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Braking the Banks

The world economy is showing signs of recovery, stock markets are soaring and bankers are again awarding themselves big bonuses. But one year after the financial conflagration that devastated Wall Street and burned financial institutions around the globe, the main firefighters — central bankers, market regulators and government policymakers — continue to struggle with a central question: How do we prevent it from happening again?

Some of the answers are technical. Regulatory oversight, almost everyone agrees, needs to be beefed up. There's also an emerging consensus on the need for banks to hold more capital and for their appetite for risk to be curtailed. But bigger issues are at stake too, ones that are more political and philosophical in nature: Should any bank be too big to fail? What should be done with financial activities that seem purely speculative and of questionable social use? How can the short-term, get-rich-quick mentality that drove so much market activity before the crash — and inflated those bonuses — be curbed? Is there a place for morality in the world of finance? (See the financial crisis after one year.)

After months of behind-the-scenes debate, these issues will be the elephants in the room at the G-20 summit meeting of major economic powers due to take place in Pittsburgh, Pa., on Sept. 24-25. Diplomats and analysts say that a growing convergence among nations on the technical details surrounding greater industry oversight may paper over a divisive philosophical gulf. The U.S. and Britain, with their instinctive support and dependence on free-market finance, are increasingly at odds with France and Germany, who are more skeptical about the benefits of unfettered capitalism and hope to win votes at home by controlling its excesses. But even among native English speakers, there's an intriguing debate taking place about the limits of finance, spearheaded by Adair Turner, the chairman of Britain's market regulator, the Financial Services Authority. To the dismay of some in the City of London, he is arguing forcefully that the financial sector in Britain has "swollen beyond its socially useful size."

None of this is simply academic theorizing. One year on, public fury about the massive banking bailouts continues to drive calls for greater oversight and regulation. Much of the outrage is directed at bankers who earned huge bonuses by taking outsized risks with complex financial instruments, only to walk away scot-free when their bets went awry, plunging the world into crisis. Bonuses are just one aspect of the larger issue of moral hazard that has been raised over the past year, as governments and central banks have spent tens of billions of dollars of taxpayers' money to rescue financial institutions whose recklessness in the name of short-term profiteering is at the root of the trouble. For all the recent signs of improvement, the financial situation is still far from normal. Some huge financial institutions, from AIG to Royal Bank of Scotland, remain on government life support. Jürgen Stark, a board member of the European Central Bank (ECB), recently estimated that financial institutions operating in Europe alone are facing total losses of around $650 billion between 2007 and 2010 — and have so far written down less than half of that amount in their books. "There is no room for complacency," he said, warning that extraordinary government and central-bank bailout measures "cannot be sustained forever."

As world leaders take stock in Pittsburgh, there'll be a plethora of issues on the table aimed at making the world's finances more stable, transparent and resilient. Here's TIME's guide to four of the initiatives deemed most important to this effort.

Reining in the Banks At the World Economic Forum in Davos last January, some participants advocated radical measures to rein in banks, including regulating their operations so heavily that they would turn into low-risk utilities. No, said Jean-Claude Trichet, the president of the European Central Bank, that wouldn't solve the problem. What's needed, he argued, "are air bags, cushions and shock absorbers." Trichet has now detailed what he means. On Sept. 6, a group of central-bank governors and regulators from 27 countries that is chaired by Trichet published specific proposals that he said would "set new standards for banking supervision and regulation at a global level."

The measures would require banks to boost their capital base and put strict limits on the extent to which they would be able to leverage their balance sheets. They would also require banks to keep a portion of the loans they sell as asset-backed securities to ensure that they have a stake in what happens to those loans. Some regulators including Britain's Turner are calling for big financial institutions to have "living wills" that would enable their activities to be wound up in an orderly manner in the event they failed, thus avoiding the sort of panic caused by the bankruptcy of Lehman Brothers a year ago.

The proposals have sparked grumbling among bankers, especially in Europe, because the requirements would crimp their profitability. JPMorgan this month estimated that, if key measures like increased capital requirements are implemented, the average return on equity of investment banks would drop by one-third. "It's out of the question to systematically increase layers of capital in the banks if there's no supplementary risk," says Ariane Obolensky, managing director of the French Banking Federation. But the tide is against such critics. As Stark of the ECB put it in a speech this month, "the simple statement that 'if banks are too big to fail, they are probably too big to exist' is a reasonable rule." The postcrisis financial system, he predicted, "will probably place greater emphasis on traditional banking activities, which tend to produce lower margins, but are also more robust, less risky and less volatile."

Taming the Markets Regulators on both sides of the Atlantic are trying to limit abuses that led to the meltdown, such as the reckless issuance of subprime mortgages. In the U.S., the Treasury Department and lawmakers are seeking to bring greater transparency to the arcane world of financial derivatives by requiring the trading of them to be done through central clearing houses. Meanwhile, Trichet's group of central bankers wants banks to put up additional capital if they engage in especially risky types of financial market transactions. As the financial services industry braces for tougher oversight, it's keeping its fingers crossed. "There's a lot of wariness about all forms of financial market activities and that's perfectly understandable," says Richard Metcalfe, global head of policy at the International Swaps and Derivatives Association. "There's a huge amount of political pressure to do things. Let's do it in a way that is intelligent." (See "Turning Point for the Global Recession?")

Edging Toward the Exit U.S. Treasury Secretary Tim Geithner this month announced that the U.S. is starting to phase out some of its emergency support for banks and financial markets. But he pointedly made no mention of a full-blown "exit strategy," saying that "we must continue reinforcing recovery until it is self-sustaining." When and how governments and central banks pull back is a critical issue that still needs to be coordinated. One of the risks is that inflation could soar due to the explosion of national debt in many countries during the crisis. And early signs suggest governments have wildly different strategies. In Germany, for example, Chancellor Angela Merkel promised tough action to bring down the budget deficit, while in France, President Nicolas Sarkozy is looking to add to the country's debt though a huge government-bond issue next year. Such divergences are already causing alarm. Unless exit strategies also address the long-term sustainability of public finance and other challenges, Stark says, "the current crisis is bound to be exacerbated by a sovereign debt crisis."

Fixing Those Bonuses Almost everyone thinks something should be done to curb big paydays for bailed-out bankers, but solutions are elusive. Finance Ministers of the G-20 nations earlier this month agreed that bonuses should be more clearly tied to performance, but Britain and the U.S. resisted demands by France and Germany to have them capped. Sensing the prevailing political winds, some bankers are already moving to forestall draconian new rules. The Dutch banking association announced that its members have agreed to cap bonuses and severance pay. And in France, bankers have been so frequently called to the Elysée Palace this year to be chided in person by Sarkozy that they're rewriting their rules.

Andreas Schmitz, head of the Association of German Banks, says "it's not up to the state to decide what banks pay their employees or managers." But like other issues on the table in Pittsburgh, this is a battle bankers are likely to lose. In a speech on Wall Street on Sept. 14, the anniversary of the failure of Lehman Brothers, President Barack Obama warned the banking industry not to fight reform. "We will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses," Obama said. The question is just how far G-20 leaders are prepared to go as they balance public rage with the need to keep their financial sectors vibrant.

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