How a Top Asset Manager Recommends We Fix the Financial System

Jeremy Grantham, chairman of asset management firm GMO, has released his latest letter and he’s focused on how the financial system should be redesigned. He offers a valuable two step process for potentially avoiding a second wave of financial crisis.

The first step he suggests is banning or separating the aggressive proprietary trading at banks that has made them seem more and more like hedge funds of late. Grantham points out that the trading has created powerful conflicts of interest with bank clients and the mentality, especially with regard to compensation, has been destructive. Trading has pushed greedy personal ambition over healthier long term corporate goals, and it’s been done with taxpayers left holding the bag when something inevitably goes awry.

The second step Grantham recommends is getting the Justice Department, and whoever else may be needed, to finally crack down on too big to fail banks. Experience has taught us that smaller banks have a simple but powerful advantage for society — they are not too big to fail. He recommends megabanks be divided into smaller and more manageable sizes. The change can be made… it’s simply not getting done.

The whole letter is worth a deep read. It offers many more insights into how the nation has suffered from the growth of the financial industry, the explicit disadvantages of too big to fail banks, and other hot button issues. The full 4-page piece begins on page 10 of Jeremy Grantham’s 3Q 2009 letter discussing lessons not learned in redesigning the financial system.