A particularly pointed historic reference can illustrate how the process develops. In the early nineteenth century, land banks were common in rural America. These institutions grew up around the acquisition and transfer of frontier land. The founders of such institutions would buy a parcel of land and use its value as the initial business capital to get a banking charter, take deposits, and lend out money, primarily for others to purchase land. The more these banks lent, the greater the demand for land and the higher the market value of their original land-based capital. These banks then used the increased value of that base to lend more. The up cycle continued until land prices lost all touch with reality. As fewer and fewer people could afford to buy, despite the easy credit offered by the land banks, reality reasserted itself. Land prices began to fall, and the process worked in reverse, frequently at lightning speed. The banks failed.

Something like this happened in the years leading up to the 2008–09 crisis. No bank used land as basic capital; the regulators never would have permitted that. But these banks were able to package their dubious mortgage lending into bonds that they then sold to the public. The cash they then received allowed them to enhance the value of their capital base, one recognized by the regulators. This enabled them to expand their mortgage lending anew, in other words, leverage their past gains. Because the flow of lending helped bid up real estate prices, the value of banks’ real estate assets also rose, encouraging them to lend still more. The process bid real estate prices still higher. The capital seemed adequate for the banks themselves, but since the banks sold off so much of the risky debt, the whole system piled enormous amounts of risky real estate credit onto an only slightly enlarged capital base. For a while, real estate prices kept rising, but the further they rose above people’s fundamental incomes, the less affordable real estate became. Eventually, buyers disappeared, prices began to fall, and things worked in reverse, just as with the land banks.

Critics point to the pattern as an illustration of the spectacular greed of finance. Yet, without doubting for a moment the greed of Wall Street, the pattern would have persisted even if those involved were saints. Finance cannot help but build on itself in this way. Any manager who balked at the process would have lost his or her job. Presumably, regulators could have slowed the process had they, for instance, insisted on capital to back each bundle of loans the banks sold to the public. But the hitherto described institutionally-based nature of the regulation prevented such a move, even had regulators considered it, which the evidence suggests they did not. The accounting and administrative difficulties of such an effort probably would have proved insurmountable in any case. Besides, the authorities at the time wanted to encourage homeownership for political reasons, even to those with dubious abilities to service their debts, and so had little inclination to stop the process, whatever they claim now in retrospect.

AT THE most fundamental level lies the third reason regulation fails. Huge risk simply is implicit in finance. The great complexities of modern finance can obscure this underlying nature, but it is nonetheless unavoidable. To see why, consider the two basic functions banks and finance generally have in the economy: 1) they offer depository services to businesses and individuals in support of essential day-to-day payments, and 2) they bear the cost of that function and turn a profit, they lend out a large portion of those deposits at interest to individuals and businesses and in this way promote economic expansion and development.

The process creates prosperity, but a simple illustration can demonstrate how much risk is involved. Say, for example, administration and interest paid on deposits cost banks a mere 1 percent of the total amount involved. If they lend all the money out at interest and charge the borrowers, say 4 percent, they would enjoy a margin of three percentage points over cost. If any more than 3 percent of their borrowers failed to pay, they would struggle to meet obligations to their depositors. A capital set aside of 3 percent would just cover it. The Basel requirement of 8 percent would protect them. But even a minor recession could easily create more troubled loans than 8 percent, and a major recession could drive up the problem loans to well over 10–20 percent. The banks are always at risk of collapse.

Of course, modern finance is much more complex and sophisticated than this. Banks have loan loss provisions on top of the capital demanded by custom and regulations. Deposit flows also make the calculations more complex than portrayed here. Loan covenants can protect the flows of repayments even if borrowers go bankrupt. Other institutions have different practices. Investment banks help larger firms borrow by selling their bond issues to other investors. Private equity and venture capital firms use their own funds to support new ventures and also enhance their ability to extend more to business by themselves borrowing from banks and elsewhere in the financial system. Complex practices and even more complex financial instruments support these structures. But fundamentally, all behave much like the above, admittedly simplistic, picture of the banks. The nature of all this business creates existential risks for them, even if only a relatively small portion of their borrowers fail.

Some might want to erase this risk by insisting on regulations that would, for instance, demand capital set aside of 25 percent or more. That would guard against failures to be sure. But it would also block a significant part of the economy’s financial resources from flowing to the businesses and people who need it to expand, innovate, and hire more workers. It would also make it all but impossible for the banks to operate the economy’s payments system. If, for instance, only 75 percent of the deposits of the earlier example were lent out at 4 percent, the average inflow, if everyone paid, would amount to only 3 percent of their deposit amount, giving banks only a two-percentage-point margin over the cost of supporting the deposit and payment system. The huge capital requirements would relieve the risk in the financial system, but the small return to banking would raise questions about whether the operations are viable. If such circumstances caused the banks to close their doors, the economy would lose both its payments system and the financial flows needed to support economic expansion. It is in consideration of this tradeoff between risk on the one hand and support for the economy on the other that prompts the BIS and other regulators to accept risk and do their best to keep the required capital cushion relatively small.

IF, THEN, regulatory approaches have clear limitations, a natural response is to look to other means that might instill prudence into financial decisionmaking. On this score, history offers a guide, but only a tenuous one. Once, an insistence on a gold base blunted these otherwise dangerous financial tendencies. Even in the absence of regulatory authorities, market practice once dictated that banks resist the tendency to build too much lending on their gold holdings. Without assurance that regulators would relieve risks, depositors and investors during these times avoided institutions that went too far beyond their gold hoard. To get depositors, banks bragged on the adequacy of their gold base. Custom dictated a percentage not much different than the capital ratios demanded today by the BIS, Dodd-Frank, and other regulatory bodies. These arrangements did not stop financial panics. The land banks, of course, operated outside gold’s influence. And even in areas where financial institutions held gold capital, the dangers of finance described above created problems from time to time. But an element of prudence existed that is missing today.

Gold offered the system two other virtues that helped secure it against collapse. One, it was widely acknowledged as having intrinsic value. The concept of intrinsic value is, of course, suspect. Value is only what markets think it is. Still, the illusion of unquestioned value gave borrowers and lenders a calming confidence that could quell a panic before it began. A second virtue was the constancy of gold’s price. The value of the gold did not rise and fall with the activity of banks. On the contrary, it was more or less fixed at a figure all prospective depositors and investors could see and on which they believed they could rely. If banks remained vulnerable to even a small loss from lending, and they were, the fixed value of gold blunted the tendency for gold-based banks to build on past success as the land banks did, and the modern system does and did in the run-up to the 2008–09 crisis.

Sadly, a return to gold would fail to meet modern needs, regardless of what the gold bugs say. The stock of gold is too small to form a base for today’s immense financial system. If banking and finance tried to return to it, the metal’s price would rise to astronomical levels. Besides, gold holdings are too unevenly distributed around the world to support the modern, global system. What could apply is the gold substitute that Alexander Hamilton devised to support America’s finances in the 1790s.