Excerpt from COMPLICIT: How Greed and Collusion Made the Credit Crisis Unstoppable, by Mark Gilbert with permission from the publisher Bloomberg Press (February 2010). Part 2 of 2. Here is Part 1.

By Mark Gilbert, London bureau chief and global capital markets columnist for Bloomberg News.

Psychiatry suggests that people whose lives have been engulfed bycatastrophe follow a predictable coping pattern. They start off engulfedin denial, try to bargain their way out of the dilemma, then succumbto depression before finally accepting their misfortune and resumingtheir lives as best they can. Unfortunately, most of the financialindustry hasn't even made it to the first stage. Too many bankers areacting as if the disaster never happened.

The financial industry's siren song is easy to summarize. Regulateus too strictly, the bankers say, and global growth will suffer. Nevermind that this argument assumes that banks cannot innovate andthat self-regulating is precisely what brought the economy crashingdown. The banking community hasn't made amends for its profligatebehavior. Indeed, it will always find ways to argue that business asusual is the only way to safeguard the global economy.

Government-sponsored mergers and opportunistic purchaseswill mean fewer and larger banks in the landscape that emerges afterthe credit crunch's dust settles. Governments, however, cannotallow these banks to dictate policy and must ignore finance chiefswho bleat at the prospect of new rules. The market needs safetystrictures, even if new safeguards make it harder for investmentbanking to invent and profit from new techniques and strategies.

Following is a list of changes designed to protect us from the worstexcesses of the finance industry, without killing its ability to contributeto the global economy.

In this credit crunch, national regulators rescued at least some failinginstitutions. In doing so, they have essentially committed to futurerescues. "The government has dispelled any constructive ambiguityon how far it's willing to let banks and investors suffer," former Bankof England Deputy Governor John Gieve said in June 2009. "There'snow a safety net covering every significant bank, even banks thathave failed. Moral hazard is a real issue now."

Moreover, it turns out that the riskier an institution is, the higherits chances of a government rescue. If regulators had seen Lehman asposing threat equal to that of Bear Stearns, a government-guaranteedtransaction might have saved Lehman, too. Bankers now haveconcrete evidence that maximizing the economic dangers posed bytheir businesses is the best way to ensure their survival.

To avoid this moral hazard, nations must force banks to set asidesufficient capital to cover unexpected disasters. Regulators shouldcompel the banking industry to insure itself, with each institutionmaking regular payments into an insurance pool. Institutions thataren't fit should be allowed to die. "Banks have to be free to makedecisions and therefore to fail," says Bill Blain, a bond broker atKNG Securities in London. "That is the unfortunate issue to address:How to allow the banking industry the efficiency to fail."

New rules must also recognize that size matters. "Banks mustresume lending, but they must also adjust by becoming smaller,simpler, and safer," the Bank for International Settlements said in itsJune 2009 annual report. "Government rescue packages implementedso far appear to be hindering rather than aiding this needed adjustment.By helping banks obtain debt financing and capital, rescue packagesallow managers to avoid the hard choices needed." Moreover, theBIS said, shotgun weddings among failing institutions create "financialinstitutions so big and complex that even their own managementmay not understand their risk exposures."

A bonus system that lets the banking community profit (but neversuffer) from reckless gambling is untenable. The days of playingnow, but discovering the consequences later must end. Bankersonce argued that they were locked into their institutions' equityperformance; this has proven false.

The authorities have a right to play a part in redrafting the financialworld's compensation system, though only because taxpayershave footed the bill for finance's disastrous exploits. Even now,though, numerical caps make no sense, no matter how well theyplay to the gallery. The government should not determine how muchmoney a smart, talented individual can earn in finance, sports,acting, or any other field, no matter how obscene the payouts mightappear to regular folk.

A possible solution might give greater weight to the amount of riska bank takes to achieve its profits, with more speculative adventuresgenerating lower bonuses. That would help reduce traders' temptationto bet the ranch. Techniques that measure risk in proportion to rewardare far from perfect, but using them would still be better than notattempting the exercise at all.

Mark Gilbert is London bureau chief and a columnist on global capital markets for Bloomberg News. He has been with the company since 1991. Mark was born in Liverpool and graduated from Kings College, Cambridge, in 1989 with a BA (Hons) in philosophy. He was nominated as a finalist in the commentary category of the U.K. 2006 Business Journalist of the Year awards, and holds a Malcolm Forbes Award for Best Business Story from the Overseas Press Club of America. When he's not watching the markets, he plays bass guitar in a rock band.