An Ex–Goldman Partner Lets Loose on Wall Street

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Peter Morgan / AP

The New York Stock Exchange on Wall Street

Roy Smith, a finance professor at New York University and a former Goldman Sachs partner, argues in Paper Fortunes, his new history of Wall Street, that decades of financial innovation that seemed like positive evolutions at the time have turned our markets into scary places. In part, Smith says Wall Street is fixing its problems by reining in pay and lowering leverage ratios. But he believes Washington and regulators still need to intervene to make financial markets safer.

You've just completed an 80-year history of Wall Street. What did you learn?
There is now about $140 trillion in market capitalization in the word's financial markets looking for investments. That money can now move around very easily. But even if a relatively small portion of that money goes after something — say, mortgages — it can quickly cause a bubble and a crisis. So all this good work we have done in the past few years to make our capital markets more efficient and open has also made them very hazardous, and we haven't done anything yet to address that problem.

What should Washington be doing?
We need to do something about firms that are too big to fail. These firms have become loss transmitters and accelerators to the rest of the system. We need to distribute the risk, not concentrate it in a few very large players. There are a number of ways to do that.

Like what?
One approach is to lay on a heavy cost of being big. Too-big-to-fail banks should have a capital cost that will make it a disadvantage to compete in the riskiest parts of the financial-services market. I also like President Obama's recent proposal, the so-called Volcker Rule, which would limit proprietary trading and investing. Combining these two regulatory changes ought to encourage big banks to figure out new business strategies, and that would involve selling off some of their riskier businesses.

A lot of people are saying that proprietary trading didn't cause the financial crisis. So why focus on that?
Proprietary investing certainly played a big role in the financial crisis. Bear Stearns, Merrill Lynch, Lehman Brothers, UBS and Citigroup all had large amounts of mortgage bonds or real estate investments that they had parked on or off their balance sheets — but were responsible for. They were chasing the same higher yields that all their investing clients were. Those investments comprised the greatest part of those firms' write-offs. Those weren't client-driven trades. They decided to take them themselves. The idea that proprietary trades were a trivial part of the losses at the banks is just not realistic.

Wall Street also seems unhappy about a fee for being big.
Financial executives don't like the idea of having to pay a too-big-to-fail tax, but nonetheless I think they get it. Banks pay for deposit insurance — this just extends the idea to the rest of the bank's liabilities, which get covered by implicit too-big-to-fail guarantees. What a lot of firms don't like is the idea of having to pay a financial-crisis-responsibility fee for the next decade, as Obama has proposed to recoup TARP loans to AIG, the auto industry and smaller banks. Economists I know don't think that idea is either fair or sensible from a policy standpoint. Nor do I.

Why not just break up the biggest firms?
I'm a Republican and a former Wall Streeter and don't favor government intervention in markets. But I can see where breaking up the banks would be a positive for the free markets. We want a system where firms are able to take risks, but we have to protect ourselves from the risks eating us alive, which can happen when the risks are concentrated in just a few banks. Breakups would distribute risk over a greater number of players and would probably be good for the banks as well. Most financial firms are trading at very low multiples these days because of their inherent trading and balance-sheet risks. Most investors just can't understand them. They are too much like black boxes. Once you lessen the risk, the value of the strong underlying banking franchises ought to be more visible and appreciated.

But it was the largest firms that survived the crisis. Could one argue that financial firms need to get bigger, not smaller?
There is no evidence that large, multiplatform banks are more efficient or able to sustain risk than smaller banks. When I was on Wall Street, we used to have at least 20 firms that competed in the market. My book is the story of how Wall Street started as a group of small firms, and how those firms maneuvered to survive and prosper, but in the process, most either failed or were swallowed up by others. The net result has been a positive for users of capital markets, which can be accessed more cheaply than ever before. But the success of the market has resulted in a vast accumulation of capital in tradable form that is now capable of wrecking whole economies. In 2000 and 2007, financial bubbles did great damage, and the monster is still out there.