A free and market-driven financial system would run smoothly by itself when all participants adhere to the set rules and greed is absent. This may sound ridiculous but that was the basis of trust in the U.S. financial system when the stock market crashed spectacularly in 1929.

After that, both the government and the private sectors agreed that new and stronger regulations were needed to curb excessive speculation, the cause of the market downfall. Thus the Glass-Steagall Act (GSA) was passed in 1933 to create the Federal Insurance Corporation System (FDIC) to safeguard banks and depositors. Investment activities and commercial banking also got separated to prevent conflicts of interest and speculation. In addition, a new financial law enforcement agency, the Security and Exchange Commission (SEC), was formed to police and intervene the financial industry to the avert system from collapsing again.

But here we are in 2008. Not only the latest U.S. financial market collapse is comparable to the 1929 Great Crash, but it is threatening a global meltdown as well.

A foreign friend had asked me how could this happen when the American banking industry was running by the best and brightest from Harvard, Wharton, and Stanford business schools?

Unfortunately, these American elites, as we have learned, were too wallowing in their greed for profit that they have become casino gamblers with subprime lending and credit default swaps (CDS). And while these troubles were brewing, the SEC not only did not intervene, but also had been deregulating and effectively festering the abuse on Wall Street. It was incredible that the situation had actually gone on for many years before things eventually got out of control and exploded spectacularly.

Unlike most critics, I don’t attribute this crisis to Wall Street. I believe greed is a natural feature, inseparable part of any free-market system. Without the profit maximization motive, we would not have many innovative financial products and low-cost services to fuel our economic growth.

On Wall Street, new instruments are often developed to gain an edge over competitors and to outsmart the regulators. Derivatives, Junk Bonds, and Hedge Funds are some examples of modern financial innovations that first became known to the public through scandals during the 1980’s and 1990’s. As these proved to be profitable, greedy financiers severely abused these new market segments and eventually they exploded. Each time, the regulators were caught sleeping at the wheels and reacted only after the fact.

The above events have a striking resemblance to the current financial market crash. Subprime loans and Credit Default Swaps (CDS) had fuelled the growth of the U.S. housing market for almost a decade. Even when the housing debt to income ratio had gone off the roof, financial regulators did not connect the dots to see the bubble was about to burst. Furthermore, when CDS instrument was created to circumvent the Federal Reserve System’s required cash reserve ratio, not only the regulators did not recognize this as a potential “casino” problem, but also allowed many insurance companies like AIG to issue policies worth billions of dollars.

This crisis has also shown us that in the age of globalization, the world financial market is actually very fragile. The collapse of one financial market, even a small exchange (one thinks of the collapse of the Bangkok exchange in 1997), could easily spread to knock out other markets around the world. This means that more than ever, the financial sector needs to be tightly regulated.

One unexpected twist coming out of this economic calamity is that GSA of 1933 is suddenly annulled to sanction investment and commercial banking activities under one roof. Such separation was designed in the aftermath of the 1929 Crash to prevent conflicts of interest and extreme speculation, some inherent by-products of greed. So instead of making the system less risky and more air tight, the government has opened a new valve with justification that new bank holding companies are required to follow stricter transparency reporting and higher cash reserve ratios.

Immediately, Bank of America absorbed the troubled brokerage-house Merrill Lynch and investment banks like Goldman Sachs and Morgan Stanley are eying commercial banks to acquire. A new era of super bank with ubiquitous reach has begun. Effectively Joe Smith in Dayton, Ohio, could take out a loan for his plumbing business, finance his home, get credit cards, set up college funds for his kids, and plan his retirement fund at the same bank. We may recall that this kind of one-stop-shop financial service had bred conflicts of interest back in the 1920’s that led to the creation of the GSA in the first place. We seem to have come full circle in a dangerous way.

Similar to Derivatives, Junk Bonds, and Hedge Funds, subprime loans and CDS instruments have been identified as the culprits of this crisis but that doesn’t mean they are illegal and should be banned like drugs. The problem was they were over abused. Leading up to the crisis, Countrywide Home Loans had been aggressively pushing subprime loans over the top and Fanny Mae and Freddy Mac were allowed to load them up in their portfolios. Concurrently, Citigroup and Wachovia banks overextended their CDS to free up more cash for subprime lending since AIG was willing to insure their gambits. Right before the housing market crashed, Wall Street had had record-breaking profits several years in a row. Everything was leading up to a perfect storm.

It’s clear that the financial regulation system needs to be revamped to have the capability to constantly screen and recognize potential financial dangers before they explode. Future innovative financial products and their providers should be required to go through rigorous regulation scrutiny before they are allowed in the open market. Even then, these products must be monitored for un-anticipated problems just as you would when a new medicine is introduced to the consumers.

Now that Derivatives, Junk Bonds, and Hedge Funds are properly regulated, these instruments have become essential parts of the financial market. When this crisis is finally over, subprime loans and CDS, as legitimate financial products, should be properly regulated as well.

We cannot eradicate greed (this does not mean we shouldn’t penalize the wrongdoers). However, we can manage this “greed” with effective regulation and yet simultaneously not stifling profit motive so it can continue to thrive to serve as a driving force for healthy competition and innovation in the financial market.

But providing regulators with more tools and power are not enough. Actually both the SEC and Treasury Department have always had enough legal tools and power to investigate and uncover many previous financial malfeasants and the current subprime loan and the CDS problems.

Eliot Spitzer, when he was New York Attorney General, was not armed with any special power when he busted a number of mal-financial practices (i.e., investment banks’ stock pricing manipulation and mutual funds’ late trading/market timing) on Wall Street. Rudy Giuliani, then the U.S. Attorney for the Southern District of New York, uncovered a network of inside trading connected with Junk Bonds led by Michal Milken. Like Spitzer, Giuliani only used the legal tools at his disposal.

To really safeguard our future financial market, which has become a lot more complicated and globalized these days, a new leadership, a new generation of dedicated and vigilant financial cops, and a new set of monitoring valuation are needed. Besides the legal tools and power at their disposals, the new crop of regulators need to be trained to make human judgements whenever certain developments, especially those new innovations, don’t seem to be right.

Any system is only as good as the people who run it. And by the way, there is no such thing as a well-run financial market without even trying.

Julian Do