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When something is too good to be true, it almost always turns out that it isn't true. The continuing wisdom in this veritable old saw was starkly revealed on Friday, March 14, a grim day in U.S. financial markets.

The venerable firm of Bear Stearns, the fifth-biggest investment bank in New York, with assets of several hundreds of billions of dollars, experienced a classic run on the bank. Bear Stearns, like other investment banks and commercial banks, is a highly leveraged institution — with a ratio of assets, i.e. loans, to capital at more than 30 to one.

When investors lose confidence in a heavily leveraged institution, and begin to call in loans, or become reluctant to conduct ordinary business transactions, the slippery slope to total destruction can be terrifyingly steep.

On Monday, Bear Stearns was assuring the markets that their $30-billion (U.S.) of reserves was ample to weather any demands on their capital. By Friday they were in total meltdown.

Other financial institutions are similarly exposed, and potentially vulnerable to the same confluence of forces. As automatic credit lines are tapped to shore up vulnerable institutions, discretionary loans — for new investment — dry up, and the real economy suffers. Goldman Sachs economists have estimated that GDP growth could be reduced by as much as 1.5 per cent by the credit freeze-up, enough to pull the U.S. into recession, with damaging side effects for Canada.

A system-wide loss of confidence does not just happen based on a few rumours. The proximate cause for the capital crunch that has affected financial institutions is the imprudent lending enabled by the housing bubble, the unprecedented (and economically unwarranted) 80-to-90-per-cent runup in housing values from 2001 to 2006. It was the failure of billions of dollars of loans as the bubble burst that led to the sharp decline in bank asset values beginning in August of 2007.

Though banks have explicit risk management strategies, the seeming ability to shift that risk to lenders around the world through the packaging of individual loans into securities led to the creation of off-balance accounts, such as structured investment vehicles, which allowed at least some banks to ignore their own risk guidelines. To bail out Bear Stearns and avoid further runs, the U.S. Federal Reserve has agreed to accept billions of dollars of highly risky mortgage-backed securities as collateral for loans to financial institutions whose capital base is under pressure. The risks have not been eliminated, but merely transferred to the public sector.

Ultimately, the whole mess reflects a serious failure of regulation. We allowed ourselves to become enamoured of the proposition that flexible U.S. capital markets could regulate themselves. However, precisely because world capital markets have been expanding so rapidly, and the opportunities for gain are so immense, financial institutions have had a strong incentive to do end-runs around the existing regulatory structure.

The U.S., as the largest economy and the world's most important financial player, bears a special responsibility to provide the global public good of a prudent regulatory environment. Instead, for temporary gain to one sector of the U.S. economy, we have engaged in a race to the bottom that has pulled the rest of the country and perhaps much of the world into economic crisis. The economic consequences for financial centres such as New York are already being felt in painful layoffs, construction plans on hold, and shrinking tax revenues. Cleaning it all up will not be pretty.

The short-term goal is to unfreeze the credit markets, by injecting reserves into the banking system and helping to rebuild the capital base of troubled financial institutions, as the Fed has been doing.

The longer-range policy must be to bring into the sunlight the shadow banking system, which was allowed to grow up around the commercial banking sector. To do this, all financial institutions, including investment banks, hedge funds, and mortgage lending institutions must be made subject to prudent and nationally uniform minimum reserve requirements. Regular examination of their accounts by auditors not dependent on the financial institutions themselves for compensation should be instituted.

Before their use becomes widespread, new financial instruments, such as credit derivatives, must be monitored and regulated to ensure that any increase in systemic risk is properly taken into account by individual firms. All regulatory changes must be national in scope, to prevent one state from trying to gain advantage over other states by offering a looser regulatory environment.

Finally, if the national government and its central bank are to bear a portion of the cost of excessive risk taking in the financial sector, then they should also share in a portion of the benefits. The most efficient and equitable way to do this is to have a system of taxation which does not offer special advantages to players in the financial system, such as the low rates of income taxation currently faced by the managers of hedge funds.

Howard Chernick is a professor in the department of economics at Hunter College, City University of New York.