EVER SINCE the panic on Wall Street began in the fall of 2008, there have been calls for changes in how the financial sector is regulated. The most valuable would be reductions in both leverage ratios and scale for the Wall Street banks; an increase in the transparency of banks’ financial statements and complex derivative instruments; and enhanced consumer protections. Unfortunately, these changes have not been enacted, and taxpayers remain angry about being taken into hock to restore Wall Street’s lofty compensation while unemployment remains near its post-Depression high. To move forward, political leaders should look more fundamentally at whether Wall Street’s work produces gains too rich for the economic value provided and the systemic risks introduced.
Leading Wall Street firms no longer think of themselves primarily as investment banks and commercial lenders, channeling money to growing companies and spurring free enterprise. Their big profits now come from trading, defined broadly to include the securitization of debt and simultaneous repurchasing of similar debt securitized by others.
Washington has been slow to consider whether the furious level of trading activity, in addition to exacerbating America’s corrosive income disparities, is a result of ill-conceived policies. The public may see the realities more clearly than the policymakers, too many of whom are mired in the fallacy that boosting Wall Street profitability to its prior levels is both necessary and sufficient to bring the rest of the economy back to prosperity. It is neither necessary nor sufficient, and it is fair to inquire whether such a course may even be counterproductive.
To understand the situation, one can start with the national income accounts. Real dollars profits of all non-financial US corporations have increased at an average annual rate of roughly 1 percent over the last 30 years. Financial sector profits more than tripled in that same period, and they had quadrupled in real dollars at their pre-crisis peak. All this moving money around has not made the country better off as a world economic competitor or as an engine of job creation. It is little wonder that there is so much fear of competition from China, where the financial sector has not taken the whole front row.
The business profits that economists admire come from value added (a nice consequence of successful manufacturing and technology), or from wisely allocating capital to companies that then prosper (the source of gain for venture capitalists and fundamental investors). The trading profits that supercharge Wall Street’s bonuses are of many types, but generally provide less value added or enhancement of sound capital allocation than traditional banking activities.
Wall Street’s trading is too often zero-sum in nature, with an explicit loser for every winner. Given the gains for the bankers, don’t the ultimate losers have to be non-financial businesses and traditional investors, exactly the parties on whom real economic prosperity depends?
A potentially valuable element of the trading volume results from the sale of hedging instruments, which can serve to reduce risk for a commercial business. These, however, can be of benefit to the client and the economy on balance only if: they are sold at fair and reasonable prices; they are sold by entities that can actually meet the obligations, without taxpayer subsidies, when things go wrong; and they don’t create more systemic risk for the economy than they remove for the buyers. These tests have proven unmet in all too many recent examples.
Wall Street activities such as providing a secure payments mechanism, investment banking, residential and commercial lending, and fundamental research are indeed all vital to the success of the economy as a whole. The role of the payments mechanism alone justifies extending government guarantees to commercial banks. It does not follow that all other activities of banks and brokers are necessarily boons for the economy, and that every other profitable activity must be permitted indiscriminately simply because its profits might add to funding for the core activities. We all learned recently that trading can put the core activities at risk.
A course of remedy is readily available once the myths are laid aside, though multiple goals require multiple elements of cure. Paul Volcker deserves support for urging that commercial banks be prohibited from employing the large balance sheets provided by insured deposits to support proprietary trading. This would help protect the banks from a next crisis.
If the objective is to remove a drag that today’s massive trading activity places on the broader economy, there should also be a tax on transactions, perhaps with rates that vary inversely by holding period. A per-transaction tax at a small percentage of the value traded would be all but invisible to everyone but professional traders.
If Wall Street bonuses are a concern of policymakers, the best medicine would be to require that all derivative instruments be traded on exchanges, or at least cleared through strong clearing houses, without the proposed exemption for so-called customized instruments, and with all the benefits of posted prices and default guarantees. The controversial bonuses would begin to take care of themselves. It is a lack of transparency in derivatives markets, more than any other factor, that generates the unfathomable pool of available bonus money and unsettles today’s political landscape.
American non-financial businesses generally do not support disclosure, but they ought to. Price transparency and the reduced costs it implies would be vastly more valuable to those non-financial businesses than the protection of privacy for their dubious hedging strategies.
Were only one change possible, the most constructive would be to forbid financial institutions of all types from operating with the sky-high leverage that catalyzed an inevitable cyclical turn in real estate prices into an international disaster. Trading at a scale beyond comprehension and the use of excessive leverage together constitute systemic nitroglycerine.
If more can be done, we should look to the other half of this admixture and trim the overall scale of trading. This step could provide wide public dividends. A reduction in the level of trading would lighten a burden on the real economy, decelerate the trend toward income inequality, remove an injurious distortion in employment markets, protect vital intermediary institutions, and allow market forces to trim Wall Street’s compensation.
The oversized financial sector profits that make voters see red are not, as some in government have been convinced, just an inevitable, if unpleasant, by-product of a vibrant and free economy. A sensibly organized, well-regulated, and transparent free marketplace would never have granted profits of that magnitude for such questionable value added in the first place.
James M. Stone, former chairman of the Commodity Futures Trading Commission and Commissioner of Insurance for Massachusetts, is CEO of the Plymouth Rock group of property and casualty insurance companies.
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