The financial reform should include some way of separating banks' proprietary trading from commercial banking, although a return to regulation similar to the Glass-Steagall Act would be impractical, legendary investor George Soros wrote in the Financial Times.
"Proprietary trading ought to be financed out of a bank's own capital," Soros wrote in the opinion piece. "If a bank is too big to fail, regulators must go even further to protect its capital from undue risk. They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned."
Hedge funds and other big investors should be monitored to ensure that they don't accumulate "dangerous imbalances," while the trading and issuing of derivatives should be as strictly regulated as that of stocks, he wrote.
"Custom-made derivatives only serve to improve the profit margin of the financial engineers designing them," Soros said, reiterating his view that some derivatives, such as credit default swaps, should be outlawed.
The efficient market hypothesis is "unrealistic," as individuals in markets may ignore imbalances if they think they can liquidate their positions, but regulators cannot ignore these imbalances, he warned.
Under financial reform rules due to be unveiled by the Obama administration later Wednesday, securitization originators, sponsors or brokers would have to keep at least 5 percent of the risk in them.
But Soros said the requirement should be doubled to 10 percent, to make sure the agents have "skin in the game," as the securitization of mortgages added a new dimension to risk, with agents more interested in maximizing fee income than in protecting the interests of bondholders.
Securities held by banks should carry a higher risk rating than they do under the Basel Accords, while the availability of credit must be controlled to control future asset bubbles, he also wrote.