In a reassessment of recent banking-stock selling history, reporter, Jacob Schlesinger, looks at the decisions which broke down financial industry safeguards.

On an unseasonably warm February morning in 1987, writes Schlesinger in today’s WSJ, three bank executives squared off against the Federal Reserve board in a crowded hearing room in Washington, D.C. Their mission was to persuade the Fed to start tearing down the half-century-old regulatory walls between the business of banking and the business of selling stocks and bonds

Paul Volcker, the Fed’s gruff chairman, was leery. He worried that easing the limits set by the Glass-Steagall Act of 1933 posed dangers: lenders recklessly lowering loan standards in pursuit of lucrative public offerings; banks marketing bad loans to an unsuspecting public.

Thomas Theobald, then vice chairman of Citicorp, countered that three “outside checks” on corporate misconduct had emerged since the financial shenanigans of the Roaring Twenties had led to Glass-Steagall. He cited “a very effective” Securities and Exchange Commission, knowledgeable investors, and “very sophisticated” rating agencies, according to a tape of the hearing.

Volcker remained hesitant, but most of his colleagues thought it was time to free the markets from the restraints of Glass-Steagall. The erosion of that landmark law was one of many steps that added up to a free-market sweep of Washington over the past quarter-century. Policymakers transferred onto the shoulders of investors more of the responsibility for steering financial markets and policing wrongdoing. Republicans and Democrats joined forces to loosen federal control over crucial economic sectors. Along with banking, they unshackled telecommunications and energy.

From the 1930s to the 1970s, Washington embraced an ever-greater role for the federal government. But the economic stagnation of the 1970s convinced politicians in both parties that the pendulum had swung too far. By the decade’s end, former president, Jimmy Carter, launched the modern deregulation movement by freeing up the airline and trucking industries. His successor, Ronald Reagan, even more enthusiastically embraced the wisdom of markets over bureaucrats.

The reforms, the officials believed, would unleash innovation and raise living standards. Those good things did happen. Deregulation and low interest rates spurred a burst of technological investment that accelerated the growth of the economy and slashed the unemployment rate. But the savviest policy makers knew they were making a choice “between economic growth with associated potential instability, and a more civil … way of life with a lower standard of living,” as current Fed Chairman Alan Greenspan recently put it.

Now, with corporate corruption on the upswing and the stock market on the downswing, the trade-offs are all too apparent. Deciding not to meddle, the Fed let the stock-market bubble expand and pop to devastating effect. The Telecommunications Act of 1996 cleared the way for highfliers such as WorldCom Inc., which imploded after the biggest accounting fraud ever. The airline industry, having never really learned to cope with deregulation, slid into a series of slumps including a particularly devastating one now.

The decision in the 1990s not to regulate the arcane financial instruments known as over-the-counter derivatives made it tougher to uncover accounting tricks favored by Enron Corp. And it is now obvious that investors, and the stock analysts who advised them, weren’t up to the task of making sure that corporate executives kept their priorities and books straight.