Big banks are too big – and unproductive

The American financial industry has become too big for its britches.

And that bloated growth has not contributed much to the real economy in the past two decades, some economists hold.

Indeed, it is "making the mainstream economy harder to function," says Ann Lee, a finance professor at New York University. Before the financial crisis, a huge portion of Wall Street had become a kind of giant casino, with traders raking in huge profits at the expense of investors such as pension funds, mutual funds, etc. Instead of just taking savers' bank deposits and loaning them to business for productive activity, financial firms were creating trillions of dollars of shaky financial paper – derivatives – that provided rich fees to reward the paper pushers. "A hundred trillion [dollars] of worthless activity," says Ms. Lee.

Already by the late 1990s, total borrowing by the financial sector was high by historical standards: equivalent to 54 percent of the gross domestic product, the nation's output of goods and services. By 2007, the borrowing amounted to 117 percent of GDP, notes Jane D'Arista, an expert at the Political Economy Research Institute, a unit of the University of Massachusetts, Amherst.

Then the financial house of cards collapsed.

"We had a run on the financial sector by the financial sector," says Ms. D'Arista.

Just as depositors may withdraw money suddenly if they fear their bank isn't sound, Wall Street firms no longer trusted one another. Too much bad investment went unreported on the balance sheets of financial institutions. Their books were too opaque.

Something similar happened in Britain. Some of the financial industry's growth was illusory, according to Mervyn King, governor of the Bank of England. Like former Fed Chairman Paul Volcker and President Obama, he has called for splitting up big banks. He says they should break off their higher-risk trading and investment banking wings from their government-guaranteed, deposit-taking business.

Lee approves of that proposal. But she doesn't believe the industry will be sufficiently cut down to size by the Obama administration's proposed pinprick tax. It wants to impose a 0.15 percent levy on the financial conglomerates' debts (not counting their deposits). "It's hardly enough to change structurally what is wrong," she says.

Mr. Obama's references to finance in his State of the Union message amounted to "a lot of hot air," she says. "Where are all the details?"

The former hedge-fund employee wants regulators to limit the leverage of investment banks. Instead of being able to borrow and invest 30 or 40 times their owned capital, they should be limited to perhaps 12 times their capital, she says.

Nor does she see tougher regulation of big US banks as endangering their competitive position internationally. China, she notes, separates commercial banking from investment banking, as was done (in theory) in the United States until the repeal of the Glass-Steagall Act in 1999.

In general, Wall Street advocates argue that some speculation is needed to provide market "liquidity" – enough buyers and sellers to move large quantities of stocks and bonds quickly when an order is received. Conservatives, wary of more regulation, also tend to support the status quo.

Lee, however, maintains that the five "too big to fail" US banks have such a large proportion of buying and selling orders that their traders have an unfair information advantage in the market. There is not enough competition.

• David R. Francis writes a weekly column.