By Simon Johnson

Three years ago, a financial crisis threatened to bring down the United States economy – and to spread economic disaster around the world. How far have we come in preventing any kind of recurrence? And will the much-discussed Volcker Rule – attempting to limit the risks that big banks can take – play a positive role as we move forward?

Bad loans were the primary cause of the 2007-8 financial debacle. When the full extent of the problems with those loans became apparent, there was a sharp fall in the values of all securities that had been constructed based on the underlying mortgages – and a collapse in the value of related bets that had been made using derivatives.

The damage to the economy became huge because these losses were not dispersed throughout the economy or around the world. Rather, many of the so-called “toxic assets” were held by the country’s largest banks. Financial institutions that used to lend to consumers and businesses had instead become drawn into various forms of gambling on the booming mortgage market (as well as on commodities, equities and all kinds of derivatives). “Wall Street gets the upside, and society gets the downside” was the operating principle.

And what a downside that proved to be. Treasury Secretary Henry Paulson said the Troubled Asset Relief Program, or TARP, was needed to buy those toxic assets from the banks. But this quickly proved unwieldy, so TARP pumped roughly half a trillion dollars into bank equity. The Federal Reserve backed this up with a massive amount of “liquidity” through more than 21,000 transactions.

The additional government debt as a direct result of this finance-induced deep recession is estimated by the Congressional Budget Office at around 50 percent of gross domestic product, roughly $7 trillion.

These are staggering numbers. And this system of big banks taking outsized risks, failing and imposing huge damage on the rest of us has to stop. This ball is now firmly in the regulators’ court.

Whatever your broader issues with the Dodd-Frank Act of 2010, one point about legislative intent in this legislation is clear: the regulators have the authority to cut banks down to size and return them to their historical role of intermediating between savers and borrowers.

As for size, the regulators have long ignored the existing guidelines and allowed the biggest banks to get bigger. We need to go in the opposite direction, and that includes cutting the private mega-banks, as well as Fannie Mae and Freddie Mac, down to size. It also means taking advantage of the resolution authority and all associated provisions that Sheila Bair, the former chairman of the Federal Deposit Insurance Corporation, worked so hard to put into the Dodd-Frank Act.

As Jon Huntsman is arguing on the Republican campaign trail, too-big-to-fail banks simply need to be forced to break themselves up.

But we also need to make the mega-banks less likely to fail. The easiest way to do that would be to require banks to have enough common equity to absorb losses.

But the bankers have pushed back hard, with Jamie Dimon, head of JPMorgan Chase, leading the way with statements such as this on capital requirements, which are known loosely as the Basel Accords: “I’m very close to thinking the United States shouldn’t be in Basel any more. I would not have agreed to rules that are blatantly anti-American.”

Dan Tarullo, responsible for this issue on the Federal Reserve Board, seems to support the idea of requiring significantly more equity in big banks, perhaps moving in the direction recommended by Anat Admati and her colleagues. But Mr. Tarullo appears to have lost that battle for now.

If we are not breaking up banks and if we are not requiring them to have reasonable levels of capital (thus limiting how much they can borrow relative to their equity), we must use all other available tools to stop the too-big-to-fail banks from taking excessive and ill-conceived risks.

This is where the Volcker Rule becomes so important. Named for Paul A. Volcker, former chairman of the Federal Reserve, and adopted as part of Dodd-Frank at the insistence of Senators Jeff Merkley, Democrat of Oregon, and Carl Levin, Democrat of Michigan, the Volcker Rule directs the regulators to get banks out of the business of betting on the markets.

The regulators are now determining how they plan to implement it. Draft proposals are currently open for comment.

But the latest news on this front is not encouraging, as key regulators seem stuck in a “bigger is better, and anything goes for the biggest” mindset.

The Volcker Rule has some good points, including a requirement that trader compensation not be tied to speculative risk-taking, and that firms collect and report some essential data to regulators. But the current draft does too little to actually stop the banks’ current risky practices.

The main problem is that the rule as drawn does not set out the clear, bright lines that banks and regulators need, nor does it provide for meaningful enforcement. Instead of drawing the lines, the proposed rule mandates that firms write many of the rules themselves.

There is some good news. At this point, it is only a proposed rule, and it is open for comment (submit a comment here). Organizations like Better Markets that promote the public interest within the regulatory process will be in there fighting to strengthen the proposed rule and make the final rule better.

Everyone who cares about real financial reform should do the same, but the regulators’ draft rule has made it harder to uphold the public interest than should have been the case. For example, the regulators ignored the breadth of the Volcker statute and focused instead only a narrow slice of the bank’s balance sheet – just what the bank says is for “trading” purposes. Much else of what big banks do seems likely to escape scrutiny.

The regulators also have given very little guidance on conflicts of interest, on what should be considered high-risk assets or on what high-risk trading strategies should be permitted.

During a Senate hearing at which I testified last week, Senator Bob Corker, Republican of Tennessee, focused on another important problem – the lack of any restrictions on trading in the enormous Treasury securities market. The regulators will create a lot more paperwork for the banks, but if the current draft is adopted, the too-big-to-fail banks are not likely to be forced to stop doing much.

Last year Senator Levin said:

“We hope that our regulators have learned with Congress that tearing down regulatory walls without erecting new ones undermines our financial stability and threatens our economic growth. We have legislated to the best of our ability. It is now up to our regulators to fully and faithfully implement these strong provisions.”

From what we’ve seen so far, our regulators have not yet understood this message. They seem instead more in tune with Mr. Dimon, who insisted earlier this year that regulators should back away from any effective implementation of the Volcker Rule:

“The United States has the best, deepest, widest, most transparent capital markets in the world which give you, the investor, the ability to buy and sell large amounts at very cheap prices. I wish Paul Volcker understood that.”

Mr. Dimon — who is on the board of the Federal Reserve Bank of New York — seems to have forgotten the financial crisis, its impact on ordinary Americans and the utter fiscal disaster that ensued. Or perhaps he never noticed.

Mr. Dimon seems to have forgotten the financial crisis, its impact on ordinary Americans and the utter fiscal disaster that ensued. Or perhaps he never noticed.

An edited version of this post appeared yesterday on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.