Analyst Highlights Three Ways to Avoid Financial Crisis

The most interesting testimony before today's Financial Crisis Inquiry Commission came from banking expert Michael Mayo.

In his prepared testimony, the Calyon Securities (USA) analyst presented a cogent summation of what caused the financial crisis. But these factors -- which include banks making too many risky loans, excessive use of leverage, "cheap money" monetary policy and lax government regulation -- are by now familiar. More interesting are his solutions to these problems. That's because they're simple, technically feasible and politically moderate.

Mayo focuses on three key factors that affect the stability of financial firms and the system at large: accounting, bankruptcy and capital (as in "easy as ABC"):

Accounting. Regulators must improve how banks keep their books. That means requiring institutions to clearly and fully reflect risky assets in their financial statements. It also entails banks taking larger reserves against problem loans. Accounting rules today largely serve to help financial firms prettify their performance. That must stop, Mayo said, comparing the situation to golf.

"If some players can take mulligans, and others can kick their ball out of the woods, and still more get 'gimmes' for all putts within five feet, the score will not be comparable at the end of the game."

Bankruptcy. Bailing out giant hedge fund Long-Term Capital in 1998 set a bad precedent, Mayo said. That effectively set a baseline for financial companies defined as too big to fail. And it guaranteed that the government would rescue larger players. The answer is to clarify the rules under which large financial firms are allowed to go bankrupt.

On this point, the analyst took issue with JPMorgan Chase (JPM) CEO Jamie Dimon, who in his testimony denied that size is an issue for financial companies. By contrast, Mayo said it's "unrealistic" to think that the government would ever allow JPMorgan Chase to go under.

"To the extent there are banks with $2 trillion balance sheets that are, in reality, too big to fail... there is a question of what price and how these banks should pay for this special status," Mayo said.

Capital. Simply, no doubt should ever exist about whether a banking company has enough capital to survive a financial shock (Easier said than done, but the principle is sound.) Financial firms must be as reliable as utilities -- when the spigot is turned on, water should flow.