Even among economists who generally favor laissez-faire policies, banks are widely regarded as a special case. The reason is that a bank failure can generate costs beyond those borne by its equity investors. Depositors at other banks may incorrectly infer that a broader credit problem is putting their own savings in jeopardy. The resulting bank run will drain assets from the banking system, leading to a contraction of credit. Potential economic output will consequently be lost, and asset values will fall. These costs constitute a spillover, or externality, that can justify regulation.

In The Road to Financial Reformation: Warnings, Consequences, Reforms, Henry Kaufman makes an ethical, rather than economic, argument for subjecting banks to government oversight rather than market discipline alone. “They have a fiduciary role as the holders of the public’s temporary funds and savings,” he writes. Furthermore, contends the eminent economist, allocating the funds entrusted to banks constitutes a public responsibility.

One may agree or disagree that the managers of banks owe a duty to someone other than their shareholders, but Kaufman points out that total reliance on market discipline is moot with respect to the U.S. banking system. That the biggest banks are not genuinely at the mercy of market forces has been made abundantly clear by the financial crisis of 2008−2009. Instead, the government deems them “too big to fail” by virtue of the massive economic shock waves that would result from their being allowed to go under.

Qualifying as too big to fail confers a competitive advantage. Knowing they will not be allowed to go bust, the largest banks can take greater risks than their smaller rivals and earn the larger profits associated with those risks. Inevitably, this incentive drives banks to combine into larger entities, which produces a concentration of financial assets that Kaufman considers unhealthy.

Compounding the problem is the fact that the biggest banks have evolved into financial conglomerates. Protection under the too-big-to-fail doctrine has thereby been extended to activities outside deposit gathering and lending, which are central to the public purpose that underlies regulation. The regulatory structure has not kept pace with this change, which means that the financial conglomerates pose systemic risk in ways that receive too little surveillance.

Kaufman catalogs many other flaws in the present regulatory setup and, true to his book’s title, proposes reforms as well. Many of his recommendations will sound familiar to readers who have followed his articles and speeches over the past several decades. A quarter of a century ago, Kaufman proposed the sort of centralized financial supervision that has lately become fashionable to advocate. Similarly, for years he has been pointing out the asymmetry in the Fed’s approach to runaway asset price appreciation, in both stocks and housing. There could hardly be a more open invitation to speculation than saying that bubbles are unrecognizable and, therefore, will not be restrained by the tightening of monetary policy but rather that each inevitable price collapse will be cushioned by a loosening of credit.

Consistent with his disdain for quantitative techniques that conceal rather than elucidate the risk in today’s complex financial instruments, Kaufman avoids mathematical formulas and uses graphs sparingly. He relies instead on cogent argumentation, buttressed by his extensive—and frequently firsthand—knowledge of financial history and its key movers and shakers.

This method of getting to the heart of the matter is more than a stylistic preference. Kaufman maintains that courses in business and financial history should be compulsory for business students, and he has endowed several chairs in the subject at leading universities. In his view, business schools have abandoned their broader responsibilities by discarding ethics, business culture, and history as allegedly too soft and impractical. “Yet we are surprised,” he writes, “when the senior managers of financial institutions that go astray hold good academic credentials.”

Fittingly, Kaufman offers his own interesting footnote to financial history. He believes that he and the late Sidney Homer, to whom he initially reported at Salomon Brothers, coined the term “credit crunch.” This claim is upheld by the British Broadcasting Corporation’s online service.

As The Road to Financial Reformation documents, financial crises are fairly frequent occurrences. The author offers some hope that well-considered regulatory reforms can at least prevent a spiral of ever-greater frequency and severity. Structural changes will have enduring benefits, however, only if regulators find a way to prevent the reforms from being chipped away by lobbyists for financial institutions. The industry can be counted on to continue pressing its cause long after congressional zeal for reform has faded.

That, however, is material for another book. To discover the roots of the most recent financial crisis and to learn its lessons, market participants cannot do better than to study the insights of Henry Kaufman.

—M.S.F.