How the City Will Look in the Future

Before investors and policymakers sign on to the idea that bigger is better, that the whole of HBOS and Lloyds TSB is greater than the sum of its parts, that the world is best served by a proliferation of Citigroups, and that the last two investment banks left standing should find shelter in the arms of big, commercial banks, let me try to make a few contrarian points.

First, and most important, this is not a good time to make decisions about the future structure of the financial-services industry. Calm heads have yet to prevail; the ordinary investor is quite properly seeking shelter from the storm by buying safe government IOUs: and we do not yet know the details of Treasury secretary Hank Paulson’s plan to substitute a general solution for the ad hoc measures he has been taking.

But we do know a few things about what has made America’s capital markets work well enough over time to assure that resources are efficiently allocated, that new businesses get funded and that badly run or obsolete businesses get starved of capital so they are no longer a drain on the nation’s resources. Not perfectly, and not always, but well enough and often enough to underwrite a high standard of living.

So we should be careful before we wave goodbye to Goldman Sachs and Morgan Stanley, the one fighting to remain independent, the other said to be negotiating with Wachovia to shelter in its not-terribly muscular arms now that China Investment Corporation has announced it will not raise its current 9.9% stake to 49%.

These firms’ survival is about more than their shareholders and employees: it is about the survival of innovation and entrepreneurship at the heart of the financial system.

Now I have nothing against large commercial banks. They do a reasonable job of collecting customers’ deposits, aggregating them, and lending that money to businesses, profiting from the difference between what they have to pay depositors and what they charge commercial borrowers. But when banks expand into unfamiliar areas, the management problems become complex, corpo-ratism overtakes individualism and (at best) workmanlike management replaces entrepreneur-ial daring.

Which brings me to Goldman Sachs, the poster boy for hard-driving capitalism. There is a perception that it wouldn’t be a bad thing if these masters of the universe got their come-uppance, as did Lehman Brothers, which went broke, and Merrill Lynch, which was forced to find a buyer.

That lumps together noncomparable companies. At the time of its takeover by Bank of America, Merrill Lynch had almost six times as much tied up in problem-area loans - residential and commercial property and leveraged loans to hedge funds – as it had capital. When Lehman went under, its ratio of shaky loans to its own capital was 3.4 times. Goldman Sachs, on the other hand, saw hard times coming and cut its problem loans from 2.5 times its own money to a mere one times those funds. Management matters.

One reason so many of the financial institutions have disappeared or have gotten into trouble is that they have hesitated to recognise that some of their decisions have been just awful. They have stuff on their books at valuations that are no longer close to reality, despite the general accounting rule that all assets should be on the books at their current market value - “marking to market” is the term accountants use. So instead of taking their medicine in one gulp, they dribble out write-downs every quarter. Goldman, on the other hand, marks its assets to market every day. And more or less gets it right: in the vast majority of its recent sale of mortgage assets, the firm realised prices equal to or in excess of the values it had assigned to the assets.

This is not a pitch for Goldman Sachs. I have no way of knowing whether in the long run it will benefit more from being one of the last banks of its kind, with less competition, than it will be hurt by the slowing of economic activity and dealmaking. But I do know that if we end up without these independent sources of ideas and risk-taking, the nation will be the poorer.

I also know it is more important than ever to preserve independent sources of ideas now that we are likely to have more intrusive government regulation of the financial sector - with some justification. Recent financial innovations created securities so complex that risk managers and rating agencies were unable to appraise the risks they carried. Since they and their bank colleagues were quite willing to reap the profits, they should also be made to reap the whirlwind.

After all, Paulson has to draw the bail-out line somewhere, and that somewhere is where he drew it in the case of Lehman Brothers - or thought he did. The theory is clear: in the case of Freddie Mac, Fannie Mae and AIG, the collateral damage of their failure was too gruesome to contemplate. Not so with Lehman Brothers - right? Surveying the devastation caused by its demise, one has to wonder. Still, it can be argued that if finance capitalism cannot survive the failure of a single investment bank, perhaps capitalism should finally be consigned to the dust-bin of history.

Which, fortunately, it will not be. Sensible policy trumps panic every time, as Friday’s share-price snap-back shows. Yes, there will be some painful adjustments. And, yes, the financial sector will never be quite the same again, with a new mix of public and private-sector emphasis. But the dust-bin of history will just have to wait for the consignment that will someday follow communism - and it certainly won’t be American capitalism.