06.26.10

Firewalls In Financial Regulation

Posted in Financial Markets, Politics and Policy at 7:00 am

The term firwall originally referred to a physical separator or wall designed to prevent or slow the spread of a fire from one area to another.  Firewalls exist in buildings, where they are designed to limit the spread of fire from one section within a building to another or between buildings.  They also exist in automobiles (the metal wall between the back of the engine and the passenger compartment) where they serve to slow the spread of a fire that develops in the engine compartment to the passenger department.

Somewhere along the line, the computer industry picked up on the term, and started using it to refer to the security software used to protect computer networks.  The idea is largely the same – the firewall sits between the internal network and the external network (e.g., the Internet) and prevents problems on the outside from coming in.

Wherever they exist, the principle remains the same – problems (be they fire or malicious computer code) can never be completely avoided, but we can take steps to contain them or limit their spread.

Firewalls can also be used within a financial system to prevent contagion – a problem in one market from spreading to others.  Probably the most famous example of a financial firewall is the Glass-Steagall Act passed during the Great Depression.  Essentially, it created a firewall between the commercial banking system and the investment banking system.  The former was limited to taking deposits and making loans, while the latter was restricted to capital market activities like underwriting securities and providing broker-dealer functions.  The idea was to prevent problems in the capital markets from spreading to banks, where they could cause the entire payments system to collapse.

In general, firewalls should be an integral part of any financial system.  As noted above, we can never fully anticipate and prevent future problems.  However, we can take steps now, to build a system that structurally, can stop or slow problems from spreading, and thus give regulators sufficient time to address them when they arise.

One has to wonder – why are there essentially no firewalls in the latest version of the Financial Reform bill?

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