10:58am

Tue January 17, 2012
Planet Money

Does Wall Street Need Downsizing? (Part II)

Originally published on Tue January 17, 2012 10:13 am

Note: This is the second of two related posts.

In his latest New York Times Magazine column, Adam Davidson writes that Wall Street, "play[s] the crucial role of intermediation — matching borrowers with lenders. Most of the time, the industry does this extremely well." Of course, sometimes the industry does it poorly. So how often does Wall Street engage in valueless lending?

To continue the discussion, we asked two economists on different sides of the debate - Thomas Philippon of New York University and John Cochrane of the University of Chicago - to answer the following question:

"How much fat can we cut out of Wall Street?"

John Cochrane's response is below. To read Thomas Philippon's response, click here.

Wall Street is big. Much of its recent growth comes from fees paid to hedge fund managers or other active traders. Chicago-school economists have been deploring this for decades – trading is a zero sum game. On the other hand, it's a pretty free market. If wealthy people want to pay hedge fund managers to churn the portfolio, that's their business. Kim Kardashian gets $600,000 just to show up at a nightclub. There are a lot more fashion designers in Milan than seem "socially necessary." Who is to play central planner here? (Though, the number of tax-free endowments handing money to active managers does raise some flags.)

Before you feel too jealous of managers and traders, note that working on Wall Street is one of the riskiest occupations in the country. This week's news announced big bonus cuts and layoffs. In how many other jobs can large numbers of workers routinely get their salaries cut in half?

Private equity managers much deplored in the news these days also serve a vital social service. What keeps private companies from looking like, say, the post office? Only the threat of a rapacious Wall Street takeover.

Adam is exactly right on regulations as well. Our government gave big banks a huge incentive to gamble, with taxpayers covering the losses because they're "too big to fail." Then, we hoped to "regulate" their activities. But the banks were always one step ahead of the regulators, and they will remain so. We're doubling our bets on this regime. Wall Street will surely get bigger, with armies of lawyers, accountants, financial engineers, and lobbyists to navigate profits out of the Dodd-Frank Rube Goldberg contraption. But whose fault is that? It feels good to deplore "greed," but is there any chance that doing so will change matters?

I have hope for the financial system, and for much-maligned financial engineering. In the 1930s, each mortgage was held by the local bank, funded by local deposits. When the mortgages failed, the bank failed, depositors failed; other banks were legally prohibited from entering, so the people who knew how to make loans were unemployed. In 2008, the mortgages were, with government encouragement, bundled into run-prone securities to avoid banking regulation.

But the mortgage-backed security is a great invention. If the originator fails, another bank can sweep in and buy the lending operation, putting it right back in business. The securities can go into a long-only mutual fund, held by a pension. If some mortgages fail, investors on the other side of the world lose money. Global risk sharing! No run, no crisis, no bailout. This is much easier than loading the whole thing on the balance sheet of some huge multinational bank, leveraged 10:1, and hoping that equity analysts and green eyeshade regulators can keep an eye on risks. Financial innovation can still give us a run-free, small enough to fail, financial system.

Copyright 2012 National Public Radio. To see more, visit http://www.npr.org/.