibilities and not a cheerleader. The FDIC needs to take its responsibilities seriously, providing real stress testing to commercial banks. Over the years a large number of items have been allowed to be posted to meet liquidity requirements, going so far as allowing "goodwill" to be posted. Having large amounts of illiquid derivatives and other so called "level 3" assets (assets where there is no readily identifiable market, allowing the holder to value the asset themselves) is irresponsible. In addition, politicians need to stand up to the financial industry and create real share holder protections. Pay needs to be linked back to performance.

Back in Reagan's time, the government set the interest rate that banks could charge. Clearly, there was a time for deregulation and it was good. However, that time has come and gone. The pendulum needs to swing back.