What Should Wall Street Do? Disappear!

The latest "Schumpeter" column in The Economist makes the case that large financial firms ("Wall Street") have not been doing enough to defend themselves against the onslaught of criticism coming out of the Occupy Wall Street movement. He says that banking is important to the economy: "....people still need loans and somewhere to park their savings.  Companies...need investment banking to help them manage their finances and grow."

Yes, but....For a long time, Wall Street has not been about maximizing social utility, and bank chiefs--who are by and large the same cast of characters that crashed the financial system to begin with-- have not been thinking about these things.  Instead they have been thinking about how to make a killing either by selling a new opaque, fee-laden product, or by taking advantage of some informational edge to make money trading in the market.

It is easy to make a case that the plain vanilla services that banks offer -- taking deposits, making loans (not repackaging them and selling them off right away), even helping companies issue stocks and bonds--are a public good.  The problem is, this is not how hot-shot Wall Street bankers got rich over the last 20 years.  They did it by trading, or through financial engineering.  And the only reason they were able to do this is because they were able to convince our public guardians to look the other way, and somehow convince the public that it was all part of a healthy, vigorous free-market system.

Paul Volcker has it right; banks should not be trading with government-insured deposits.  I believe they should  not resist putting derivatives onto exchanges where they would trade efficiently with the lowest spread possible. And probably credit default swaps should be regulated as insurance contracts, which would effectively make them illegal.

"Middle class Wall Street"--brokerage, custody, retail banking--has been shrinking for decades as a result of technology.  But Wall Street as a whole has been growing, as firms take advantage of deregulation to make money in ways that offer very little public benefit.  Can Jon Corzine make the case that by having his firm, MF Global, invest $6 billion in European bonds on a capital base of $500 million he was somehow benefiting society?  I would like to hear that.

Yes, modern society needs banks.  But it does not need super-sized institutions whose main source of profits is trading, it does not need opaque and gargantuan over-the-counter derivatives markets, and it does not need regulated institutions making leveraged bets and paying out 7-figure bonuses.

Technology should be making the banking industry shrink every year.  Profits should be shrinking, not just jobs.  Yes, this would be bad for places like New York in the short term.  But in the long term it will be good for society as a whole, as borrowers, lenders and investors are matched together at the lowest cost possible.  And New York has recovered from worse dislocations than this.

A truly free market should lead to less money for Wall Street middle men, not more, as their margins and fees are squeezed through competition.  Of course, if all profit is squeezed out, then banks will go under, which will hurt society.  So the case can be made for regulating banks as a public utility, allowing them to maintain a certain profit margin in exchange for submitting to price controls and strong regulatory oversight--like what is done with power plants and railroads.

If a Lloyd Blankfein or a Jamie Dimon wants to come out and make the argument for downsizing trading, profits and bonuses and returning banking to the conservative, risk-averse, highly regulated activity it once was, then I'm sure America will be most grateful, and protests may even calm down.  But we know how these guys made their money, and how they continue to make it.  There is no reason to expect them to change.  They will continue to keep their heads down, pay their lawyers and lobbyists, and keep raking it in for as long as it lasts.