How Banking Diversification Steered Us Wrong

The mess we're in started with financial theories that substituted banking innovation for due diligence and sensible regulation

By Amar Bhidé

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Glass-Steagall, enacted in 1933, limited banks to deposits and loans Classicstock/Alamy

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"Where enterprise leads," wrote British economist Joan Robinson in 1952, "finance follows." But now finance has led industry—into a ravine. It didn't start with the recent missteps of bankers, rating agencies, and mortgage brokers. Finance has been on the wrong trajectory for more than a half-century: The current crisis has deep historical roots in financial theories that regarded diversification as a substitute for due diligence—and in a dysfunctional regulatory system.

Commercial banking's diversification, its expansion beyond traditional lending, has been disastrous. What's needed now is a Glass-Steagall Act for the 21st century—rules requiring banks to focus simply on taking deposits and granting loans. This would protect depositors, limit financial-risk contagion, and allow the FDIC and the Federal Reserve to do what they do best. Others—hedge funds, private equity firms—would face no further regulation.

How did the banks' recklessness, masked as innovation, evolve? Until the 1930s, economists had two views of uncertainty. John Maynard Keynes and Frank Knight (who then dominated the University of Chicago's economics department) treated uncertainties as elements that couldn't be quantified.Followers of the 18th century mathematician Reverend Thomas Bayes, on the other hand, quantified uncertainties as if they were bets placed on a roulette wheel. Throughout the 1940s and beyond, the Bayesian view gained the upper hand. Its conquest of scholarly journals helped mathematical modeling leap into financial practice. The idea was that all uncertainty could be reduced to probability distributions. Case-by-case judgment? Unnecessary. Returns could be maximized for the least risk simply by diversification.

In 1974, economist Paul Samuelson, who spearheaded this triumph of mathematical economics, famously challenged investors in an article published in The Journal of Portfolio Management. The world of "practical operators," he wrote, was yielding to a "new world of the academics with their mathematical stochastic processes." Scholars understood that valuing individual securities was a wasted effort, he said. So should ordinary investors. Eschew stockpicking. Instead, buy a diversified portfolio.

The Samuelson challenge was enormously influential. It inspired Vanguard Group founder John C. Bogle to launch the first stock index fund in 1976. By November 2000 it was the largest mutual fund ever, with $100 billion in assets.

The mantra of diversification also took hold in the credit markets. In 1970, financier Bruce R. Bent launched the first U.S. money-market fund; today nearly 2,000 such funds manage a total of about $3.8 trillion. Following the lead of stock index funds, the money-market funds eliminated the cost of case-by-case judgment. Their portfolios of short-term debt instruments were certified by credit rating agencies, which themselves were relying on modeling rather than due diligence. The lending model of commercial banks—encumbered by the cost of having loan officers and committees make judgment calls—could not compete.

As we now know, blind diversification didn't always work in money-market funds. In September 2008, losses on debt issued by Lehman Brothers "broke the buck" at Bent's pioneering Reserve Fund, causing share value to fall below $1.

How does regulation fit into the picture? Through the unintended consequences of rules that date back to the Great Depression. The Glass-Steagall Act of 1933, which banned banks from stock investing and created the FDIC, protected depositors from imprudent bankers and bankers from jittery depositors. But the FDIC also freed banks from the challenge of earning the confidence of depositors. And eventually, as money-market and bond funds eroded banks' lending franchises, bankers used the regulatory canopy to take complex, dangerous risks. Regulators apparently succumbed to the idea, peddled by financiers and modern theorists, that if a little financial innovation was good, a lot must be great—even if it was far outside their capacity to monitor.