The Financial Crisis—How'd We Get Here, and What's Next?

The resolution of the banking crisis could be back to the future, Vernon Hill writes.


Without a doubt, America is experiencing the most severe financial crisis since World War II. Institutions are failing, iconic brands are disappearing, and Americans are wondering what is next.

How did we get here? Who is at fault? Where are we going? What will the new American financial landscape look like?

During the Depression, the U.S. financial structure was radically reshaped. Investment banks were separated from deposit-taking commercial banks, with risk and innovation removed from the insured deposit banking system. A bargain was struck: Commercial banks would receive FDIC insurance, serve their communities with credit and banking services, and avoid high-risk, high-profit investment banking. Investment banks would be free to pursue underwriting, principal investment, and investment activities at their own risk but free of meaningful regulation and government support.

And so it was for 30 years.

Then, beginning in the 1970s, the pact was broken, and the "shadow banking system" began. Money market funds, commercial paper, hedge funds, securitization, CDOs, and SIVs were all created by the clever investment bankers anxious to steal the cream from the commercial banking system. Money market funds provided higher rates without the safeguards and burdens of insured bank deposits. Commercial paper provided lower rates with the false illusion of stable funding. Securitization completely separated the lenders from the borrowers.

While America's banks were burdened by stifling regulation, inept supervision, and social burdens (such as the Community Reinvestment Act, which mandated loans to credit-unworthy borrowers), the investment banks were free to invest, invest, and exploit. But the assumption was that the risk was theirs—not the American taxpayer's.

Now the "shadow banking system" has collapsed. Massive borrowing, backed with unstable funding, and overinvestment in assets of questionable value has led to the Wall Street panic. And where do the uninsured, unregulated "shadow banks" go for rescue? Not to their shareholders, not to the market, but to the federal government.

In one day, with none of the usual supervision or regulatory review, congressional oversight, or information, two of the largest players—Goldman Sachs and Morgan Stanley—get instant commercial bank charters and are now bailed out by the federal government. Treasury Secretary Paulson—until recently chairman of Goldman Sachs—bails out Goldman Sachs.

And now the "shadow banking system," in the name of Mom and Pop, cries for a massive taxpayer bailout. But America rebels: Why should the taxpayers bail out Wall Street? Why is this only a crisis when Wall Street is in trouble?

It is not the American banking system that is broken, but the Wall Street "masters of the universe" and, of course, such fatally flawed S&L models as Washington Mutual. Where are we going? Back to the future?

Here's what we can expect:

  • Investment banks as independent companies will cease to exist.
  • Commercial banks with stable deposit funding will prosper.
  • Credit will continue to grow.
  • Innovation will suffer, but risk will be reduced.
  • The federal government will intrude even more on our freedoms with more regulation, ridiculous legislation, and invasion of our privacy.

Yet despite this massive failure of not only Wall Street but also the federal government and a few bank outliers, America will solve the problem and continue to prosper. American ingenuity has always overcome government idiocy and in this case Wall Street excesses, and it will again.

Vernon Hill is the founder and former CEO of Commerce Bancorp. He writes at