I recount this story not because Fannie Mae and Freddie Mac were the main cause of the recent financial crisis — they were only one element — but because it shows the kind of problem we’ll encounter on a larger scale as we reform oversight of the financial system.

Image Credit... David G. Klein

We should certainly aim for better financial regulation, especially for institutions with government-insured deposits. More transparency and more accurate assessment of risks are admirable goals. Higher capital requirements would be a step in the right direction.

There has been much talk about restricting the use of financial derivatives. Unfortunately, writing good rules is not easy. Derivatives, like fire, can lead to disaster if not handled with care, but they can also be used to good effect.

Whatever we do, let’s not be overoptimistic about how successful improved oversight will be. The financial system is diverse and vastly complicated. Government regulators will always be outnumbered and underpaid compared with those whose interest it is to circumvent the regulations. Legislators will often be distracted by other priorities. To believe that the government will ever become a reliable watchdog would be a tragic mistake.

So where does this leave us? We should plan for future financial crises, to occur at some unknown date for some unknown reason, and arm ourselves with better tools to clean up the mess.

Much focus in Washington has been on expanding the government’s authority to step in when a financial institution is near bankruptcy, and to fix the problem before the institution creates a systemic risk.

That makes some sense, but creates risks of its own. If federal authorities are responsible for troubled institutions, creditors may view those institutions as safer than they really are. When problems arise, regulators may find it hard to avoid using taxpayer money. The entire financial system might well become, in essence, a group of government-sponsored enterprises.